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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549

FORM 10-Q

(Mark One)

x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended December 31, 2010.

OR

o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from __________ to __________

Commission File Number:  0-21184
 
 
 
 
 
MICROCHIP TECHNOLOGY INCORPORATED
(Exact Name of Registrant as Specified in Its Charter)

Delaware
 
86-0629024
(State or Other Jurisdiction of Incorporation or Organization)
 
(IRS Employer Identification No.)

2355 W. Chandler Blvd., Chandler, AZ  85224-6199
(480) 792-7200
(Address, Including Zip Code, and Telephone Number,
Including Area Code, of Registrant's
Principal Executive Offices)
 
Indicate by checkmark 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 the filing requirements for the past 90 days.
 
Yes          x
No             o
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
 
Yes           x
No              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 definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act:

Large accelerated filer
x
Accelerated filer
o
Non-accelerated filer
o
Smaller reporting company
o
(Do not check if a smaller reporting company)

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

Shares Outstanding of Registrant's Common Stock
Class
Outstanding at January 31, 2011
Common Stock, $0.001 par value
188,422,764 shares
 
 

 


 
 

 


MICROCHIP TECHNOLOGY INCORPORATED AND SUBSIDIARIES

INDEX
 
 
 
   
Page
     
PART I.  FINANCIAL INFORMATION
 
     
 
     
  3
     
  4
     
  5
     
  6
     
22
     
38 
     
39 
     
PART II.  OTHER INFORMATION
 
     
39 
     
40 
     
50 
   
 
   
CERTIFICATIONS
 
   
EXHIBITS
 
 
 
 
 

 
 

 

 
Item 1.                      Financial Statements

MICROCHIP TECHNOLOGY INCORPORATED AND SUBSIDIARIES
(in thousands, except share and per share amounts)
(unaudited)

ASSETS
 
   
December 31,
   
March 31,
 
   
2010
   
2010
 
Cash and cash equivalents
 
$
500,616
   
$
492,130
 
Short-term investments
   
690,568
     
722,193
 
Accounts receivable, net
   
187,267
     
137,806
 
Inventories
   
177,705
     
116,579
 
Prepaid expenses
   
20,968
     
13,068
 
Deferred tax assets
   
107,617
     
77,810
 
Assets held for sale
   
1,109
     
---
 
Other current assets
   
52,594
     
51,383
 
Total current assets
   
1,738,444
     
1,610,969
 
                 
Property, plant and equipment, net
   
528,215
     
493,039
 
Long-term investments
   
381,832
     
317,215
 
Goodwill
   
59,457
     
40,338
 
Intangible assets, net
   
79,074
     
35,527
 
Other assets
   
41,704
     
19,225
 
                 
Total assets
 
$
2,828,726
   
$
2,516,313
 
                 
LIABILITIES AND STOCKHOLDERS' EQUITY
 
                 
Accounts payable
 
$
66,070
   
$
44,238
 
Accrued liabilities
   
91,180
     
60,211
 
Deferred income on shipments to distributors
   
142,685
     
98,941
 
Total current liabilities
   
299,935
     
203,390
 
                 
Junior convertible debentures
   
345,581
     
340,672
 
Long-term income tax payable
   
106,201
     
57,140
 
Deferred tax liability
   
415,807
     
376,713
 
Other long-term liabilities
   
11,257
     
5,018
 
                 
Stockholders' equity:
               
Preferred stock, $0.001 par value; authorized 5,000,000 shares; no shares issued or outstanding
   
---
     
---
 
Common stock, $0.001 par value; authorized 450,000,000 shares; 218,789,994 shares issued and 188,305,939 shares outstanding at December 31, 2010; 218,789,994 shares issued and 185,329,144 shares outstanding at March 31, 2010
   
188
     
185
 
Additional paid-in capital
   
1,268,449
     
1,276,822
 
Retained earnings
   
1,303,311
     
1,266,699
 
Accumulated other comprehensive income
   
2,774
     
3,032
 
Common stock held in treasury: 30,484,055 shares at December 31, 2010; 33,460,850 shares at March 31, 2010
   
(924,777)
     
(1,013,358
)
Total stockholders' equity
   
1,649,945
     
1,533,380
 
                 
Total liabilities and stockholders' equity
 
$
2,828,726
   
$
2,516,313
 
   
See accompanying notes to condensed consolidated financial statements
 


 
 
 

 

