UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

Form 10-K

 

 

 

Commission File No. 1-10317

LSI CORPORATION

(Exact name of registrant as specified in its charter)

 

1621 Barber Lane

Milpitas, California 95035

(Address of principal executive offices) (Zip Code)

 

Registrant’s telephone number, including area code:

(408) 433-8000

 

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

 

 

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

NONE

 

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

 

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

 

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

 

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

 

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

 

 

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

 

The aggregate market value of the voting and non-voting common stock held by non-affiliates of the registrant as of June 29, 2008 was approximately $4.1 billion, based on the reported last sale price on the New York Stock Exchange of such equity on the last business day of the fiscal quarter ending on such date.

 

As of February 20, 2009, 648,135,650 shares of common stock were outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Certain information required by Part III of this report is incorporated by reference from the registrant’s proxy statement to be filed pursuant to Regulation 14A with respect to the registrant’s 2009 annual meeting of stockholders.

 

 

LSI Corporation
Form 10-K
For the Year Ended December 31, 2008

 

FORWARD-LOOKING STATEMENTS

 

This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. The words “estimate,” “plan,” “intend,” “expect,” “anticipate,” “believe” and similar words are intended to identify forward-looking statements. Although we believe our expectations are based on reasonable assumptions, our actual results could differ materially from those projected in the forward-looking statements. We have described in Part I, Item 1A-“Risk Factors” a number of factors that could cause our actual results to differ from our projections or estimates. Except where otherwise indicated, the statements made in this report are made as of the date we filed this report with the Securities and Exchange Commission and should not be relied upon as of any subsequent date. We expressly disclaim any obligation to update the information this report, except as may otherwise be required by law.

 

 

General

 

We design, develop and market complex, high-performance semiconductors and storage systems. We provide silicon-to-system solutions that are used at the core of products that create, store, consume and transport digital information. We offer a broad portfolio of capabilities including custom and standard product integrated circuits used in hard disk drives, high-speed communications systems, computer servers, storage systems and personal computers. We also offer external storage systems and host bus adapter boards and software applications for attaching storage devices to computer servers and for storage area networks.

 

Integrated circuits, also called semiconductors or chips, are made using semiconductor wafers imprinted with a network of electronic components. They are designed to perform various functions such as processing electronic signals, controlling electronic system functions and processing and storing data.

 

Our business is currently focused on providing integrated circuits for storage and networking applications and on providing storage systems and related boards and software. Since the beginning of 2007, we have completed the following actions as part of our efforts to focus on those areas:

 

 

 

We operate in two segments — the Semiconductor segment and the Storage Systems segment. We market our products primarily to original equipment manufacturers, or OEMs, that sell products to our target end customers. In 2008, the Semiconductor segment accounted for approximately 67.1% of our revenue and the Storage Systems segment accounted for approximately 32.9% of our revenue. You can find additional financial information about our segments and geographic financial information in Note 9 to our financial statements in Item 8. See Item 1A — “Risk Factors” for information about risks we face as a result of our operations outside the United States.

 

Our Semiconductor segment designs, develops and markets highly complex integrated circuits for storage and networking applications. These solutions include both custom solutions and standard products. Custom solutions are designed for a specific application defined by the customer. Standard products are developed for market applications that we define and are sold to multiple customers. Our Storage Systems segment designs and sells enterprise storage systems. Our high-performance, highly scalable open storage systems and storage solutions are distributed through OEMs. The Storage Systems segment also offers host bus adapters; redundant array of independent disks, or RAID, adapters; software and related products and services.

 

Shortly after the Agere acquisition, we changed our name to LSI Corporation from LSI Logic Corporation. LSI Logic Corporation was incorporated in California on November 6, 1980, and was reincorporated in Delaware on June 11, 1987.

 

We maintain an Internet website at www.lsi.com. We make available free of charge on our website our annual reports on Form 10-K, our quarterly reports on Form 10-Q, our current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) of the Securities Exchange Act of 1934 as soon as reasonably practicable after we electronically file such material with, or furnish it to, the U.S. Securities and Exchange Commission. You can read any materials that we file with the Commission at the Commission’s Public Reference Room at 100 F Street, N.E., Room 1580, Washington, D.C. 20549. You can obtain information on the operation of the Public Reference Room by calling the Commission at (800) 732-0330. Information on our website is not incorporated by reference into this report.

 

Products

 

SEMICONDUCTOR SEGMENT

 

Storage Products

 

Hard Disk and Tape Drive Electronics.  We sell integrated circuits for hard disk and tape drive solutions, which are used to store and retrieve data in personal computers, corporate network servers, archive/back-up devices and consumer electronics products such as digital video recorders, game consoles and digital media players. A disk drive contains physical media, one or more “platters” that store data, a motor that spins the media, drive heads that read data from and write data to the media and electronics that process the data and control the disk drive. Tape drives store data on magnetic tape and provide a high capacity, cost effective tiered data storage back-up solution. In 2008, we began developing integrated circuits for use in solid state storage devices, which store data in flash memory instead of on a hard disk.

 

Our TrueStore^® family of storage electronics products includes systems-on-a-chip, read channels, pre-amplifiers, serial physical interfaces and hard disk controllers as well as custom firmware. These are the critical chips required to read, write and protect data. We offer products that can be used in a variety of hard disk applications, including hard drives intended for notebook computers, desktop computers and enterprise computers, and in tape drives.

 

A storage system-on-a-chip, or SoC, is an integrated circuit that combines the functionality of a read channel, serial interface, memory and a hard disk controller in a small, high-performance, low-power and cost-effective package.

Read channels convert analog signals that are generated by reading the stored data on the physical media into digital signals. Analog refers to a transmission technique employing a continuous signal that varies in amplitude, frequency or phase of the transmission. Digital refers to a method of transmitting, storing and processing data that uses distinct electronic or optical pulses to represent the binary digits 0 and 1. We also sell pre-amplifiers, or preamps, which are used to amplify the initial signal to and from the drive disk heads so the signal can be processed by the read channel. We provide similar technology for tape drives. Our hard disk controllers are used to control signal processing and communications functions within the disk drive.

 

Storage Interface Products.  We also offer solutions that make possible data transmission between a host computer and storage peripheral devices such as magnetic and optical disk drives and disk and tape-based storage systems. These products include:

 

 

Networking Products

 

We offer comprehensive solutions that allow networking service providers to deliver a variety of highly reliable communications services to homes, businesses and mobile users over Internet Protocol, or IP, networks. IP networks are packet based. In an IP network, packets of data that are part of the same telephone conversation or video program can be routed over different paths. Traditional telephone networks are circuit-based where all data packets follow the same dedicated path or circuit. Historically, the dedicated paths in circuit-based networks have provided greater reliability than packet-based networks, although at the cost of flexibility.

 

Our networking solutions are designed to enable IP networks to provide reliability similar to that of circuit-based networks and incorporate quality of service features that allow more critical data to receive priority over less critical data. For example, packets containing data about a television picture, where a delayed packet can mean a noticeable flaw in the picture, can be delivered before packets containing web-page data being downloaded to a personal computer, where a slight delay is less likely to be noticed.

 

Our networking portfolio includes solutions for carrier-managed gateways that would be used in residential, small office, home office and small-to-medium business applications. The portfolio also includes solutions for multi-service wired and wireless access systems found in carrier networks. Multi-service systems can handle traffic such as data and video in addition to voice. Our networking solutions include chips such as our network processors, digital signal processors, content-inspection processors, traffic shaping devices and physical layer devices as well as software, evaluation systems and reference designs. Our development efforts are focused on multicore processor SoCs to deliver solutions for wireline and wireless access, media gateway, service provider and enterprise networks.

Network Processors

 

Network processors are typically used in switching and routing systems to classify, prioritize and forward packets as they move through a carrier’s network. We offer network processors with the ability to handle a range of data throughputs, from 200 megabits per second up to 6 gigabits per second. Megabits and gigabits are units of measurement for data. A megabit is equal to approximately one million bits and a gigabit is equal to approximately 1,000 megabits. For example, our APP2200 family provides a lower cost solution intended for systems located between the customer’s premises and the carrier’s local central office, where data throughput demands are lower, but the need to prioritize the packets is still critical for all services to be delivered successfully. Our APP650 is a higher throughput solution designed for use in systems that are closer to the core of a carrier’s IP network, where data throughput demands are higher.

 

Digital Signal Processors

 

Digital signal processors, or DSPs, transform analog signals into digitally-encoded bitstreams and perform advanced algorithms on these bitstreams. Our DSPs perform audio, video and speech signal processing, compression and transcoding and can be used in applications including Voice-over-IP, or VoIP, business and enterprise gateways, video delivery, media gateways and wired and wireless access network equipment.

 

Content Inspection Processors

 

We offer a family of content-inspection processors, which are available as integrated circuits, boards and software acceleration components designed for network equipment, appliance and server vendors. Our Tarari^® content inspection processors perform deep packet inspection at wire speeds, ranging from 100 megabits per second to over 10 gigabits per second. These products offload and accelerate applications such as anti-virus, anti-spam, intrusion prevention/detection systems, compliance, content-based routing and XML processing.

 

Network Traffic Aggregation and Framing Solutions

 

In addition to the networking products described above, we offer chips with supporting software that are designed for equipment used in metropolitan and wide area backbone telecommunications networks. That equipment can be used in both wired and wireless networks.

 

Broadband Aggregation Devices.  Broadband is a general term that refers to high-speed data transmission. Our broadband access integrated circuits, or mappers, support data transport between central offices and enterprise sites by aggregation and termination. Aggregation refers to the combining of many low-speed, or tributary, data signals from enterprises into higher speed, or trunk, data signals for transmission to a central office. Termination refers to the separation of trunk data signals into lower-speed, tributary data signals.

 

Our products support data transport for T-carrier data transport in North America. T-carrier is a digital transmission service from a common carrier. We support similar services worldwide. These services are referred to as J-carrier in Japan and E-carrier in Europe. T-carrier services such as T1 and T3 lines are widely used to create point-to-point networks for use by enterprises. T1 and T3 lines refer to different levels of T-carrier service that transmit data at 1.544 megabits per second and 44.736 megabits per second, respectively.

 

SONET/SDH Network Devices.  Synchronous optical networks, which are typically referred to as SONET, and synchronous digital hierarchy standard networks, or SDH, carry data, voice and video traffic through a network by combining lines carrying traffic at slower speeds with lines carrying traffic at higher speeds. This process is known as multiplexing, and involves directing traffic from the individual lines into designated time slots in the higher speed lines, and directing those lines into still higher speed lines. The SONET/SDH equipment that handles the directing of traffic into slower speed and faster speed lines is the add-drop multiplexer. Add-drop multiplexers handle the addition and removal of traffic from a SONET/SDH communication transmission. We offer single-chip integrated circuit solutions called framers, for add-drop multiplexing of data and voice traffic. In addition, our framers are used in high-speed routers within optical networks. A router is an interface, or link, between two networks.

Personal Connectivity Solutions

 

We sell high speed input/output products primarily to manufacturers of computers, peripheral equipment and communications equipment. Input/output refers to the transfer of data within and between computers; peripheral equipment, such as printers, scanners and digital cameras; and data networks. Our products support established connectivity and transmission standards known as Gigabit Ethernet, IEEE-1394, and Universal Serial Bus or USB.

 

In addition, we sell integrated circuits and associated software for modem products, primarily to leading manufacturers of personal computers, notebook computers, point-of-sale terminals, facsimile machines, multi-function printers, cable and satellite set-top boxes and other electronic equipment.

 

Other Networking Products

 

We also sell integrated circuits that are custom developed for our customers. These integrated circuits incorporate our intellectual property or combine our intellectual property with the intellectual property of our customers or other third parties to create a customized solution for these customers. For some customers, we design and manufacture the integrated circuit while the key intellectual property belongs solely to our customers.

 

We believe that our systems-level knowledge and integrated circuit design methodologies allow us to turn our customers’ design concepts into systems solutions quickly and effectively. Our intellectual property gives our customers the flexibility to customize their products to meet their individual cost and performance objectives.

 

STORAGE SYSTEMS SEGMENT

 

We offer a broad line of open, modular storage products comprised of complete systems and sub-assemblies configured from modular components, such as our storage controller modules, disk drive enclosure modules, related management software and advanced data protection software for creating local and remote copies of critical data. The modularity of our products provides our original equipment manufacturer, or OEM, customers with the flexibility to integrate our sub-assemblies with third-party components, such as disk drives, or software to form their own storage system products. Our modular product approach allows OEM customers to create highly customized storage systems that can then be integrated with value-added software and services and delivered as a complete, differentiated data storage solution to enterprises.

 

We design and develop storage systems, sub-assemblies and storage management software that operate within all major open operating systems, including Windows, UNIX and UNIX variants and Linux environments. We test and certify our products, both independently and jointly with our customers, with those of other hardware, networking and storage software vendors to ensure a high level of interoperability and performance. Our products are targeted at a wide variety of data storage applications, including Internet-based applications such as online transaction processing and e-commerce, data warehousing, video editing and post-production and high-performance computing.