MICROCHIP TECHNOLOGY INCORPORATED AND SUBSIDIARIES
(in thousands, except per share amounts)
(Unaudited)

   
Three Months Ended December 31,
   
Nine Months Ended December 31,
 
   
2010
   
2009
   
2010
   
2009
 
Net sales
  $ 367,824     $ 250,099     $ 1,107,220     $ 669,709  
Cost of sales (1)
    151,427       104,103       458,375       303,938  
   Gross profit
    216,397       145,996       648,845       365,771  
                                 
Operating expenses:
                               
   Research and development  (1)
    42,198       30,332       126,448       87,536  
   Selling, general and administrative  (1)
    56,100       43,096       170,896       120,525  
   Special charges
    646       ---       1,679       1,238  
      98,944       73,428       299,023       209,299  
                                 
Operating income
    117,453       72,568       349,822       156,472  
Gains on equity method investments
    280       ---       185       ---  
Other income (expense):
                               
   Interest income
    3,955       4,946       12,371       12,727  
   Interest expense
    (7,672 )     (7,763 )     (23,456 )     (23,312 )
   Other, net
    375       128       1,747       7,929  
                                 
Income from continuing operations before income taxes
    114,391       69,879       340,669       153,816  
Income tax provision
    12,461       476       42,114       12,560  
Net income from continuing operations
    101,930       69,403       298,555       141,256  
Discontinued operations:
                               
Loss from discontinued operations before income taxes
    (1,317 )     ---       (5,372 )     ---  
Income tax benefit
    (163 )     ---       (239 )     ---  
Net loss from discontinued operations
    (1,154 )     ---       (5,133 )     ---  
Net income
  $ 100,776     $ 69,403     $ 293,422     $ 141,256  
                                 
Basic net income per common share – continuing operations
  $ 0.54     $ 0.38     $ 1.60     $ 0.77  
Basic net loss per common share – discontinued operations
    (0.01 )     ---       (0.03 )     ---  
Basic net income per common share
  $ 0.54     $ 0.38     $ 1.57     $ 0.77  
Diluted net income per common share – continuing operations
  $ 0.52     $ 0.37     $ 1.55     $ 0.76  
Diluted net loss per common share – discontinued operations
    (0.01 )     ---       (0.03 )     ---  
Diluted net income per common share
  $ 0.51     $ 0.37     $ 1.53     $ 0.76  
Dividends declared per common share
  $ 0.689     $ 0.340     $ 1.374     $ 1.018  
Basic common shares outstanding
    187,488       183,856       186,444       183,301  
Diluted common shares outstanding
    196,255       187,861       192,344       186,770  
                                 
(1) Includes share-based compensation expense as follows:
                         
   Cost of sales
  $ 1,708     $ 1,266     $ 5,416     $ 4,845  
   Research and development
    3,324       3,108       9,516       9,205  
   Selling, general and administrative
    4,377       4,463       12,853       13,285  
                                 
See accompanying notes to condensed consolidated financial statements
 



 
 
 

 

MICROCHIP TECHNOLOGY INCORPORATED AND SUBSIDIARIES
(in thousands)
(Unaudited)

   
Nine months ended December 31,
 
   
2010
   
2009
 
Cash flows from operating activities:
           
Net income
  $ 293,422     $ 141,256  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Depreciation and amortization
    80,153       67,735  
Deferred income taxes
    17,380       17,555  
Share-based compensation expense related to equity incentive plans
    27,785       27,335  
Excess tax benefit from share-based compensation
    (1,240 )     (2,050 )
Convertible debt derivatives - revaluation and amortization
    (192 )     154  
Amortization of convertible debenture issuance costs
    165       302  
Amortization of debt discount on convertible debentures
    5,101       4,662  
Gains on equity method investments
    (185 )     ---  
Gain on sale of assets
    (89 )     (100 )
Unrealized impairment loss on available-for-sale investments
    1,263       2,170  
Special charge
    ---       1,238  
Sales of trading securities, net
    ---       86,970  
Gain on trading securities
    ---       (7,425 )
Changes in operating assets and liabilities:
               
Increase in accounts receivable
    (3,016 )     (25,238 )
(Increase) decrease in inventories
    (20,779 )     19,216  
Increase in deferred income on shipments to distributors
    41,422       13,652  
(Decrease) increase in accounts payable and accrued liabilities
    (19,279 )     14,600  
Change in other assets and liabilities
    8,213       (18,013 )
Net cash provided by operating activities
    430,124       344,019  
                 
Cash flows from investing activities:
               
Purchases of available-for-sale investments
    (859,307 )     (1,311,946 )
Sales and maturities of available-for-sale investments
    838,995       1,083,146  
Purchase of Silicon Storage Technology, Inc., net of cash received
    (112,707 )     ---  
Investment in other assets
    (14,843 )     (5,975 )
Proceeds from sale of assets
    30,559       100  
Capital expenditures
    (100,114 )     (28,416 )
Net cash used in investing activities
    (217,417 )     (263,091 )
                 
Cash flows from financing activities:
               
Payment of cash dividend
    (256,808 )     (186,594 )
Proceeds from sale of common stock
    51,347       18,578  
Excess tax benefit from share-based compensation
    1,240       2,050  
Net cash used in financing activities
    (204,221 )     (165,966 )
Net increase (decrease) in cash and cash equivalents
    8,486       (85,038 )
Cash and cash equivalents at beginning of period
    492,130       446,329  
Cash and cash equivalents at end of period
  $ 500,616     $ 361,291  
                 
                 
See accompanying notes to condensed consolidated financial statements
 



 
 
 

 


MICROCHIP TECHNOLOGY INCORPORATED AND SUBSIDIARIES
(Unaudited)

 
(1)
Basis of Presentation
 
The accompanying unaudited condensed consolidated financial statements include the accounts of Microchip Technology Incorporated and its wholly-owned subsidiaries (the Company).  All intercompany balances and transactions have been eliminated in consolidation.  The Company owns 100% of the outstanding stock in all of its subsidiaries.
 
The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States of America, pursuant to the rules and regulations of the Securities and Exchange Commission (the SEC).  The information furnished herein reflects all adjustments which are, in the opinion of management, necessary for a fair statement of the results for the interim periods reported.  With the exception of certain adjustments associated with the acquisition of Silicon Storage Technology, Inc. (SST), all such adjustments are, in the opinion of management, of a normal recurring nature.  Certain information and footnote disclosures normally included in audited consolidated financial statements have been condensed or omitted pursuant to such SEC rules and regulations.  It is suggested that these condensed consolidated financial statements be read in conjunction with the audited consolidated financial statements and the notes thereto included in the Company's Annual Report on Form 10-K for the fiscal year ended March 31, 2010.  The results of operations for the nine months ended December 31, 2010 are not necessarily indicative of the results that may be expected for the fiscal year ending March 31, 2011 or for any other period.
 
As further discussed in Note 3, on April 8, 2010, the Company completed its acquisition of SST and the Company's fiscal 2011 financial results include SST's results beginning April 9, 2010.
 
(2)
Adopted and Recently Issued Accounting Pronouncements
 
The Company adopted the provisions of Accounting Standards Codification (ASC) 810-10 (previously included in Financial Accounting Standard 167) on April 1, 2010.  The Company noted no arrangements at April 1, 2010 which would be within the scope of ASC 810-10.  Upon completing the acquisition of SST, the Company evaluated whether any of SST's relationships with other entities would result in those entities being consolidated under the variable-interest accounting guidance.  Based on the Company's evaluation, this guidance had no impact on the Company's financial position, results of operations or cash flows.
 
The Financial Accounting Standards Board (FASB) issued Accounting Standards Update 2009-13, Multiple Deliverable Revenue Arrangements (codified in ASC 605-25) in October 2009.  This guidance is effective for fiscal periods beginning on or after June 15, 2010, with early adoption permitted.  The new revenue recognition guidance is for arrangements that include both software and non-software related deliverables.  This guidance requires entities to allocate the overall consideration to each deliverable by using a best estimate of the selling price of individual deliverables in the arrangement in the absence of VSOE or other third party evidence of the selling price.  Additionally, the guidance modifies the manner in which the transaction consideration is allocated across the separately identified deliverables by no longer permitting the residual method of allocating arrangement consideration.  The Company is currently evaluating the impact of adopting this new guidance on its consolidated financial statements.
 
(3)           Acquisition of Silicon Storage Technology, Inc.
 