 

We offer entry level and mid-range storage systems. In 2008, we introduced a new mid-range storage system platform, the Engenio 7900, which delivers enhanced performance, reliability and scalability. We also recently introduced our LSI StoreAge^TM SVM suite of hardware and software products that provide virtual storage capabilities in a heterogeneous storage environment enabling customers to achieve better utilization of SAN assets.

 

In addition, we offer a wide spectrum of direct-attach redundant array of independent disks, or RAID, solutions as part of our MegaRAID^® product family. Our MegaRAID products include single-chip RAID-on-motherboard solutions, a broad family of PCI-X and PCI Express RAID controller boards featuring SATA and SAS interfaces, and our software-based RAID products for entry level RAID data protection. All of these solutions utilize MegaRAID’s fully featured RAID software and management utilities for robust storage configuration and deployment.

Marketing and Distribution

 

Semiconductor Marketing and Distribution

 

The semiconductor industry is highly competitive and is characterized by rapidly changing technology, short product cycles and emerging standards. Our marketing strategy requires that we forecast trends in the evolution of products and technology. We must then act upon this knowledge in a timely manner to develop competitively priced products offering superior performance or integration. As part of this strategy, we are actively involved in the formulation and adoption of critical industry standards that influence the design specifications of our products.

 

Our semiconductor products and design services are sold primarily through our network of direct sales and marketing and field engineering offices located in North America, Europe, Japan and elsewhere in Asia. We also work with independent component and commercial distributors and manufacturers’ representatives or other channel partners in North America, Europe, Japan and elsewhere in Asia. Some of our distributors possess engineering capabilities, and design and purchase both custom solutions and standard products from us for resale to their customers. Other distributors focus solely on the sale of standard products.

 

Storage Systems Marketing and Distribution

 

We sell our storage systems products and MegaRAID products to our OEM customers who sell them worldwide under their own brand identities using their sales and distribution channels. We also distribute our MegaRAID products through a network of resellers and distributors, who resell the products to end users with additional hardware, software and services, or on a standalone basis for use with existing equipment.

 

The products sold by our OEM partners may be integrated by the OEM with value-added services, hardware and software and delivered as differentiated complete storage solutions to enterprises. We work closely with our OEM customers and tailor these relationships to meet the diverse needs and requirements of end customers worldwide. We also provide our OEM partners with training services to enhance their abilities to sell and support our products. After receiving our training services, most of our OEM partners independently market, sell and support our products, requiring limited ongoing product support from us. We assist some of our OEM partners further by providing additional resources such as tailored, account-specific education, training, technical support and sales and marketing assistance, allowing these partners to leverage our storage products and industry expertise. By selling products through our OEM customers and leveraging their brand marketing and worldwide sales channels, we are able to address more markets, reach a greater number of enterprises, and achieve better leverage of our sales and marketing expenditures.

 

Our marketing efforts support our OEM customers, as well as distributors and reseller channels, with programs targeted at developing differentiated go-to-market strategies and increasing sales effectiveness. Depending on the nature of our channel customer engagement, our marketing teams offer various levels of assistance in assessing and analyzing the competitive landscape, defining product strategy and roadmaps, developing product positioning and pricing, creating product launch support materials and assisting in closing the sales process. These marketing teams carefully coordinate joint product development and marketing efforts between our customers and us to ensure that we address and effectively target enterprise requirements. We maintain sales and marketing organizations in the United States and internationally in China, France, Germany, Italy, Japan, Singapore, Sweden and the United Kingdom.

 

Customers

 

In 2008, Seagate Technology accounted for approximately 17% and International Business Machines Corporation accounted for approximately 16% of our total revenues. No other customer accounted for more than 10% of our total revenues in 2008. We currently have a highly concentrated customer base as a result of our strategy to focus our marketing and sales efforts on select, large-volume customers. Our top 10 end customers in 2008, based on revenue, accounted for approximately 60.7% of our revenue. The loss of any of our significant customers, any substantial decline in sales to these customers, or any significant change in the timing or volume of purchases by our customers could result in lower revenues and could harm our business, financial condition or results of operations.

Manufacturing

 

Semiconductor Manufacturing

 

The semiconductor manufacturing process begins with wafer fabrication, where a design is transferred to silicon wafers through a series of processes, including photolithography, ion implantation, deposition of numerous films and the etching of these various films and layers. Each circuit on the wafer is tested in the wafer sort operation. The good circuits are identified and the wafer is then separated into individual die. Each good die is then assembled into a package that encapsulates the integrated circuit for protection and allows for electrical connection to a printed circuit board. The final step in the manufacturing process is final test, where the finished devices undergo stringent and comprehensive testing.

 

Wafer fabrication is very complex and costly, and the industry trend has been towards outsourcing all or a portion of this operation to silicon foundries located throughout the world. Our wafer fabrication is performed by third-party foundries, including Taiwan Semiconductor Manufacturing Corporation, our primary foundry partner, and other foundries such as IBM and Silicon Manufacturing Partners, a joint venture owned by Chartered Semiconductor and LSI.

 

We also use third-party suppliers, including STATS ChipPAC and Amkor Technology, to perform final assembly and test operations for us.

 

We believe that using third-party manufacturing services allows us to focus on product development and increases our operational flexibility, by improving our ability to adjust manufacturing capacity in response to customer demand and to introduce new products rapidly. It also reduces our capital requirements as we do not need to spend large amounts to build and upgrade manufacturing facilities, particularly in the area of wafer fabrication, where facilities must be upgraded periodically and each upgrade tends to cost significantly more than the preceding upgrade.

 

Storage Systems Manufacturing

 

We use third-party suppliers for standard components, such as disk drives and standard computer processors, which are designed and incorporated into our products. Additionally, we outsource the manufacturing of our product components, such as printed circuit boards, chassis assemblies and enclosures, in order to take advantage of scale, quality and cost benefits afforded by using third-party manufacturing services. We also use third-party suppliers to assemble and test our storage systems products. In 2008, we discontinued assembly and test operations for storage systems and sub-assemblies at our manufacturing facility in Wichita, Kansas, and transitioned the work performed there to third-party suppliers.

 

The assembly of our storage system products involves integrating components and manufactured sub-assemblies into final products, which are configured and rigorously tested before being delivered to our customers. The highly modularized nature of our storage system products allows for flexible assembly and delivery models, which include build-to-order, configure-to-order, direct shipment, bulk shipment and local fulfillment services. We have implemented these models in an effort to reduce requisite lead times for delivery of our products and to enable channel customers to select from among multiple manufacturing and delivery alternatives, the methods that best complement their operations.

 

Our host bus adapter board products incorporate a variety of standard industry components and LSI designed components, mounted on printed circuit board assemblies. The manufacturing, assembly and test operations of LSI’s host bus adapter boards are all fully outsourced to third-party suppliers to take advantage of the scale, quality and cost benefits that such manufacturing models provide. The host bus adapter boards are produced in configurations ranging from bulk packaging of high volume units sold to the major server and workstation OEMs, to low volume products for indirect channels featuring retail packaging with software media, documentation and interconnect cables. LSI’s host bus adapter boards are shipped from our third-party suppliers to our worldwide inventory hubs, directly to OEM factories, or to distributors who supply them to a variety of indirect channels in the market.

Backlog

 

Semiconductor Backlog

 

In the Semiconductor segment, we generally do not have long-term volume purchase contracts with our customers. Instead, customers place purchase orders that are subject to acceptance by us. The timing of the design activities for which we receive payment and the placement of orders included in our backlog at any particular time is generally within the control of the customer. For example, there could be a significant time lag between the commencement of design work and the receipt of a purchase order for the units of a developed product. Also, customers may from time to time revise delivery quantities or delivery schedules to reflect their changing needs. For these reasons, we do not believe that our backlog as of any particular date is a meaningful indicator of future annual sales.

 

Storage Systems Backlog

 

Due to the nature of our business, we generally have relatively low levels of backlog in the Storage Systems segment and our quarterly revenues depend largely on orders booked and shipped within the same quarter. Consequently, we believe that backlog is not a good indicator of future sales. Because lead times for delivery of our products are relatively short, we must build products in advance of orders. This subjects us to certain risks, most notably the possibility that expected sales will not materialize, leading to excess inventory, which we may be unable to sell to our customers.

 

Competition

 

Semiconductor Competitors

 

The semiconductor industry is intensely competitive and characterized by constant technological change, rapid product obsolescence, evolving industry standards and price erosion. Many of our competitors are larger, diversified companies with substantially greater financial resources. Some of our competitors are also customers who have internal semiconductor design and manufacturing capacity. We also compete with smaller and emerging companies whose strategy is to sell products into specialized markets or to provide only a portion of the products and services that we offer.

 

Our competitors in the Semiconductor segment include Adaptec, Inc., Broadcom Corporation, Freescale, Inc., International Business Machines Corporation, Marvell Technology Group, Ltd., NEC Corporation, NetLogic Microsystems, Inc., NXP Semiconductors, PMC-Sierra, Inc., STMicroelectronics N.V. and Texas Instruments, Inc.

 

The principal competitive factors in the semiconductor industry include:

 

 

While we believe we are competitive on the basis of all the factors listed above, we believe some of our competitors compete more favorably on the basis of price and on delivering products to market more quickly. However, we feel we are particularly strong in offering integrated solutions, broad product lines, customer support and logistics and planning systems. In addition, existing suppliers tend to have an advantage when competing for

designs, which can make it difficult for us to win designs at new customers, even if we compete favorably on the factors identified above.

 

The markets into which we sell our semiconductor products are subject to severe price competition. We expect to continue to experience declines in the selling prices of our semiconductor products over the life cycle of each product. In order to offset or partially offset declines in the selling prices of our products, we continually strive to reduce the costs of products through product design changes, manufacturing process changes, yield improvements and procurement of wafers from outsourced manufacturing partners.

 

Storage Systems Competitors

 

The market for our storage system products is highly competitive, rapidly evolving and subject to changing technology, customer needs and new product introductions. We compete with products from storage system and component providers such as Adaptec, Inc., AMCC-3ware, Dot Hill Systems Corporation, Infortrend Technology Inc., XIOtech Corporation, and Xyratex Group Limited. We also compete with the internal storage divisions of existing and potential OEM customers, with large well-capitalized storage system companies such as EMC Corporation, Hitachi Data Systems and Network Appliance, Inc. and with newer competitors such as 3Par Inc., Compellent Technologies Inc. and ISILON Systems Inc.

 

The principal competitive factors for storage system products include:

 

 

Our ability to remain competitive will depend largely upon our ongoing performance in the areas of product development and customer support. To be successful in the future, we believe that we must respond promptly and effectively to the challenges of technological change and our competitors’ innovations by continually innovating and enhancing our product offerings. We must also continue to aggressively recruit and retain employees highly qualified and technically experienced in hardware and software development in order to achieve and maintain industry leadership in product development and support.

 

Patents, Trademarks and Licenses

 

We own or have rights to a number of patents, trademarks, copyrights, trade secrets and other intellectual property directly related to and important to our business. As of December 31, 2008, we had approximately 11,000 U.S. patents and patent applications and a number of related foreign patents and patent applications. These patents include patents related to the following technologies:

 

 

 

We have patents of all ages ranging from pending applications, which, if awarded, will have a duration of 20 years from their filing dates, through patents soon to expire.

 

We indemnify our customers for some of the costs and damages of patent infringement in circumstances where our product is the primary factor creating the customer’s infringement exposure. We generally exclude coverage where infringement arises out of the combination of our products with products of others.

 

We protect our products and processes by asserting our intellectual property rights where appropriate and prudent. We also obtain licenses to patents, copyrights and other intellectual property rights used in connection with our business when practicable and appropriate.

 

Companies in the technology industry are often subject to claims of intellectual property infringement. You can find information about the impact of these types of claims in Item 1A — “Risk Factors.” You can also find information about several legal proceedings against us that involve intellectual property claims in Note 15 to our financial statements in Item 8.

 

Research and Development

 

Our industry experiences rapid change and we must continually develop new products to remain competitive. Our research and development expenditures were $673 million, $655 million and $413 million for fiscal 2008, 2007 and 2006, respectively. Our research and development expenditures increased significantly in 2007 as a result of the Agere Systems acquisition. We anticipate that we will continue to make significant research and development expenditures to maintain our competitive position with a continuing flow of innovative products and technology.

 

Working Capital

 

Information about our working capital practices is included in Item 7 — “Management’s Discussion and Analysis of Financial Condition and Results of Operation” under the heading “Financial Condition, Capital Resources and Liquidity” and is incorporated herein by reference.

 

Environmental Regulation

 

Federal, state and local regulations, in addition to those of other nations, impose various environmental controls on certain chemicals and restricted substances used in semiconductor and storage products and their processing. Our facilities have been designed to comply with these regulations through the implementation of environmental, health and safety management systems. We offer products that comply with the requirements of the European Union Restriction of Hazardous Substances Directive 2002/95/EC (RoHS Directive) that was implemented on July 1, 2006 and other international environmental regulations impacting electronic equipment and components. While to date we have not experienced any material adverse impact on our business from environmental regulations, such regulations might be adopted or amended so as to impose expensive obligations on us in the future. In addition, violations of environmental regulations including impermissible discharges or use of restricted substances could result in:

 

 

Employees

 

As of December 31, 2008, we had 5,488 full-time employees.