On April 8, 2010, the Company acquired SST, a public company based in Sunnyvale, California, in a merger transaction for $3.05 per share, or a total of $353.8 million, which included $295.4 million of cash consideration for the outstanding shares of SST common stock, and $58.4 million of SST shares acquired by the Company on March 8, 2010.  The fair value of the SST shares held by the Company on April 8, 2010 was equal to the fair value at March 8, 2010, the date the shares were acquired, and the Company did not recognize any gain or loss on such shares.  The SST business acquired included a variety of different business units including a licensing business focused on opportunities in the embedded control market, a microcontroller business, a variety of memory businesses and a Wi-Fi business. The Company's primary reason for this acquisition was to gain access to SST's SuperFlash® technology and extensive patent portfolio, which it believes are critical building blocks for advanced microcontrollers.
 
The acquisition was accounted for under the acquisition method of accounting, with the Company identified as the acquirer, and the operating results of SST have been included in the Company's condensed consolidated financial statements as of the effective date of the acquisition.  Under the acquisition method of accounting, the total purchase price was allocated to SST's net tangible assets and intangible assets based on their estimated fair values as of April 8, 2010.  The excess purchase price over the value of the net tangible assets and intangible assets was recorded to goodwill.  The Company has not completed its allocation of goodwill to its reporting segments. 
 
 
6 
 

 
 
 
 
None of the goodwill related to the SST acquisition is deductible for tax purposes.  The Company retained an independent third-party appraiser to assist management in its valuation; however, the purchase price allocation has not been finalized.  Completion of the valuation could result in adjustments to the carrying value of the assets acquired and liabilities assumed, the useful lives of intangible assets and residual amount allocated to goodwill.  The remaining areas of the purchase price allocation may be subject to change as the allocation relates to accrued liabilities, deferred tax assets and long-term income taxes payable, purchased intangible assets and goodwill.  The preliminary allocation of the purchase price is based on the best estimates of management and is subject to revision based on the final valuations and estimates of useful lives.
 
The table below represents the preliminary allocation of the purchase price to the acquired net assets based on their estimated fair values as of April 8, 2010, as well as the associated estimated useful lives of the acquired intangible assets at that date.  There were no changes to the purchase price allocation in the three months ended December 31, 2010.

   
April 8, 2010
 
   
(in thousands)
 
Assets acquired
     
Cash and cash equivalents
  $ 182,735  
Short-term investments
    12,069  
Accounts receivable, net
    44,820  
Inventories
    39,962  
Deferred tax assets
    22,899  
Other current assets
    6,877  
Long-term investments
    54,342  
Property, plant and equipment, net
    6,623  
Non-marketable equity investments
    27,372  
Other assets
    3,634  
Goodwill
    9,017  
Purchased intangible assets
    50,930  
Assets held for sale
    23,761  
Total assets acquired
    485,041  
         
Liabilities assumed
       
Accounts payable
    (28,906 )
Accrued liabilities
    (40,914 )
Deferred income on shipments to distributors
    (2,322 )
Long-term income tax payable
    (36,466 )
Deferred tax liability
    (17,599 )
Other liabilities
    (4,990 )
Total liabilities assumed
    (131,197 )
Purchase price allocated
  $ 353,844  

 
Purchased Intangible Assets
 
Useful Life
 
April 8, 2010
 
   
(in years)
 
(in thousands)
 
           
Core/developed technology
    5-10   $ 32,900  
In-process research and development
       10     900  
Trademarks and trade names
         5     1,730  
Customer-related
      10     13,100  
Backlog
        1     2,300  
          $ 50,930  

As of the date of acquisition, the gross contractual amount of trade accounts receivable acquired was $44.8 million.
 
Purchased intangible assets include core and developed technology, in-process research and development, trademarks and trade names, customer-related intangibles and acquisition-date backlog.  The preliminary estimated fair values of the core and developed technology and in-process research and development were determined based on the present value of the expected cash flows to be generated by the respective existing technology or future technology.  The core and developed technology intangible assets are being amortized on a technology-by-technology basis with the amortization recorded for each technology commensurate with the expected cash flows used in the initial determination of fair value.  In-process research and development is capitalized until such time the related projects are completed or abandoned at which time the capitalized amounts will begin to be amortized or written off.
 
 
7
 

 
 
 
 
 
Trademarks and trade names include SST's corporate trade name as well as the SuperFlash trademark.  The preliminary estimated fair value of the trademarks and trade names was determined based on the income approach, using the relief from royalty methodology.  Trademarks and trade names are being amortized using the straight-line method, which management believes is materially consistent with the pattern of benefit to be realized by these assets.
 