 

Our future success depends upon the continued service of our key technical and management personnel and upon our ability to continue to attract and retain qualified employees, particularly those highly skilled design, process and test engineers involved in the development of new products and processes. We currently have favorable employee relations, but the competition for technical personnel is intense, and the loss of key employees or the inability to hire such employees when needed could have a material adverse impact on our business and financial condition.

 

Seasonality

 

Our business is largely focused on the information technology industry. Due to seasonality in this industry, we typically expect to see stronger revenues in the second half of the year.

 

 

Set forth below are risks and uncertainties that, if they were to occur, could materially adversely affect our business or could cause our actual results to differ materially from the results contemplated by the forward-looking statements in this report and other public statements we make.

 

We depend on a small number of customers. The loss of, or a significant reduction in revenue from, any of these customers would harm our results of operations.

 

A limited number of customers accounts for a substantial portion of our revenues. In 2008, Seagate and IBM, our two largest customers, represented approximately 17% and 16%, respectively, of our total revenues, and our 10 largest customers accounted for approximately 60.7% of our revenue. If any of our key customers reduced significantly or canceled its orders, our business and operating results could be significantly harmed. Because many of our semiconductor products are designed for specific customers and have long product design and development cycles, it may be difficult for us to replace key customers that reduce or cancel their existing orders for these products.

 

In addition, if we fail to win new product designs from our major customers, our business and results of operations may be harmed. Further, if our major customers make significant changes in scheduled deliveries, or decide to pursue the internal development of the products we sell to them, our business and results of operations may be harmed.

 

If we fail to keep pace with technological advances, or if we pursue technologies that do not become commercially accepted, customers may not buy our products and our results of operations may be harmed.

 

Many of the industry segments in which we operate are characterized by rapid technological change, changes in customer requirements, frequent new product introductions and enhancements, short product cycles and evolving industry standards. We believe that our future success will depend, in part, on our ability to improve on existing technologies and to develop and implement new ones, as well as on our ability to adopt and implement emerging industry standards in a timely manner and to adapt products and processes to technological changes. If we fail to develop new and enhanced products and technologies, if we focus on technologies that do not become widely adopted, or if new technologies that we do not offer and that compete with our technologies become widely accepted, demand for our current and planned products may be reduced.

 

In addition, the emergence of markets for integrated circuits may be affected by factors beyond our control. For example, we design some products to conform to current specific industry standards. If a competitor offers a product based on a standard before we are able to do so, our customers may buy our competitor’s product rather than our product. Our customers may not adopt or continue to follow these standards, which would make our products less desirable to customers, and could negatively affect sales. Also, competing standards may emerge that are preferred by our customers, which could reduce sales and require us to make significant expenditures to develop new

products. To the extent that we are not able to adapt effectively and expeditiously to new standards, our business may be harmed.

 

We operate in intensely competitive markets, and our failure to compete effectively would harm our results of operations.

 

We derive significant revenue from the sale of integrated circuits as well as storage systems. These industries are intensely competitive, and competition may increase as existing competitors enhance their product offerings and as new participants enter the market. Our competitors include large domestic and foreign companies that have substantially greater financial, technical and management resources than us. Several major diversified electronics companies offer products that compete with our products. Other competitors are specialized, rapidly growing companies that sell products into the same markets that we target. Some of our customers may also design and manufacture products internally that compete with our products. We can not provide any assurances that the price and performance of our products will be superior relative to the products of our competitors or will be sufficient to obtain business.

 

Increased competition may harm our revenues and margins. For example, competitors with greater financial resources may be able to offer lower prices than us, or they may offer additional products, services or other incentives that we may not be able to match. Competitors may be better able than us to respond quickly to new technologies and may undertake more extensive marketing campaigns than we do. They may also make strategic acquisitions or establish cooperative relationships among themselves or with third parties to increase their market share. In addition, competitors may sell commercial quantities of products before we do, establishing a market position that we may not be able to overcome once we introduce similar products in commercial quantities. If we are unable to develop and market competitive products on a timely basis, we will likely fail to maintain or expand our market share and our revenues will likely decline.

 

Customer orders and ordering patterns can change quickly, making it difficult for us to predict our revenues and making it possible that our actual revenues may vary materially from our expectations, which could harm our results of operations and stock price.

 

We sell a significant amount of product pursuant to purchase orders that customers may cancel or defer on short notice without incurring a significant penalty. In addition, the period of time between order and product shipment can be very short. If customers reduce the rate at which they place new orders, whether because of changing market conditions for their products or other reasons, or if they cancel or defer previously placed orders, the impact on our revenue can occur quickly and could cause us to experience revenues that are lower than we may have indicated in any forecast of our future revenue that we may have made publicly. For example, as economic conditions deteriorated in the fourth quarter of 2008, our sales declined below the expectations we had publicly announced earlier that quarter because our customers’ orders declined to a level below that which we had anticipated. Reductions in new order rates as well as cancellations or deferrals of existing orders could also cause us to hold excess inventory, which could adversely affect our results of operations.

 

A prolonged economic downturn could have a material negative impact on our results of operations and financial condition.

 

In late 2008, the media reported significant declines in economic activity and reduced availability of credit in the United States and other countries around the world. Prices of equity securities generally also experienced declines. If these declines persist or get worse, they could negatively affect our business in several ways, in addition to resulting in lower demand for our products and causing potential disruptions at customers or suppliers that might encounter financial difficulties.

 

We have defined benefit pension plans under which we are obligated to make future payments to participants. We have set aside funds to meet our anticipated obligations under these plans. These funds are invested in equity and fixed income securities. Since mid-2008, market prices of these types of securities declined significantly. At December 31, 2008, our projected benefit obligations under our pension plans exceeded the value of the assets of those plans by approximately $450 million. U.S. law provides that we must make contributions to the pension plans

in 2009 of at least $20 million. We may be required to make additional contributions to the plans in later years if the value of the plan assets does not increase, or continues to decrease, and these amounts could be significantly larger than the required contributions in 2009. We may also choose to make additional, voluntary contributions to the plans.

 

At December 31, 2008, we had contractual purchase commitments with suppliers, primarily for raw materials and manufacturing services and for some non-production items, of approximately $511 million. If our actual revenues in the future are lower than our current expectations, we may not meet all of our buying commitments. As a result, it is possible that we will have to make penalty-type payments under these contracts, even though we are not obtaining any products that we can sell.

 

During the year ended December 31, 2008, we recognized goodwill and intangible asset impairment charges of $541.6 million. If economic conditions worsen and our revenues decline below our recent forecasts, we may recognize additional impairment of our assets.

 

While we believe we currently have sufficient cash and short term investments to fund our operations for the near term, we may find it desirable to obtain additional debt or equity financing or seek to refinance our existing convertible notes in the event of a prolonged or worsening downturn. We believe that financing is currently difficult or impossible for many companies to obtain on acceptable terms or at all. Accordingly, financing may not be available to us at all or on acceptable terms if we determine that it would be desirable to obtain additional financing.

 

We depend on outside suppliers to manufacture, assemble, package and test our products; accordingly, any failure to secure and maintain sufficient manufacturing capacity or to maintain the quality of our products could harm our business and results of operations.

 

We depend on third-party foundries to manufacture integrated circuits for us and on outside suppliers to assemble and test our semiconductor products and to assemble our storage systems products. As such, we face the following risks:

 

 

The ability of an independent foundry to provide us with integrated circuits is limited by its available capacity and existing obligations. We generally do not enter into contracts to reserve foundry capacity. Availability of foundry capacity has in the past been reduced from time to time due to strong demand and may not be available when needed at reasonable prices. If foundry capacity is limited, it is possible that one of our foundries may allocate capacity to the production of other companies’ products. This reallocation could impair our ability to obtain sufficient wafers. We may also use a second foundry for a particular product when capacity at the main foundry is limited, but the cost of integrated circuits at the second foundry may be higher, which would reduce our margins.

 

By relying on outside suppliers to manufacture, assemble and test our products, we may have a reduced ability to control directly product delivery schedules and quality assurance. This lack of control may result in product shortages or quality assurance problems that could delay shipments of products or increase manufacturing, assembly, testing or other costs. In addition, if these outside suppliers are unable to obtain sufficient raw materials in a timely manner, we may experience product shortages or delays in product shipments, which could harm our customer relationships and results of operations.

 

If any of our manufacturing suppliers experiences capacity constraints, encounters financial difficulties, or experiences any other major disruption of its operations, we may need to qualify an alternate supplier, which may

take several months and could result in delays in product shipments. These delays could cause our customers to seek alternate suppliers, which could adversely impact our business.

 

As a result of all of these factors and risks, and although we carefully monitor and plan for capacity and other issues, we can not provide any assurances that we can obtain products from our suppliers on a timely basis or at reasonable prices.

 

Failure to qualify our semiconductor products or our suppliers’ manufacturing lines with key customers could harm our business and results of operations.

 

Some customers will not purchase any products, other than limited numbers of evaluation units, until they qualify the products or the manufacturing line for the product. We may not always be able to satisfy the qualification requirements of these customers. Delays in qualification may cause a customer to discontinue use of non-qualified products and result in a significant loss of revenue.

 

Any defects in our products could harm our reputation, customer relationships and results of operations.

 

Our products may contain undetected defects, errors or failures, which may not become apparent until the products are deployed in commercial applications and other equipment. Consequently, customers may discover errors after the products have been deployed. The occurrence of any defects, errors or failures could result in:

 

 

Any of these occurrences could also result in the loss of or delay in market acceptance of products and loss of sales, which could negatively affect our business and results of operations. As our products become even more complex in the future, this risk may intensify over time and may result in increased expenses.

 

As part of our integration efforts with Agere, we intend to transition Agere’s operation to our enterprise resource planning system. Any issues that may arise with this transition could interfere with our business and harm our operating results or our ability to produce accurate and timely financial statements.

 

Agere’s business utilizes a different enterprise resource planning system, or ERP, system than the system we have used historically. To streamline operations, we are in the process of converting Agere’s business to our ERP system. Converting Agere’s business processes, data and applications is a complex and time-consuming task. During this transition period, we are exposed to the possibility that we may not combine information correctly from the two systems, impacting our financial statements or our planning processes, and to the additional cost of maintaining two ERP systems.

 

Although we are planning the conversion carefully and expect to perform extensive testing before the actual conversion, it is possible that we may not convert all information or processes correctly or that some other problem could arise. Any problems that arise could impair our ability to process customer orders, ship products, provide services and support to our customers, bill and track orders, fulfill contractual obligations, file reports with the Securities and Exchange Commission in a timely manner and otherwise run our business. Even if we do not encounter these adverse effects, the transition to a single ERP system may be much more costly than we anticipated, which would adversely affect our future operating results.

We may be subject to intellectual property infringement claims and litigation, which could cause us to incur significant expenses or prevent us from selling our products.

 

As is typical in the semiconductor industry, we are frequently involved in disputes regarding patent and other intellectual property rights. We have in the past received, and we may in the future receive, communications from third parties asserting that our products, processes or technologies infringe on the patent or other intellectual property rights of third parties, and we may also receive claims of potential infringement if we attempt to license intellectual property to others. Intellectual property litigation, regardless of the outcome, may be costly and time consuming, and may divert the attention of management and key personnel from other business issues. Claims of intellectual property infringement also might require us to enter into costly royalty or license agreements. We may not be able to obtain royalty or license agreements on acceptable terms. If any of our products or intellectual property infringes on valid rights held by others, our results of operations or financial position may suffer and we may have to make material changes in production processes or products.

 

In April 2008, we filed an action with the International Trade Commission seeking the exclusion from the United States of products produced by 23 companies. Subsequently, a number of these companies have filed lawsuits or actions in the International Trade Commission claiming that our products infringe on their intellectual property rights and seeking either damages or an order excluding some of our products from sale in the United States. While we do not believe any of these actions to be material, we cannot give you any assurance that we will not be required to pay a material amount or that we will not have our products excluded from sale in the United States.

 

If we are unable to protect or assert our intellectual property rights, our business and results of operations may be harmed.

 

Our future success will depend, in part, upon our ability to protect and assert our intellectual property rights. We rely primarily on patent and other intellectual property laws, as well as nondisclosure agreements and other methods, to protect our proprietary technologies and processes. It is possible that competitors or other unauthorized third parties may obtain, copy, use or disclose proprietary technologies and processes, despite our efforts to protect them.

 

While we hold a significant number of patents, we can give you no assurance that any additional patents will be issued. Even if new patents are issued, the claims allowed may not be sufficiently broad to protect our technology. In addition, any of our existing patents, and any future patents issued to us, may be challenged, invalidated or circumvented, or changes in law may result in us having less protection than we may have experienced historically. As such, any rights granted under these patents may not provide us with meaningful protection. We may not have foreign patents or pending applications corresponding to our U.S. patents and applications. Even if foreign patents are granted, effective enforcement in foreign countries may not be available.