Customer-related intangible assets consist of SST's contractual relationships and customer loyalty related to the distributor and end-customer relationships, and the preliminary fair values of the customer-related intangibles were determined based on the projected revenues for the licensing entity and the microcontroller entity.  An analysis of expected attrition and revenue growth for existing customers was prepared from SST's historical customer information.  A similar analysis was performed for the acquired intangible assets related to the business units held for sale.  Customer relationships are being amortized in a manner consistent with the estimated cash flows associated with the existing customers and anticipated retention rates. Backlog relates to the value of orders not yet shipped by SST at the acquisition date, and the preliminary fair values were based on the estimated profit associated with those orders.  Backlog related assets are being recognized commensurate with recognition of the revenue for the orders on which the backlog intangible assets were determined.  Amortization expense associated with acquired intangible assets is not deductible for tax purposes.  Thus, approximately $2.0 million was established as a net deferred tax liability for the future amortization of the intangible assets.
 
Contingent liabilities were recorded in the amount of $13.0 million, as an adverse outcome was determined to be probable and estimable at the acquisition date.  The Company was not able to determine the fair value of these contingencies, and as such, the amount recorded reflects the Company's estimate of the outcome of these matters.  At December 31, 2010, there were no changes to the amount recognized at the acquisition date related to these contingencies.  The amount recorded is presented within accrued liabilities.
 
The amount of continuing SST revenue and earnings included in the condensed consolidated statements of income for the period April 9, 2010 to September 30, 2010 was $114.9 million and $17.4 million, respectively. The amount of continuing SST revenue included in the condensed consolidated statements of income for the three months ended December 31, 2010 was $56.8 million. The amount of continuing SST revenue included in the condensed consolidated statements of income for the period April 9, 2010 to December 31, 2010 was $171.7 million.  The operations of SST have been fully integrated into the Company’s operations as of October 1, 2010 and as such, cost of sales and operating expenses were no longer segregated in the three months ended December 31, 2010.
 
The following unaudited pro-forma consolidated results of operations for the three and nine-month periods ended December 31, 2010 and 2009, assume the SST acquisition occurred as of April 1 of each year and have been restated for the operations of SST that have been discontinued.  The pro-forma results of operations are presented for informational purposes only and are not indicative of the results of operations that would have been achieved if the acquisition had taken place on April 1, 2010 and April 1, 2009 or of results that may occur in the future (amounts in thousands):

   
Three Months Ended
December 31,
   
Nine Months Ended
December 31,
 
   
2010
   
2009
   
2010
   
2009
 
Total revenue
  $ 367,824     $ 313,959     $ 1,114,742     $ 844,432  
Net income
    101,930       70,353       299,182       130,321  
Basic earnings per share
  $ 0.54     $ 0.38     $ 1.60     $ 0.71  
Diluted earnings per share
  $ 0.52     $ 0.37     $ 1.56     $ 0.70  

 
(4)           Discontinued Operations and Assets Held for Sale
 
Discontinued operations includes the following product families that were acquired in the acquisition of SST:  NAND Drives, NAND controllers, Smart Card ICs, Combo Memory, Concurrent SuperFlash, Small-Sector Flash and many-time Programmable Flash memories and certain serial NOR Flash products from 512K to 64MB density in the geographic regions of Taiwan, China, Hong Kong, Singapore, Malaysia, Thailand, Indonesia, Vietnam and Philippines.  These product lines have been marketed for sale since the acquisition of SST on April 8, 2010 based on management's decision regarding them not being a strategic fit into the Company's product portfolio.  On May 21, 2010, the Company completed a transaction to sell the NAND Drives, NAND controllers, Smart Card ICs, Combo Memory, Concurrent SuperFlash, Small-Sector Flash and many-time Programmable Flash memories to Greenliant Systems Ltd.  The sale price in this transaction was determined by management to represent fair value, and accordingly, no gain or loss was recognized on the sale of the net assets.  In this sale, the Company disposed of
 
 
 

 
 
 
 
approximately $23.6 million of assets held for sale, primarily comprised of inventory, property, plant and equipment, intangible assets and non-marketable securities.  On July 8, 2010, the Company granted an exclusive limited license for the manufacture of certain Serial NOR-Flash products to Professional Computer Technology, Ltd. ("PCT").  The license to PCT is limited to the industry segments of optical disc drives, set top boxes, electronic books, video games, digital displays, DVD player/recorder, notebook computers, netbooks, desktop computers, PC monitors, mass storage devices, printers/scanners/copiers/faxes, PC-CAM, point of sale devices, graphic cards, servers/clients/workstations, and mobile phones.  PCT has no license to sell these products to any other industry segment or geographic region other than those listed above.  Certain multi-national customers are excluded from this license.
 