 

If our patents do not adequately protect our technology, competitors may be able to offer products similar to our products more easily. Our competitors may also be able to develop similar technology independently or design around our patents. Some or all of our patents have in the past been licensed and likely will in the future be licensed to certain of our competitors through cross-license agreements.

 

A decline in the revenue that we derive from the licensing of intellectual property could have a significant impact on our net income.

 

The revenue we generate from the licensing of our intellectual property typically has a higher gross margin compared to the revenue we generate from the sale of other products. Although we derive a relatively small percentage of our total revenue from the licensing of intellectual property, a decline in this licensing revenue would likely have a greater impact on our profitability than a similar decline in revenues from the sale of our other products. Our licensing revenue tends to come from a limited number of transactions and the failure to complete one or more transactions in a quarter could have a material adverse impact on our profitability.

We are exposed to legal, business, political and economic risks associated with our international operations.

 

We derive, and we expect to continue to derive, a substantial portion of our revenue from sales of products shipped to locations outside of the United States. In 2008, approximately 72.5% of our total revenue was derived from sales outside the United States. In addition, we perform a significant amount of our development work outside the United States and most of our products are manufactured outside of the United States. Operations outside of the United States are subject to a number of risks and potential costs that could harm our business and results of operations, including:

 

 

We use indirect channels of product distribution over which we have limited control.

 

Although we have in the past sold our storage systems products directly to end customers, we have discontinued this practice and now sell only to other companies that may or may not add features or functionality to our products before reselling them to end customers. We also sell some of our semiconductor products through distributors. A deterioration in our relationships with our distributors or resellers, or a decline in their business, could harm our sales. In addition, we may increase our reliance on indirect channels of distribution in the future. We may not successfully maintain or expand these indirect channels of distribution, and our failure to do so could result in the loss of sales opportunities. Furthermore, our reliance on indirect channels of distribution may reduce visibility with respect to future business opportunities, thereby making it more difficult to forecast orders.

 

We may engage in acquisitions and strategic alliances, which may not be successful and could harm our business and operating results.

 

We expect to continue to explore strategic acquisitions that build upon or expand our library of intellectual property, human capital and engineering talent, and increase our ability to address the needs of our customers. For example, in 2007, in addition to our merger with Agere, we acquired SiliconStor, a privately held company that provided silicon solutions for enterprise storage networks, and Tarari, a privately-held maker of silicon and software that provided content and application awareness in packet and message processing. Mergers and acquisitions of high-technology companies have inherent risks. No assurance can be given that our previous acquisitions or future acquisitions will be successful and will not harm our business or operating results. In addition, we may make

investments in companies, products and technologies through strategic alliances and otherwise. If these investments are not successful, our results of operations may suffer.

 

The semiconductor industry is highly cyclical, which may cause our operating results to fluctuate.

 

We operate in the highly cyclical semiconductor industry. This industry is characterized by wide fluctuations in product supply and demand. In the past, the semiconductor industry has experienced significant downturns, often in connection with, or in anticipation of, excess manufacturing capacity worldwide, maturing product cycles and declines in general economic conditions. Even if demand for our products remains constant, a lower level of available foundry capacity could increase our costs, which would likely have an adverse impact on our results of operations.

 

Our failure to attract, retain and motivate key employees could harm our business.

 

In some of our fields of operation, there are only a limited number of people in the job market who possess the requisite skills. In the past, we have experienced difficulty in identifying and hiring sufficient numbers of qualified engineers in parts of our business as well as in retaining qualified employees. The loss of the services of any key personnel or our inability to hire new personnel with the requisite skills could restrict our ability to develop new products or enhance existing products in a timely manner, to sell products to our customers or to manage our business effectively. In light of recent economic conditions, we have implemented several cost-saving measures which directly affect employee compensation. These measures, or others that we may take in the future, may negatively impact our ability to recruit and retain qualified personnel.

 

Our operations and our suppliers’ operations are subject to natural disasters and other events outside of our control that may disrupt our business and harm our operating results.

 

Our operations and those of our suppliers are subject to natural disasters and other events outside of our control that may disrupt our business and harm our operating results. For example, a widespread outbreak of an illness such as avian influenza, or bird flu, or severe acute respiratory syndrome, or SARS, could harm our operations and those of our suppliers as well as decrease demand from customers. We have operations in Singapore, Thailand and China, countries where outbreaks of bird flu and/or SARS have occurred. Also, we have substantial operations in parts of California that have experienced major earthquakes and in parts of Asia that have experienced both typhoons and earthquakes. If our operations or those of our suppliers are curtailed because of health issues or natural disasters, our business may be disrupted and we may need to seek alternate sources of supply for manufacturing or other services. Alternate sources may not be available, may be more expensive or may result in delays in shipments to customers, which would affect our results of operations. In addition, a curtailment of design operations could result in delays in the development of new products. If our customers’ businesses are affected by health issues or natural disasters, they might delay or reduce purchases, which could harm our business and results of operations.

 

We are subject to various environmental laws and regulations that could impose substantial costs on us and may harm our business.

 

Our business is subject to various environmental laws and regulations. For example, some countries have begun to require companies selling a broad range of electrical equipment to conform to legislation such as the Waste Electrical and Electronic Equipment (WEEE) Directive, the Restriction of the use of certain Hazardous Substances in Electrical & Electronic Equipment (RoHS) Directive, and Registration, Evaluation, Authorization and Restriction of Chemicals (REACH) Regulation in the European Union. Environmental legislation such as these could require us to redesign our products in order to comply with the standards and require the development of compliance administration systems. Redesigned products could be more costly to manufacture or require more costly or less efficient raw materials, making our products more costly or less desirable. In addition, under certain environmental laws, we could be held responsible, without regard to fault, for costs relating to any contamination at our past facilities and at third party waste disposal sites. We could also be held liable for consequences arising out of human exposure to such substances or other environmental damage. If we cannot develop compliant products on a timely basis or properly administer our compliance programs, our revenues may also decline due to lower sales, which may harm our business.

Our blank check preferred stock and Delaware law contain provisions that may inhibit potential acquisition bids, which may harm our stock price, discourage merger offers or prevent changes in our management.

 

Our board has the authority to issue preferred stock and to determine the rights, preferences, privileges and restrictions, including voting rights, of the shares without any further vote or action by our stockholders. If we issue any of these shares of preferred stock in the future, the rights of holders of our common stock may be negatively affected. Although we have no current plans to issue shares of preferred stock, if we issue preferred stock, a change of control of our company could be delayed, deferred or prevented. Furthermore, Section 203 of the Delaware General Corporation Law restricts certain business combinations with any “interested stockholder” as defined by that statute. These provisions are designed to encourage potential acquirers to negotiate with our board of directors and give our board an opportunity to consider various alternatives to increase stockholder value. These provisions are also intended to discourage certain tactics that may be used in proxy contests. However, the potential issuance of preferred stock or the restrictions in Section 203 of the Delaware General Corporation Law could discourage potential acquisition proposals and could delay or prevent a change in control, which may adversely affect the market price of our stock. These provisions may also have the effect of preventing changes in our management or board of directors.

 

Class action litigation due to stock price volatility or other factors could cause us to incur substantial costs and divert our management’s attention and resources.

 

In the past, securities class action litigation often has been brought against a company following periods of volatility in the market price of its securities. Companies in the technology industry are particularly vulnerable to this kind of litigation due to the high volatility of their stock prices. Our stock has experienced substantial price volatility in the past. This may be a result of quarterly variations in our results of operations, the published expectations of security analysts and announcements by us and our competitors as well as general economic conditions and our stock price may continue to experience substantial volatility. Accordingly, we may in the future be the target of securities litigation. Any securities litigation could result in substantial costs and could divert the attention and resources of our management.

 

 

Not applicable.

 

 

We lease office space in two buildings in Milpitas, California for our corporate headquarters, administration and engineering offices. We also own a 600,000 square foot office complex in Allentown, Pennsylvania that we use for administration and engineering offices. We have leased out approximately 69,000 square feet of space in that facility in connection with the sale of our mobility business.

 

In our Storage Systems business, we own approximately 330,000 square feet of space in Wichita, Kansas which includes engineering, administrative offices and systems training.

 

We also own approximately 170,000 square feet of sales and engineering office space in Fort Collins, Colorado and approximately 180,000 square feet of sales and engineering office space in Colorado Springs, Colorado. These facilities are used by both our Semiconductor segment and our Storage Systems segment.

 

We own or lease additional space in the United States and in various other countries, and use that space for sales, marketing, engineering, general corporate and test purposes.

 

We believe that our existing facilities and equipment are well maintained, in good operating condition, suitable for our operations and are adequate to meet our current requirements.

 

This information is included in Note 15 (“Commitments, Contingencies and Legal Matters”) to our financial statements in Item 8 and is incorporated herein by reference.

 

 

During the fourth quarter of 2008, no matter was submitted to a vote of our security holders.

 

Set forth below is information about our executive officers.

 

 

Mr. Talwalkar has been our President and Chief Executive Officer and a member of our Board of Directors since May 2005. Prior to joining LSI, Mr. Talwalkar was employed by Intel Corporation, a microprocessor manufacturer. At Intel, he was Corporate Vice President and Co-general Manager of the Digital Enterprise Group from January 2005 until May 2005, Vice President and General Manager of Intel’s Enterprise Platform Group from May 2004 to January 2005, and Vice President and General Manager of Intel’s Platform Products Group, within Intel’s Enterprise Platform Group, from April 2002 through May 2004. Mr. Talwalkar also served as Vice President and Assistant General Manager of Intel’s Enterprise Platform Group from June 2001 to March 2002.

 

Mr. Bullinger has led our Storage Systems business since August 2005, a role he has shared with Mr. Santoni since June 2008. From September 2001 through August 2005, he served as Vice President and General Manager of our RAID Storage Adapters division. He joined LSI in 1998, following LSI’s acquisition of Symbios, Inc., a storage company, and served as Director of Product Development until August 2001.

 

Mr. Gibson has been the leader of our Human Resources organization since November 2001. Between 1984 and 2001, he held a number of managerial positions in our Human Resources organization.

 

Mr. Look has been Executive Vice President, Chief Financial Officer and Chief Administrative Officer since January 2009. From November 2000 through January 2009, he served as Executive Vice President and Chief Financial Officer. Between March 1997 and November 2000, he was our Vice President, Corporate Development and Strategic Planning. Prior to joining LSI, he was manager of business development in Hewlett-Packard’s corporate development department. During a 21-year career at Hewlett-Packard, Mr. Look held a variety of management positions in finance and research and development.

 

Mr. Micallef has been in charge of our manufacturing, real estate and supply chain operations since April 2007. Mr. Micallef joined LSI in April 2007 following our acquisition of Agere Systems. At Agere, he held a number of senior management positions in manufacturing and supply chain operations from 2000 through April 2007.

Ms. Rankin has been our Executive Vice President, General Counsel and Secretary since April 2007. Ms. Rankin joined LSI in 2007 following the acquisition of Agere Systems. At Agere, she had been Executive Vice President, General Counsel and Secretary since 2000.

 

Mr. Richardson has been the leader of our Semiconductor Solutions Group since January 2009. From April 2007 through January 2009, he led our Network and Storage Products Group, which included our Networking and Storage Interfaces businesses. From September 2005 through April 2007, he was the leader of our Custom Solutions Group, and from June 2005 through September 2005, he led our Corporate Strategy function. From 1992 through June 2005, he held a variety of management positions at Intel, including positions as Vice President of the Digital Enterprise Group and General Manager of the Server Platform Group from February 2005 through June 2005 and General Manager of Intel’s Enterprise Platforms and Services Division from June 2001 to January 2005. From January 1999 to June 2001, he was Director of Product Development of Intel’s Enterprise Platforms and Services Division.

 

Mr. Santoni has led our Storage System business together with Mr. Bullinger since June 2008. Prior to assuming this role, he was the head of our Storage Systems sales organization since October 2006. From February 2001 through October 2006, he held a number of senior sales and marketing positions for our Storage Systems business. Before joining LSI in 2001, Mr. Santoni was Executive Vice President and Chief Operating Officer at Sutmyn Storage Corporation and held various senior management positions with Memorex Telex in the United States, United Kingdom and Italy.

 

Officers are not elected for a fixed term of office but hold office until their successors have been elected. There are no family relationships among the executive officers and directors of LSI.

 

 

Our stock trades on the New York Stock Exchange under the symbol “LSI.” In June 2008, our Chief Executive Officer submitted to the Exchange an annual certification stating that he was not aware of any violations of the Exchange’s corporate governance listing standards.

 

The table below shows the high and low sales prices for our common stock for each quarter during our last two full fiscal years, as reported in the consolidated transaction reporting system.