For financial statement purposes, the results of operations for these discontinued businesses have been segregated from those of the continuing operations and are presented in the Company's condensed consolidated financial statements as discontinued operations and the net assets of the remaining discontinued business have been presented as assets held for sale.
 
At the time of the acquisition, the Company determined that it would hold SST's SuperFlash Memory and RF businesses as assets held for sale, in addition to other businesses that the Company has sold since the acquisition date.  After operating the SST business for two quarters, the Company found synergies between SST's RF business and the Company's wireless, microcontroller and analog businesses.  On the memory side, after divesting the low margin business to PCT, the Company had substantially improved the gross margin for the rest of the SuperFlash Memory business.  The Company also determined that running some volume on the memory business is critical to proving out the SuperFlash technology before it can be licensed.  As a result, the Company decided to integrate the SuperFlash Memory and RF businesses of SST into the ongoing businesses of the Company during the second quarter of fiscal 2011.
 
The results of discontinued operations for the three and nine months ended December 31, 2010 are as follows (in thousands):
 
 
Three Months Ended
December 31, 2010
   
Nine Months Ended
December 31, 2010
 
Net sales
$ 364     $ 25,177  
Cost of sales
  1,681       26,873  
Operating expenses
  ---       3,676  
Income tax benefit
  (163 )     (239 )
Net loss from discontinued operations
$ (1,154 )   $ (5,133 )

In the three months and nine months ended December 31, 2010, the Company had inventory write-downs of approximately $1.3 million and $3.6 million, respectively, related to discontinued operations.
  
Assets held for sale as of December 31, 2010 include a building in Macao being actively marketed for sale with a net book value of $1.1 million.
 
(5)           Special Charges
 
During the three and nine months ended December 31, 2010, the Company incurred $0.6 million and $1.7 million, respectively, of severance-related and office closing costs associated with the acquisition of SST.  See Note 3 for more information related to this acquisition.
 
During the nine months ended December 31, 2009, the Company agreed to the terms of a patent license with an unrelated third-party and signed an agreement on July 9, 2009.  The patent license settled alleged infringement claims.  The total payment made to the third-party in July 2009 was $1.4 million, $1.2 million of which was expensed in the first quarter of fiscal 2010 and the remaining $0.2 million was recorded as a prepaid royalty that was amortized over the remaining life of the patent, which expired in June 2010.
 
(6)           Segment Information
 
In connection with the acquisition of SST, the Company re-evaluated its segment reporting, based on the nature of the products and services provided to customers, and the information provided to the Company's chief operating decision maker.  Based on that evaluation, the Company determined its reporting segments include semiconductor products and technology licensing.  The technology licensing segment is a result of the acquisition of SST, and thus for the three and nine months ended December 31, 2009, net sales and gross profit are solely attributable to the semiconductor product segment.  The Company does not allocate operating expenses, interest income, interest expense, other income or expense, or provision for or benefit from income taxes to these segments for internal reporting purposes, as the Company does not believe that allocating these expenses is beneficial in evaluating segment performance.  Additionally, the Company does not allocate assets to segments for internal reporting purposes as it does not manage its segments by such metrics.
 
 
 

 
 
 
 
The following table represents revenues and gross profit for each segment (in thousands):

 
Three Months Ended
December 31, 2010
   
Nine Months Ended
December 31, 2010
 
 
Net Sales
   
Gross Profit
   
Net Sales
   
Gross Profit
 
Semiconductor products
$ 348,766     $ 198,347     $ 1,055,532     $ 600,179  
Technology licensing
  19,058       18,050       51,688       48,666  
  $ 367,824     $ 216,397     $ 1,107,220     $ 648,845  

(7)           Investments
 
The Company's investments are intended to establish a high-quality portfolio that preserves principal, meets liquidity needs, avoids inappropriate concentrations, and delivers an appropriate yield in relationship to the Company's investment guidelines and market conditions.  The following is a summary of available-for-sale and marketable equity securities at December 31, 2010 (amounts in thousands):