 

 

At February 20, 2009, there were 354,006 holders of record of our common stock. We believe that we have a greater number of additional stockholders who own their shares through brokerage firms and other nominees.

 

We have never paid cash dividends on our common stock. It is presently our policy to reinvest our earnings, and we do not currently anticipate paying any cash dividends to stockholders in the foreseeable future.

 

PERFORMANCE GRAPH

 

The following graph compares the cumulative total stockholder return on our common stock to that of the S&P 500 Index and the S&P 500 Semiconductors Index. The graph assumes that a $100 investment was made in our common stock and each of the indices at December 31, 2003, and that dividends, if any, were reinvested in all cases. The stock price performance shown on the graph is not necessarily indicative of future price performance.

 

 

Five-Year Consolidated Summary

 

 

Starting in 2007, we included amortization of intangibles in cost of revenues. For the years ended December 31, 2006, 2005 and 2004, amortization of intangibles of $32.1 million, $62.5 million and $75.1 million, respectively, which was previously reported as a separate component of operating expenses, has been reclassified to cost of revenues for consistency.

 

On April 2, 2007, we acquired Agere Systems Inc. through the merger of Agere and a subsidiary of ours. The merger was accounted for as a purchase. Accordingly, the results of operations of Agere and estimated fair value of assets acquired and liabilities assumed were included in our consolidated financial statements from April 2, 2007.

 

During the years ended December 31, 2008 and 2007, we recognized goodwill and intangible asset impairment charges of $541.6 million and $2,021.5 million, respectively, in the Semiconductor segment.

 

On January 1, 2006, we adopted the fair value recognition provisions of Financial Accounting Standards Board, or FASB, Statement of Financial Accounting Standards, or SFAS, No. 123(R), or FAS 123R, “Share-Based Payment,” using the modified prospective transition method. In accordance with the modified prospective transition

method, we began recognizing compensation expense for all share-based awards granted on or after January 1, 2006, plus unvested awards granted prior to January 1, 2006. Under this method of implementation, no restatement of prior periods has been made.

 

 

This management’s discussion and analysis should be read in conjunction with the other sections of this Form 10-K, including Part 1, “Item 1: Business”; Part II, “Item 1A: Risk Factors”; Part II, “Item 6: Selected Financial Data”; and Part II, “Item 8: Financial Statements and Supplementary Data.”

 

Where more than one significant factor contributed to changes in results from year to year, we have quantified these factors throughout Management’s Discussion and Analysis of Financial Condition and Results of Operations where practicable and material to understanding a material change included in the discussion.

 

OVERVIEW

 

We design, develop and market complex, high-performance semiconductors and storage systems. We provide silicon-to-system solutions that are used at the core of products that create, store, consume and transport digital information. We offer a broad portfolio of capabilities including custom and standard product integrated circuits used in hard disk drives, high-speed communication systems, computer servers, storage systems and personal computers. We also offer external storage systems and host bus adapter boards and software applications for attaching storage devices to computer servers and for storage area networks.

 

We operate in two segments — the Semiconductor segment and the Storage Systems segment. For the Semiconductor segment, we sell our integrated circuits for storage applications to makers of hard disk drives and computer servers. We sell our integrated circuits for networking applications principally to makers of devices used in computer and communications networks and, to a lesser extent, to makers of personal computers. For the Storage Systems segment, we sell our storage systems, host adapter boards and software applications for attaching storage devices to computer servers and for storage area networks to original equipment manufacturers, or OEMs, who resell those products to end customers under their own brand name. We also generate revenue by licensing other entities to use our intellectual property primarily in the Semiconductor segment.

 

Our revenues depend on market demand for these types of products and our ability to compete in highly competitive markets. We face competition not only from makers of products similar to ours, but also from competing technologies. For example, we see the development of solid state drives, based on flash memory rather than the spinning platters used in hard disk drives, as a long-term potential competitor to certain types of hard disk drives, and have begun focusing development efforts in that area.

 

Recently, the U.S. and global economies have experienced a significant downturn driven by a financial and credit crisis that could continue to challenge such economies for some period of time. In the fourth quarter of 2008, our revenues declined significantly as compared to our revenues in the third quarter due to the global economic downturn. As our outlook continued to deteriorate into January 2009, we took a number of actions to reduce our expenses, including a corporate-level restructuring designed to increase synergies across our semiconductor investment, a 5% reduction of our global workforce, reductions in employee compensation-related expenses and reductions in discretionary spending.

 

Our business is currently focused on providing integrated circuits for storage and networking applications and on providing storage systems and related boards and software, where we believe we have the scale, technology and customer relationships to be most successful. Since the beginning of 2007, we have completed the following actions as part of our efforts to focus on those areas:

 

 

 

Our revenues for the year ended December 31, 2008 were $2,677.1 million, an increase of $73.5 million, compared to $2,603.6 million for the year ended December 31, 2007. The increase in revenues was primarily attributable to a full year of revenues from Agere in 2008 and increased demand for semiconductors used in storage and networking product applications, for our entry level storage systems and for our premium feature and direct-attached storage software products. The increase was offset by the absence of revenues from the Mobility and Consumer Product Groups.

 

We reported a net loss of $622.3 million, or $0.96 per diluted share, for the year ended December 31, 2008, as compared to a net loss of $2,486.8 million, or $3.87 per diluted share, for the year ended December 31, 2007. During the years ended December 31, 2008 and 2007, we recognized goodwill impairment charges of $364.1 million and $2,019.9 million in the Semiconductor segment in the respective years. In addition, we recognized $177.5 million and $1.6 million in charges for the impairment of other intangible assets in the Semiconductor segment for the years ended December 31, 2008 and 2007, respectively.

 

For the year ended December 31, 2008, we recorded restructuring of operations and other items, net of $43.7 million compared to $148.1 million for the year ended December 31, 2007. The 2007 restructuring of operations related primarily to the sale of the Mobility Products Group. For the year ended December 31, 2007, we recorded a $188.9 million charge for acquired in-process research and development primarily associated with the merger with Agere on April 2, 2007. We did not record any charge related to acquired in-process research and development during the year ended December 31, 2008.

 

Cash, cash equivalents and short-term investments were $1,119.1 million as of December 31, 2008, as compared to $1,397.6 million as of December 31, 2007. For the year ended December 31, 2008, we generated $278.1 million in cash from operating activities as compared to $295.0 million for the year ended December 31, 2007.

 

RESULTS OF OPERATIONS

 

Revenues

 

The following table summarizes our revenues by segment for the years ended December 31, 2008, 2007 and 2006:

 

 

2008 compared to 2007:

 

Total consolidated revenues for 2008 increased $73.5 million or 2.8% as compared to 2007.

Semiconductor Segment:

 

Revenues for the Semiconductor segment increased $16.2 million or 0.9% in 2008 as compared to 2007. The increase was primarily attributable to:

 

 

The increase was partially offset by the absence of $213.1 million and $54.6 million of revenues from the Mobility Products Group and the Consumer Products Group, respectively.

 

Storage Systems Segment:

 

Revenues for the Storage Systems segment increased $57.3 million or 6.9% in 2008 as compared to 2007. The increase was primarily attributable to an increase in revenues for our entry level storage systems and a continued increase in demand for our premium feature and direct-attached storage software products, partially offset by a decline in the sales of our mid-range storage systems.

 

See Note 9 to our consolidated financial statements in Item 8 for information about our significant customers.

 

2007 compared to 2006:

 

Total consolidated revenues for 2007 increased $621.5 million or 31.4% as compared to 2006, primarily due to the merger with Agere in April 2007.

 

Semiconductor Segment:

 

Revenues for the Semiconductor segment increased $555.8 million or 45.4% in 2007 as compared to 2006. The increase was primarily due to revenues attributable to Agere of $821.5 million and, to a lesser extent, increased demand for semiconductors used in storage product applications associated with the ramping of our Serial Attached SCSI, or SAS, products.

 

The increase was partially offset by:

 

 

Storage Systems Segment:

 

Revenues for the Storage Systems segment increased $65.7 million or 8.7% in 2007 as compared to 2006. The increase was primarily attributable to:

 

 

The increase was partially offset by decreased revenues for our RAID storage adapters due to lower hardware sales.

Revenues by Geography

 

The following table summarizes our revenues by geography for the years ended December 31, 2008, 2007 and 2006:

 

 

 

 

2008 compared to 2007:

 

Revenues in Europe and the Middle East increased 68.8% in 2008 compared to 2007. The increase was primarily attributable to increased revenues in storage systems and increased revenues in semiconductors used in storage product applications. The increase in European revenues for storage systems was primarily the result of a significant customer shifting order placements from our U.S. subsidiary to a subsidiary in Europe. Revenues in North America decreased 14.1%. The decrease in North America was primarily attributable to decreased revenues in storage systems primarily for the reason discussed above, offset by increased revenues from semiconductors used in storage and networking standard products.

 

2007 compared to 2006:

 

Revenues in Europe and the Middle East increased 50.5% in 2007 compared to 2006. The increase was primarily attributable to an increase in revenues associated with the merger with Agere, increased revenues in storage systems and increased revenues in semiconductors used in storage product applications. Revenues in Asia increased 75.8% in 2007. The increase in Asia was primarily attributable to revenues from Agere and increased revenues in semiconductors used in storage product applications, offset in part by a decrease in revenues from the Consumer Products Group and decreased revenues from semiconductors used in communication product applications. Revenues in North America decreased 10.2%. The decrease in North America was primarily attributable to decreased revenues from semiconductors used in consumer product applications, offset in part by increased storage system revenues, increased revenues from semiconductors used in storage product applications and revenues from Agere.

 

Gross Profit Margin

 

The following table summarizes our gross profit margins by segment for the years ended December 31, 2008, 2007 and 2006:

 

Amortization of intangibles, which was previously reported as a separate component of operating expenses, has been reclassified to cost of revenues for the year ended December 31, 2006 for consistency.

 

2008 compared to 2007:

 

The consolidated gross profit margin as a percentage of total revenues increased to 39.9% in 2008 from 34.7% in 2007.

 

Semiconductor Segment:

 

The gross profit margin as a percentage of segment revenues for the Semiconductor segment increased to 41.1% in 2008 from 33.9% in 2007. The increase in 2008 was primarily attributable to:

 

 

Storage Systems Segment:

 

The gross profit margin as a percentage of segment revenues for the Storage Systems segment increased to 37.7% in 2008 from 36.4% in 2007. The increase was primarily driven by lower manufacturing costs across the product lines and higher demand for our premium feature and direct-attached storage software products, which have higher margins.

 

2007 compared to 2006:

 

The consolidated gross profit margin as a percentage of total revenues declined to 34.7% in 2007 from 41.5% in 2006. This primarily reflects a decrease in Semiconductor segment gross margins caused in large part by the merger with Agere.

 

Semiconductor Segment:

 

The gross profit margin as a percentage of segment revenues for the Semiconductor segment decreased to 33.9% in 2007 from 45.9% in 2006. The decline was primarily attributable to:

 

 

Storage Systems Segment:

 

The gross profit margin as a percentage of segment revenues for the Storage Systems segment increased to 36.4% in 2007 from 34.5% in 2006. This increase was primarily driven by lower manufacturing costs across the mid-range product line and higher demand for premium feature and direct-attached storage software products, which have higher margins.

Research and Development

 

The following table summarizes our research and development, or R&D, expenses by segment for the years ended December 31, 2008, 2007 and 2006:

 

 

2008 compared to 2007:

 

Consolidated R&D expenses increased $17.3 million or 2.6% in 2008 as compared to 2007.

 

Semiconductor Segment:

 

R&D expenses for the Semiconductor segment consist primarily of employee salaries, costs related to third party design tools and materials used in the design of custom silicon and standard products, as well as depreciation of capital equipment and facilities-related expenditures. In 2008, we focused our R&D efforts in the storage and networking markets.

 

R&D expenses for the Semiconductor segment increased by $8.6 million or 1.6% in 2008 as compared to 2007 and increased slightly as a percentage of segment revenues from 29.5% in 2007 to 29.7% in 2008. The increase was attributable to the merger with Agere, partially offset by reduced expenditures resulting from the sale of the Mobility and Consumer Product Groups, headcount reductions from our restructuring actions and decreased spending related to third party design tools used in the design of custom silicon and standard products.

 

Storage Systems Segment:

 

R&D expenses for the Storage Systems segment consist primarily of employee salaries and materials used in product development, as well as depreciation of capital equipment and facilities. In addition to the significant resources required to support hardware technology transitions, we devote significant resources to developing and enhancing software features and functionality to remain competitive.

 

R&D expenses for the Storage Systems segment increased $8.7 million or 6.7% in 2008 as compared to 2007. The increase was primarily attributable to increased compensation-related expenditures as well as increased material spending for R&D projects associated with new product development. R&D expenses as a percentage of segment revenues remained flat at 15.7% in 2008 and 2007.

 

2007 compared to 2006:

 

Consolidated R&D expenses increased $241.8 million or 58.5% in 2007 as compared to 2006. This reflects increases in R&D expenditures, both in dollar amounts and as a percentage of revenues, in both segments, primarily as a result of the Agere acquisition.

 

Semiconductor Segment:

 

R&D expenses for the Semiconductor segment increased $209.5 million or 66.3% in 2007 as compared to 2006 and increased as a percentage of segment revenues to 29.5% in 2007 from 25.8% in 2006. The increase was primarily attributable to the acquisition of Agere, SiliconStor and Tarari during 2007. The increase was partially offset by reduced expenditures resulting from the sale of the Consumer Products Group and headcount reductions

from our restructuring actions during 2007. In 2007, we focused our R&D efforts in the storage and networking markets.

 

Storage Systems Segment:

 

R&D expenses for the Storage Systems segment increased by $32.3 million or 33.1% in 2007 as compared to 2006 and increased as a percentage of segment revenues to 15.7% in 2007 from 12.8% in 2006. The increase was primarily attributable to the acquisition of StoreAge and increased compensation-related expenditures due to an increase in headcount, increased spending for R&D projects associated with new product lines and expenses related to a contract with a significant customer.

 

Selling, General and Administrative

 

The following table summarizes our selling, general and administrative, or SG&A, expenses by segment for the years ended December 31, 2008, 2007 and 2006:

 

 

2008 compared to 2007:

 

Consolidated SG&A expenses increased $25.5 million or 6.7% in 2008 as compared to 2007.

 

Semiconductor Segment:

 

SG&A expenses for the Semiconductor segment increased $14.5 million or 5.5% in 2008 as compared to 2007 and increased as a percentage of segment revenues from 14.8% in 2007 to 15.5% in 2008. The increase was attributable to the merger with Agere, partially offset by reduced expenditures resulting from the sale of the Mobility and Consumer Product Groups as well as headcount reductions from our restructuring actions.

 

Storage Systems Segment:

 

SG&A expenses for the Storage Systems segment increased $11.0 million or 9.4% in 2008 as compared to 2007 and increased as a percentage of segment revenues from 14.2% in 2007 to 14.5% in 2008. The increase was primarily attributable to an increase in sales and marketing expenditures to support higher revenues in 2008 compared to 2007.

 

2007 compared to 2006:

 

Consolidated SG&A expenses increased $125.8 million or 49.2% in 2007 as compared to 2006.

 

Semiconductor Segment:

 

SG&A expenses for the Semiconductor segment increased $106.7 million or 67.8% in 2007 as compared to 2006 and increased as a percentage of segment revenues to 14.8% in 2007 from 12.9% in 2006. The increase in the amount and as a percentage of segment revenues was primarily attributable to the merger with Agere, partially offset by reduced expenditures as a result of headcount reductions from our restructuring actions and decreased selling expenses due to the sale of the Consumer Products Group.

Storage Systems Segment:

 

SG&A expenses for the Storage Systems segment increased $19.1 million or 19.5% in 2007 as compared to 2006 and increased as a percentage of segment revenues to 14.2% in 2007 from 12.9% in 2006. The increase in the amount and as a percentage of revenues was primarily attributable to the additional expenses resulting from the acquisition of StoreAge, increased compensation-related expenses based on increased headcount and an increase in sales commissions due to increased revenues.

 

Restructuring of Operations and Other Items

 

A complete discussion of our restructuring actions in 2008, 2007 and 2006 is included in Note 2 to our consolidated financial statements in Item 8.

 

2008:

 

We recorded charges of $43.7 million in restructuring of operations and other items, net, for the year ended December 31, 2008, consisting of $35.5 million in charges for restructuring of operations and $8.2 million in charges for other items. Of these charges, $41.1 million were attributable to the Semiconductor segment and $2.6 million were attributable to the Storage Systems segment. The restructuring charges were largely related to severance and termination benefits for approximately 260 employees associated with a broad-based reorganization that was announced in January 2009 and lease termination costs. The charges were offset in part by a gain on the sale of land in Gresham, Oregon.

 

As a result of the recent restructuring action taken in January 2009, we expect to realize quarterly operating expense savings of approximately $7.0 million starting from the second quarter of 2009. Suspended depreciation amounted to $5.3 million for the period from January 1, 2008 to June 30, 2008 associated with holding the Singapore assembly and test facility for sale.

 

2007:

 

We recorded charges of $148.1 million in restructuring of operations and other items, net, for the year ended December 31, 2007, consisting of $142.9 million in charges for restructuring of operations and a charge of $5.2 million for other items. Of these charges, $143.4 million were recorded in the Semiconductor segment and $4.7 million were recorded in the Storage Systems segment. We completed the sale of our Consumer Products Group in the third quarter of 2007 and the sales of our semiconductor assembly and test operations in Thailand and our Mobility Products Group in the fourth quarter of 2007. We also announced the elimination of approximately 900 non-production positions, inclusive of the Consumer Products Group, across all business and functional areas worldwide in the second quarter of 2007, and in the third quarter of 2007 announced the elimination of approximately 2,100 production positions worldwide associated with the sale of our assembly and test operations in Thailand and our plan to transition assembly and test operations performed at our facilities in Singapore and Wichita, Kansas to current manufacturing partners.

 

2006:

 

We recorded a credit of $8.4 million in restructuring of operations and other items, net, for the year ended December 31, 2006. Of this amount, a credit of $9.6 million was recorded in the Semiconductor segment and a charge of $1.2 million was recorded in the Storage Systems segment. We sold the Gresham facility in the second quarter of 2006.

 

Goodwill and Other Intangible Asset Impairment Charges

 

We monitor the recoverability of goodwill and other intangible assets recorded in connection with acquisitions, by reporting unit, annually in our fourth quarter or sooner if events or changes in circumstances indicate that the carrying amount may not be recoverable. During the fourth quarters of 2008 and 2007, we determined that, based on the then current market conditions in the semiconductor industry, the carrying amounts of goodwill and certain other intangible assets for our Semiconductor reporting unit were no longer recoverable. We recognized goodwill

impairment charges of $364.1 million in the fourth quarter of 2008 and $2,019.9 million in the fourth quarter of 2007. The fair value of the Semiconductor reporting unit was estimated by using the present value of estimated future cash flows. In addition, we recognized $177.5 million and $1.6 million in charges for the impairment of certain other intangible assets in the Semiconductor segment for the years ended December 31, 2008 and 2007, respectively. There was no impairment of goodwill and other intangible assets for the year ended December 31, 2006. For additional details, see “Valuation of Long-Lived Assets, Intangible Assets and Goodwill” under “Critical Accounting Estimates”.

 

Acquired In-Process Research and Development

 

As of December 31, 2008, the actual development timelines and costs for the in-process research and development, or IPR&D, projects described below were in line with original estimates. However, development of the technology remains a substantial risk to us due to a number of factors, including the remaining effort to achieve technical feasibility, rapidly changing customer needs and competitive threats from other companies. Failure to bring these products to market in a timely manner could adversely affect our sales and profitability in the future. Additionally, the value of other intangible assets acquired may become impaired.

 

Our methodology for allocating the purchase price relating to purchase acquisitions to IPR&D uses established valuation techniques in the high-technology industry. IPR&D is expensed upon acquisition because technological feasibility has not been established and no future alternative uses exist. The fair value of technology under development is determined using the income approach, which discounts expected future cash flows to present value. A discount rate is used for the projects to account for the risks associated with the inherent uncertainties surrounding the successful development of the technology, market acceptance of the technology, the useful life of the technology, the profitability level of such technology and the uncertainty of technological advances, which could impact the estimates recorded. The discount rates used in the present value calculations are typically derived from a weighted-average cost of capital analysis. These estimates do not account for any potential synergies realizable as a result of the acquisition and are in line with industry averages and growth estimates.

 

2008:

 

There were no IPR&D charges for the year ended December 31, 2008.

 

2007:

 

We recorded charges of $188.9 million for the year ended December 31, 2007 associated with IPR&D in connection with the Tarari, Agere and SiliconStor acquisitions.

 

The following table summarizes details for the 2007 acquisitions at the acquisition dates:

 

 

 

 

2006:

 

We recorded charges of $4.3 million for the year ended December 31, 2006 associated with IPR&D in connection with the StoreAge and Metta Technology acquisitions.

 

The following table summarizes details for the 2006 acquisitions at the acquisition dates:

 

 

Interest (Expense) or Income and Other, net

 

The following table summarizes our interest expense and components of interest income and other, net, for the years ended December 31, 2008, 2007 and 2006:

 

 

Interest Expense:

 

Interest expense increased $3.9 million in 2008 compared to 2007 as a result of interest on 6.5% convertible notes we guaranteed in connection with the Agere merger in April 2007, offset in part by the repurchase of $118.6 million of these notes in 2008.

 

Interest expense increased $6.7 million to $31.0 million in 2007 compared to 2006 as a result of interest on 6.5% convertible notes we guaranteed in connection with the Agere merger, offset in part by the repayment at maturity of $271.8 million of 4% convertible notes in the fourth quarter of 2006.

 

Interest Income and Other, net:

 

Interest income decreased $12.4 million in 2008 compared to 2007 primarily as a result of lower interest rates during 2008 compared to 2007. Interest income increased $11.3 million in 2007 compared to 2006 primarily as a result of higher interest rates and higher cash and investment balances in 2007 as compared to 2006.

 

Other expenses, net, decreased $1.7 million in 2008 compared to 2007 primarily as a result of foreign exchange gains in 2008 compared to foreign exchange losses in 2007 and a gain from the repurchase of convertible notes, offset in part by impairment charges related to certain available-for-sale debt and equity securities.

 

Other expenses, net, increased $15.8 million in 2007 compared to 2006 primarily as a result of foreign exchange losses, charges for points on foreign currency forward contracts, loss on impairment of certain non-marketable equity securities and absence of gain on available for sale of equity securities in 2007 that existed in 2006.

 

For all investments in debt and equity securities, unrealized losses are evaluated to determine if they are other than temporary. In order to determine if an impairment has occurred for marketable debt securities, we monitor the

credit quality, performance of the underlying collateral for asset- and mortgage-backed securities, as well as the severity and duration of the unrealized loss. In order to determine if an impairment has occurred for equity securities, we review the financial performance of each investee, industry performance and outlook for each investee, the trading prices of marketable equity securities and pricing in current rounds of financing for non-marketable equity securities. If an unrealized loss is determined to be other than temporary, a loss is recognized as a component of interest income and other. For marketable equity securities, the impairment losses were measured using the closing market price of the marketable securities on the date management determined that the investments were impaired. For non-marketable equity securities, the impairment losses were measured by using pricing in current rounds of financing.

 

Provision for Income Taxes

 

During 2008, we recorded an income tax provision of $27.7 million, which represents an effective tax rate of approximately (5)% on the loss before income taxes of $594.6 million. This rate differs from the U.S. statutory rate primarily due to a full valuation allowance recorded against U.S. and certain non-U.S. net deferred tax assets and income taxes related to certain profitable non-U.S. jurisdictions. We have also recorded a release of a $13.9 million liability relating to FASB Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes — an interpretation of SFAS No. 109,” because various statutes of limitations expired during the year, and an increase of $5.6 million as a result of a re-measurement of uncertain tax positions taken in prior periods based on new information received during 2008.

 

During 2007, we recorded an income tax provision of $11.3 million, which represents an effective tax rate of approximately 0%. This rate differs from the U.S. statutory rate primarily due to a full valuation allowance recorded against U.S. and certain non-U.S. net deferred tax assets. We also benefited from lower tax rates in foreign jurisdictions. The provision for income taxes for 2007 reflects the release of a $5.4 million FIN 48 liability because various statutes of limitations expired and a reduction of previous years’ uncertain tax positions. The provision for income taxes for 2007 also includes the impact of recording a $26.1 million tax benefit as a result of a $67.9 million reduction to the pension benefit and other obligations.

 

During 2006, we recorded a provision for income taxes of $15.7 million, which represents an effective tax rate of approximately 8%. This rate differs from the U.S. statutory rate primarily due to the realization of deferred tax assets not previously recognized in the U.S., which offset the tax expenses generated from U.S. sourced income as well as from earnings of certain foreign subsidiaries taxed in the U.S. We also benefited from lower tax rates in foreign jurisdictions. During 2006, we closed various audits, which resulted in a tax benefit of $3.1 million in the 2006 tax provision. These audits included the U.S. federal, various state and certain foreign audits.

 

Excluding certain foreign jurisdictions, management believes that the future benefit of deferred tax assets is not more likely than not to be realized.

 

FINANCIAL CONDITION, CAPITAL RESOURCES AND LIQUIDITY

 

Cash, cash equivalents and short-term investments decreased to $1,119.1 million as of December 31, 2008 from $1,397.6 million as of December 31, 2007. The decrease was mainly due to cash outflows from financing and investing activities as described below, offset in part by cash inflows from operating activities.

 

Working Capital

 

Working capital decreased by $428.2 million to $1.0 billion as of December 31, 2008 from $1.4 billion as of December 31, 2007. The decrease was attributable to the following:

 

 

 

These decreases in working capital were offset in part by the following:

 

 

Working capital increased by $321.1 million to $1.4 billion as of December 31, 2007 from $1.1 billion as of December 31, 2006. The increase in working capital was attributable to the following:

 

 

These increases in working capital were offset in part by the following:

 

 

Cash Provided by Operating Activities

 

During the year ended December 31, 2008, we generated $278.1 million of cash from operating activities compared to $295.0 million generated in 2007. Cash generated by operating activities in 2008 was the result of the following:

 

 

Cash and Cash Equivalents Used in Investing Activities

 

Cash and cash equivalents used in investing activities for the year ended December 31, 2008 were $163.4 million as compared to $1,121.4 million provided by investing activities for the year ended December 31, 2007. The primary investing activities during 2008 were:

 

 

We expect capital expenditures to be approximately $50.0 million in 2009. In recent years, we have reduced our level of capital expenditures as a result of our focus on establishing strategic supplier alliances with foundry semiconductor manufacturers and with third-party assembly and test operations, which enables us to have access to advanced manufacturing capacity and reduce our capital spending requirements.

 

Cash and Cash Equivalents Used in Financing Activities

 

Cash and cash equivalents used in financing activities for the year ended December 31, 2008 were $303.0 million as compared to $724.5 million in 2007. The primary financing activities during 2008 were the purchase of common stock under our repurchase programs, the repurchase of convertible subordinated notes, and the issuance of common stock under our employee stock plans.

 

On December 4, 2006, we announced that our Board of Directors had authorized a stock repurchase program of up to $500.0 million worth of our common stock and terminated the prior stock repurchase program authorized by the Board of Directors on July 28, 2000. In July 2007, we completed the repurchase program announced on December 4, 2006. On August 20, 2007, we announced that our Board of Directors had authorized a repurchase program of up to an additional $500.0 million worth of our common stock. During the year ended December 31, 2008, we repurchased 44.6 million shares for $229.2 million in cash, which together with the repurchases in 2007, effectively completed the authorization announced on August 20, 2007. The repurchased shares were retired immediately after the repurchases were complete. Retirement of the repurchased shares is recorded as a reduction of common stock and additional paid-in-capital.

 

It is our policy to reinvest our earnings, and we do not anticipate paying any cash dividends to stockholders in the foreseeable future.

 

Cash, cash equivalents and short-term investments are our primary source of liquidity. We believe that our existing liquid resources and cash generated from operations will be adequate to meet our operating and capital requirements and other obligations, including repayment of our outstanding convertible subordinated notes as they

mature, for the foreseeable future. We may, however, seek additional equity or debt financing from time to time. We believe that financing is currently difficult for many companies to obtain on acceptable terms or at all. Accordingly, such financing may not be available to us at all or on acceptable terms if we determine that it would be desirable to obtain additional financing. Moreover, any future equity or convertible debt financing may decrease the percentage of equity ownership of existing stockholders and may result in dilution, depending on the price at which the equity is sold or the debt is converted.

 

CONTRACTUAL OBLIGATIONS

 

The following table summarizes our contractual obligations as of December 31, 2008:

 

 

 

 

Convertible Subordinated Notes

 

As of December 31, 2008, we had outstanding $350.0 million of 4% Convertible Subordinated Notes due May 15, 2010. Interest on these notes is payable semiannually on May 15 and November 15 of each year. These convertible notes are subordinated to all existing and future senior debt and are convertible at the holder’s option into shares of our common stock at a conversion price of approximately $13.42 per share at any time prior to maturity. We cannot elect to redeem these notes prior to maturity. Each holder of these notes has the right to cause us to repurchase all of such holder’s convertible notes at a price equal to 100% of their principal amount plus any accrued interest upon the occurrence of any fundamental change, which includes a transaction or an event such as an

exchange offer, liquidation, a tender offer, consolidation, certain mergers or combination. The merger with Agere did not trigger this right.

 

As part of the merger with Agere, we guaranteed Agere’s 6.5% Convertible Subordinated Notes due December 15, 2009. As of December 31, 2008, we had outstanding $243.0 million of these notes. Interest on these notes is payable semiannually on June 15 and December 15 of each year. These notes are unsecured and subordinated obligations and are subordinated in right of payment to all of Agere’s existing and future senior debt. These notes are convertible at the holder’s option into shares of our common stock at a current conversion price of $15.3125 per share, subject to adjustment in certain events, at any time prior to maturity, unless previously redeemed or repurchased. We may redeem these notes in whole or in part at any time. We may be required to repurchase these notes at a price equal to 100% of their principal amount plus any accrued and unpaid interest if our stock is no longer approved for public trading, if our stockholders approve our liquidation or if a specified change in control occurs.

 

Operating Lease Obligations

 

We lease real estate, certain non-manufacturing equipment and software under non-cancelable operating leases.

 

Purchase Commitments

 

We maintain certain purchase commitments with suppliers primarily for raw materials and manufacturing services and for some non-production items. Purchase commitments for inventory materials are generally restricted to a forecasted time-horizon as mutually agreed upon between the parties. This forecasted time-horizon can vary among different suppliers.

 

FIN 48 Tax Liabilities

 

As of December 31, 2008, the amount of the unrecognized tax benefits determined under FIN 48 was $232.0 million. This is a net increase of $25.4 million in unrecognized tax benefits from the previous year. Of the $232.0 million in unrecognized tax benefits, we are expected to pay $36.5 million within one year. Accordingly, this amount has been reclassified to other current liabilities. For the remaining balance, we are unable to make a reasonably reliable estimate as to when cash settlement with a taxing authority may occur. It is reasonably possible that the total amount of unrecognized tax benefits will increase or decrease in the next 12 months. Such changes could occur based on the normal expiration of various statutes of limitations or the possible conclusion of ongoing tax audits in various jurisdictions around the world. If those events occur within the next 12 months, we estimate that, in addition to the $36.5 million discussed above, additional unrecognized tax benefits, plus accrued interest and penalties, could decrease by an amount in the range of $0 to $31.6 million.

 

Standby Letters of Credit

 

As of December 31, 2008 and 2007, we had outstanding obligations relating to standby letters of credit of $19.2 million and $11.1 million, respectively. Standby letters of credit are financial guarantees provided by third parties for leases, claims from litigations and certain self-insured risks. If the guarantees are called, we must reimburse the provider of the guarantee. The fair value of the letters of credit approximates the contract amount and they generally have one-year terms.

 

CRITICAL ACCOUNTING ESTIMATES

 

The discussion and analysis of our financial condition and results of operations is based on the consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. Note 1 to those financial statements describes our significant accounting policies. The preparation of these financial statements requires estimates and assumptions that affect the reported amounts and disclosures.

 

We believe the following to be critical accounting estimates. They are important to the portrayal of our financial condition and results, and they require significant management judgment and estimates about matters that

are inherently uncertain. As a result of the inherent uncertainty, there is a likelihood that materially different amounts would be reported under different conditions or using different assumptions. Although we believe that our judgments and estimates are reasonable, appropriate and correct, different amounts could have been reported if different estimates were made.

 

Stock-Based Compensation

 

On January 1, 2006, we adopted FAS 123R, using the modified prospective transition method. Under this method of implementation, no restatement of prior periods has been made. Determining the fair value of stock-based awards at the grant date requires considerable judgment, including estimating expected volatility, expected term and risk-free rate. Our stock-based compensation expense under FAS 123R in 2008, 2007 and 2006 was $72.3 million, $77.3 million and $47.0 million, respectively. Stock-based compensation costs capitalized to inventory and software development for 2008, 2007 and 2006 were not significant. (See Note 3 to our consolidated financial statements in Item 8 for a description of our equity compensation plans.)

 

Stock Options:

 

The fair value of each option grant is estimated on the date of grant using a reduced form calibrated binomial lattice model (the “lattice model”). This model requires the use of historical data for employee exercise behavior and the use of assumptions outlined in the following table:

 

 

The expected life of employee stock options represents the weighted-average period the stock options are expected to remain outstanding and is a derived output of the lattice model. The expected life of employee stock options is affected by all of the underlying assumptions and calibration of our model.

 

The risk-free interest rate assumption is based upon observed interest rates for constant maturity U.S. Treasury securities appropriate for the term of our employee stock options.

 

We use an equally weighted combination of historical and implied volatilities as of the grant date. The historical volatility is the standard deviation of our daily stock returns from the date of the initial public offering of our common stock in 1983. For the implied volatilities, we use near-the-money exchange traded call options, as stock options are call options that are granted at-the-money. The historical and implied volatilities are annualized and equally weighted to determine the volatilities as of the grant date. We believe that the equally weighted combination of historical and implied volatilities is more representative of future stock price trends than sole use of historical or implied volatilities.

 

The lattice model assumes that employees’ exercise behavior is a function of the option’s remaining vested life and the extent to which the option is in-the-money. The lattice model estimates the probability of exercise as a function of these two variables based on the entire history of exercises and cancellations for all past option grants made by us since our initial public offering.

 

Because stock-based compensation expense recognized is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures were estimated based on historical experience.

Employee Stock Purchase Plan:

 

Under the employee stock purchase plan, rights are granted to our employees to purchase shares of common stock at 85% of the lesser of the fair market value of such shares at the beginning of a 12-month offering period or the end of each six-month purchase period within such an offering period. Compensation expense is calculated using the fair value of the employees’ purchase rights under the Black-Scholes model. For disclosure purposes, the assumptions that went into the calculation of fair value for the May and November 2008, 2007 and 2006 grants were as follows:

 

 

Restricted Stock Awards:

 

The cost of these awards is determined using the fair value of our common stock on the date of the grant and compensation expense is recognized over the vesting period on a straight-line basis.

 

Our determination of fair value of share-based payment awards on the date of grant using an option-pricing model is affected by our stock price as well as a number of highly complex and subjective assumptions. We use third-party consultants to assist in developing the assumptions used in, as well as calibrating, the lattice model. We are responsible for determining the assumptions used in estimating the fair value of our share-based payment awards. Option-pricing models were developed for use in estimating the value of traded options that have no vesting or hedging restrictions and are fully transferable. Because our employee stock options have certain characteristics that are significantly different from traded options, and because changes in the subjective assumptions can materially affect the estimated value, in management’s opinion, the existing valuation models may not provide an accurate measure of the fair value of our employee stock options. Although the fair value of employee stock options is determined in accordance with FAS 123R and Staff Accounting Bulletin No. 107 using an option-pricing model, that value may not be indicative of the fair value observed in a willing buyer/willing seller market transaction.

 

Inventory Valuation Methodology

 

Inventories are valued at the lower of cost or market using the first-in, first-out (FIFO) method. We write down our inventories for estimated obsolescence and unmarketable inventory in an amount equal to the difference between the cost of the inventory and the estimated market value based upon assumptions about future demand and market conditions. Inventory impairment charges create a new cost basis for inventory.

 

We balance the need to maintain strategic inventory levels to ensure competitive delivery performance to our customers with the risk of inventory obsolescence due to rapidly changing technology and customer requirements, product life-cycles, life-time buys at the end of supplier product runs and a shift of production to outsourcing. If actual demand or market conditions are less favorable than we project or our customers fail to meet projections, additional inventory write-downs may be required. Our inventory balance was $220.5 million and $240.8 million as of December 31, 2008 and 2007, respectively.

 

If market conditions are more favorable than expected, we could experience more favorable gross profit margins going forward as we sell inventory that was previously written down.

 

Valuation of Long-Lived Assets, Intangible Assets and Goodwill

 

We have historically pursued the acquisition of businesses, which has resulted in significant goodwill and intangible assets. We assess the impairment of long-lived assets, identifiable intangibles and related goodwill annually or sooner if events or changes in circumstances indicate that the carrying value may not be recoverable.

Factors that could trigger an impairment review include the following: (i) significant negative industry or economic trends; (ii) exiting an activity in conjunction with a restructuring of operations; (iii) current, historical or projected losses that demonstrate continuing losses associated with an asset; or (iv) our market capitalization being less than net book value. When we determine that there is an indicator that the carrying value of long-lived assets, identifiable intangibles or related goodwill may not be recoverable, we measure impairment based on estimates of future cash flows. See Notes 6 and 7 to our financial statements in Item 8 for more details on long-lived assets, intangible assets and goodwill.

 

The goodwill impairment testing is a two-step process and is performed by reporting unit in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets”. Our reporting units are Semiconductor and Storage Systems. The first step requires comparing the fair value of each reporting unit to its net book value. If the fair value of the reporting unit is greater than its net book value, there is no impairment. Otherwise, the second step must be completed to measure the amount of impairment. The second step calculates the implied fair value of goodwill by deducting the fair value of all tangible and intangible assets, excluding goodwill, of the reporting unit from the fair value of the reporting unit as determined in step 1. The implied fair value of goodwill determined in step 2 is compared to the carrying value of goodwill. If the implied fair value of goodwill is less than the carrying value of goodwill, an impairment loss is recognized equal to the difference.

 

In determining the fair value of each reporting unit, we rely solely on a discounted cash flow analysis. We do research and analyze peer multiples for comparison purposes, but we do not rely directly upon such data due to the lack of specific comparability between the peer companies and our reporting units. Instead we employ the peer multiple data as a general check on the results of our discounted cash flow analysis. The material assumptions used in performing the discounted cash flow analysis include forecasts of expected future cash flows, including elements such as revenues, cost of sales, operating expenses, tax expenses, working capital, investment and capital expenditures. Key assumptions include expected near and long-term growth rates, as well as expected profitability levels and capital investment. Since the forecasted cash flows of the business, as well as those allocated to individual assets, need to be discounted to present value in order to arrive at estimates of fair value, discount rates must be estimated and applied in the valuation models. These discount rates are based on estimates of a market weighted average cost of capital for each reporting unit, with adjustments made to account for the relative risk of individual assets valued.

 

In the fourth quarters of 2008 and 2007, the economic conditions in the semiconductor industry deteriorated and our stock price declined, resulting in our market capitalization falling below our net book value. Additionally, in the fourth quarter of 2008, our revenues declined significantly from initial expectations amidst a global economic down turn.

 

During the fourth quarters of 2008 and 2007, the results of our analysis indicated that the carrying amounts of goodwill for our Semiconductor reporting unit were no longer recoverable under the first step of the test for impairment. We recognized goodwill impairment charges of $364.1 million and $2,019.9 million in the Semiconductor segment during 2008 and 2007, respectively, under the second step of the test for impairment. There was no impairment charge to goodwill in 2006. As of December 31, 2008, we had a remaining goodwill balance of $175.6 million associated with the Storage Systems segment. There is no remaining goodwill for the Semiconductor segment. Our next annual test for the impairment of goodwill is expected to be performed in the fourth quarter of 2009 or sooner if events or changes in circumstances indicate that the carrying amount may not be recoverable.

 

As of December 31, 2008, we had intangible assets of $890.0 million. For the years ended December 31, 2008 and 2007, we recognized other intangible asset impairment charges of $177.5 million and $1.6 million, respectively, in the Semiconductor segment.

 

Based upon market conditions in the semiconductor industry in 2008 and 2007, we assessed the recoverability of our other intangible assets in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”. The assessment of recoverability was based on management’s estimates of undiscounted projected future operating cash flows compared to the net book value of the other intangible assets. In cases where the net book value exceeded undiscounted projected future operating cash flows, an impairment existed. The impairment charge was measured as the difference between the net book value of the other intangible assets and the fair value of such assets. The fair value is determined using a discounted cash flow approach for each asset grouping.

Based on the assessment, we recorded intangible asset impairment charges of $177.5 million during the three months ended December 31, 2008, of which $98.1 million related to existing technology and $79.4 million related to customer relationships. In 2007, we recorded an impairment charge of $1.6 million which related primarily to existing technology.

 

Restructuring Reserves

 

We have recorded reserves/accruals for restructuring costs related to our restructuring of operations. The restructuring reserves include estimated payments to employees for severance, termination fees associated with leases and other contracts, decommissioning and selling costs associated with assets held for sale, and other costs related to the closure of facilities. Reserves are recorded when management has approved a plan to restructure operations and a liability has been incurred. The restructuring reserves are based upon management estimates at the time they are recorded. These estimates can change depending upon changes in facts and circumstances subsequent to the date the original liability was recorded. For example, existing accruals for severance may be modified if employees are redeployed due to circumstances not foreseen when the original plans were initiated, accruals for outplacement services may not be fully utilized by former employees, and severance accruals could change for statutory reasons in countries outside the United States. Accruals for facility leases under which we ceased using the benefits conveyed to us under the lease may change if market conditions for subleases change or if we later negotiate a termination of the lease.

 

Income Taxes

 

Deferred tax assets and liabilities are recognized for temporary differences between financial statement and income tax bases of assets and liabilities. We have recorded a valuation allowance to reduce the deferred tax assets to the amount that is more likely than not to be realized. We have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance. See Note 13 to our financial statements in Item 8 for more details about our deferred tax assets and liabilities.

 

The calculation of our tax liabilities involves the application of complex tax rules and regulations in multiple jurisdictions throughout the world. Our tax liabilities include estimates for all income-related taxes that we believe are probable and that can be reasonably estimated. To the extent that our estimates are understated, additional charges to income tax expense would be recorded in the period in which we determine such understatement. If our income tax estimates are overstated, income tax benefits will be recognized when realized.

 

Retirement Benefits

 

Post-retirement assets and liabilities are our estimates of benefits that we expect to pay to eligible retirees. We consider various factors in determining our post-retirement group life asset, including the number of employees that we expect to receive benefits and other actuarial assumptions. Effective January 1, 2009, the post-retirement medical plans were terminated, and therefore that liability represents management’s best estimate for medical claims from 2008. If the actual post-retirement benefits paid differ from our current estimate, we may be over- or under- accrued.

 

We also have pension plans covering substantially all former Agere U.S. employees, excluding management employees hired after June 30, 2003, and pension plans covering certain international employees. We consider various factors in determining our pension liability, including the number of employees that we expect to receive benefits, their salary levels and years of service, the expected return on plan assets, the discount rate used to determine the benefit obligation, the timing of the payment of benefits, and other actuarial assumptions. Effective April 6, 2009, the Company will freeze the U.S. management pension plan. If the actual results and events of our pension plan differ from our current assumptions, our benefit obligations may be over- or under- valued.

 

As a result of the acquisition of Agere, we re-measured the pension and post-retirement liabilities, and adopted FASB SFAS No. 158, or FAS 158, “Employers’ Accounting for Defined Benefit Pension and Other Post-retirement Plans,” effective April 2, 2007. The key benefit plan assumptions are the discount rate and the expected rate of return on plan assets. These assumptions are discussed below for our U.S. retirement benefit plans. For our international plans, we chose assumptions specific to each country.

The discount rate we use is based on a cash flow analysis using the Citigroup Pension Discount Curve and the Citigroup Above Median Pension Discount Curve as of the measurement date. For the year ended December 31, 2008, the rate used to determine our net periodic benefit cost was 6.5%. The discount rate used to determine the benefit obligation as of December 31, 2008 was 6.5%.

 

For the year ended December 31, 2007, we used two discount rates to determine our net periodic benefit cost for our management plans since we were required to re-measure our post-retirement plans due to a curtailment. The rates used prior to and after the curtailment effect taken in the fourth quarter of 2007 were 6.00%, and 6.25%, respectively. The rate used to determine our net periodic benefit cost for our represented plans and our non-qualified pension plan was 6.00%. The discount rate used to determine the benefit obligation as of December 31, 2007 was 6.50%.

 

We base our salary increase assumptions on historical experience and future expectations. The expected rate of return for our retirement benefit plans represents the average rate of return expected to be earned on plan assets over the period that the benefit obligations are expected to be paid. In developing the expected rate of return, we consider long-term compound annualized returns based on historical market data, historical and expected returns on the various categories of plan assets, and the target investment portfolio allocation between debt and equity securities. The weighted average investment portfolio allocation for our U.S. management and represented pension plans as of December 31, 2008 was 48% in equity and 52% in debt investments as compared to the target investment portfolio allocation of 53% equity and 47% debt. The portfolio’s equity weighting is consistent with the long-term nature of the plans’ benefit obligations. For 2008, we used an expected rate of return on plan assets of 8.25% and 8.00% for the management and represented pension plans, respectively, consistent with the target investment portfolio allocation. The actual loss on our pension assets during 2008 was $252.1 million, with the losses smoothed over the next five years through the return on assets assumption using the market related value of assets (“MRVA”), with those not yet recognized through MRVA amortized under current accounting rules for recognizing asset and liability gains and losses. For our U.S. post-retirement benefit plans, we used a weighted-average long-term rate of return on assets of 7.75%.

 

The weighted average investment portfolio allocation for our U.S. management and represented pension plans as of December 31, 2007 was 53% in equity and 47% in debt investments as compared to the target investment portfolio allocation of 53% equity and 47% debt. For 2007, we used an expected rate of return on plan assets of 8.25% and 8.00% for the management and represented pension plans, respectively, consistent with the target investment portfolio allocation. For our U.S. post-retirement benefit plans, we used a weighted-average long-term rate of return on assets of 7.75%.

 

Actuarial assumptions are based on our best estimates and judgment. Material changes may occur in retirement benefit costs in the future if these assumptions differ from actual events or experience. We performed a sensitivity analysis on the discount rate, which is the key assumption in calculating the pension and post-retirement benefit obligations. For the year ended December 31, 2008, each change of 25 basis points in the discount rate assumption would have an estimated $0.8 million impact on annual net retirement benefit costs and a $31.0 million impact on benefit obligations. Each change of 25 basis points in the expected rate of return assumption would have an estimated $2.6 million annual impact on net retirement benefit costs.

 

For the year ended December 31, 2007, each change of 25 basis points in the discount rate assumption would have an estimated $0.6 million impact on annual net retirement benefit costs and a $36.0 million impact on benefit obligations. Each change of 25 basis points in the expected rate of return assumption would have an estimated $2.7 million annual impact on net retirement benefit costs.

 

RECENT ACCOUNTING PRONOUNCEMENTS

 

The information contained in Note 1 to our financial statements in Part II, Item 8 under the heading “Recent Accounting Pronouncements” is incorporated by reference into this Part II, Item 7.

 

Interest Rate Sensitivity

 

A 10% weighted-average worldwide interest rate movement affecting our fixed and floating rate financial instruments as of December 31, 2008 and 2007, including investments and debt obligations, would not have had a significant effect on our financial position, results of operations and cash flows over the next fiscal year, assuming that the debt and investment balances remained consistent.

 

With the objective of protecting our cash flows and earnings from the impact of fluctuations in interest rates, while minimizing the cost of capital, we may enter into interest rate swaps. As of December 31, 2008, there were no interest rate swaps outstanding.

 

Foreign Currency Exchange Risk

 

We have foreign subsidiaries that operate and sell our products in various global markets. As a result, our cash flows and earnings are exposed to fluctuations in foreign currency exchange rates. We attempt to limit these exposures through operational strategies and financial market instruments. We use various hedge instruments, primarily forward contracts with maturities of twelve months or less and currency option contracts, to manage our exposure associated with net asset and liability positions and cash flows denominated in non-functional currencies. We did not enter into derivative financial instruments for trading purposes during 2008 and 2007.

 

Based on our overall currency rate exposures at December 31, 2008, including derivative financial instruments and non-functional currency-denominated receivables and payables, a near-term 10% appreciation or depreciation of the U.S. dollar would not have a significant effect on our financial position, results of operations and cash flows over the next fiscal year. In 2007, a near-term 10% appreciation or depreciation of the U.S. dollar would also not have had a significant effect.

 

Equity Price Risk

 

We have investments in available-for-sale equity securities included in long-term assets. The fair values of these investments are sensitive to equity price changes. Changes in the value of these investments are ordinarily recorded through accumulated comprehensive income. The increase or decrease in the fair value of the investments would affect our results of operations to the extent that the investments were sold or that declines in value were concluded by management to be other than temporary.

 

If the prices of our available-for-sale equity securities were to increase or decrease 10% from their fair values as of December 31, 2008, it would increase or decrease the investment values by $0.1 million. As of December 31, 2007, a 10% increase or decrease in fair values would have increased or decreased the investment values by $0.2 million. We do not use any derivatives to hedge the fair value of our marketable available-for-sale equity securities.

 

Credit and Market Liquidity Risks

 

As of December 31, 2008, we had investments in money market mutual funds of $664.1 million and available-for-sale debt securities of $297.3 million. These securities are classified as available-for-sale under the guidance of SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities” and accordingly are recorded at fair market value in cash and cash equivalents or short-term investments with unrealized gains or losses reported as a separate component of accumulated other comprehensive income, net of applicable taxes.

 

These investments expose us to credit risk, or the risk of loss should the issuer of the debt securities held in our portfolio or by the money market mutual funds we invest in be unable to meet their financial obligations under those securities. Our available-for-sale debt securities at December 31, 2008 included $184.5 million of asset-backed and mortgage-backed securities, of which $148.5 million are issued by agencies of the U.S. government. We diversify our investments to reduce the exposure to loss from any single issuer, sector, bank or mutual fund.

 

We are also exposed to market liquidity risk. This is the risk that the demand for securities in the market becomes significantly lower than normal or ceases to exist. The U.S. government has recently instituted several

programs to restore market liquidity such as money market guarantees, The Commercial Paper Funding Facility, and the Troubled Asset Relief Program. However, access to our funds could be limited in some cases and some money market funds could limit redemptions for a period of time. The impact of market liquidity risk on our investments is that we may be unable to sell our investments in a timely manner should we need to, or if we are able to sell them, the sale price of the investments may be lower than we expect.

 

Credit and market liquidity risks could impact our results of operations to the extent we incur a loss or if management determines that changes in prices of available-for-sale debt securities are other than temporary.

 

 

The accompanying notes are an integral part of these Consolidated Financial Statements.

 

 

The accompanying notes are an integral part of these Consolidated Financial Statements.