 
Available-for-sale Securities
 
 
Adjusted
Cost
   
Gross
Unrealized
Gains
   
Gross
Unrealized
Losses
   
Estimated
Fair Value
 
Government agency bonds
$ 466,548     $ 282     $ 329     $ 466,501  
Municipal bonds
  36,812       32       38       36,806  
Auction rate securities
  12,889       ---       ---       12,889  
Corporate bonds and debt
  498,230       4,899       482       502,647  
Marketable equity securities
  56,446       9       2,898       53,557  
  $ 1,070,925     $ 5,222     $ 3,747     $ 1,072,400  
 
 
The following is a summary of available-for-sale and trading securities at March 31, 2010 (amounts in thousands):

 
Available-for-sale Securities
 
 
Adjusted
Cost
   
Gross
Unrealized
Gains
   
Gross
Unrealized
Losses
   
Estimated
Fair Value
 
Government agency bonds
$ 389,801     $ 215     $ 622     $ 389,394  
Municipal bonds
  156,415       1,290       ---       157,705  
Auction rate securities
  14,151       ---       ---       14,151  
Marketable equity securities
  58,402       ---       ---       58,402  
Corporate bonds
  392,108       2,983       235       394,856  
  $ 1,010,877     $ 4,488     $ 857     $ 1,014,508  
 

 
Trading Securities
 
 
Adjusted
Cost
   
Gross
Unrealized
Gains
   
Gross
Unrealized
Losses
   
Estimated
Fair Value
 
ARS
$ 23,086     $ ---     $ ---     $ 23,086  
Put option on ARS
  1,814       ---       ---       1,814  
  $  24,900     $  ---     $  ---     $  24,900  
 
 
At December 31, 2010, the Company's available-for-sale debt securities, and marketable equity securities are presented on the condensed consolidated balance sheets as short-term investments of $690.6 million and long-term investments of $381.8 million.  At March 31, 2010, the Company’s available-for-sale debt securities, marketable equity securities and trading securities are presented on the condensed consolidated balance sheets as short-term investments of $722.2 million and long-term investments of $317.2 million.
 
At December 31, 2010, $12.9 million of the fair value of the Company's investment portfolio was invested in auction rate securities (ARS).  With the continuing liquidity issues in the global credit and capital markets, the Company's ARS have experienced multiple failed auctions from September 2007 through the date of this report.  While the Company continues to earn interest on these investments based on a pre-determined formula with spreads tied to particular interest rate indices, the estimated market value for these ARS no longer approximates the original purchase value.
 
 
10 
 

 
 
 
 
The fair value of the failed ARS of $12.9 million has been estimated based on market information and estimates determined by management and could change significantly based on market conditions.  The Company evaluated the impairments in the value of these ARS, determining its intent to sell these securities prior to the recovery of its amortized cost basis resulted in the securities being other-than-temporarily impaired and has recognized impairment charges on these investments of $0.4 million and $1.3 million, respectively, in the three and nine months ended December 31, 2010, and impairment charges on these investments of $0.5 million and $2.2 million, respectively, in the three and nine months ended December 31, 2009.
 
The Company believes that, based on its current unrestricted cash, cash equivalents and short-term investment balances, the current lack of liquidity in the credit and capital markets for ARS will not have a material impact on its liquidity, cash flow or ability to fund its operations.
 
At December 31, 2010, the Company evaluated its investment portfolio and noted unrealized losses of $0.9 million on its debt securities, which were due to fluctuations in interest rates and credit market conditions.  Management does not believe any of the unrealized losses represent other-than-temporary impairment based on its evaluation of available evidence as of December 31, 2010, except for the ARS described above.  The Company's intent is to hold these investments until these assets are no longer impaired.  For those investments not scheduled to mature until after December 31, 2010, such recovery is not anticipated to occur in the next year and these investments have been classified as long-term investments.
 
The amortized cost and estimated fair value of the available-for-sale securities at December 31, 2010, by maturity, excluding marketable equity securities of $53.6 million and corporate debt of $3.5 million, which have no contractual maturity, are shown below (amounts in thousands).  Expected maturities can differ from contractual maturities because the issuers of the securities may have the right to prepay obligations without prepayment penalties, and the Company views its available-for-sale securities as available for current operations.

 
Adjusted
Cost
   
Gross
Unrealized
Gains
   
Gross
Unrealized
Losses
   
Estimated
Fair Value
 
Available-for-sale
                     
  Due in one year or less
$ 161,975     $ 1,008     $ ---     $ 162,983  
  Due after one year and through five years
  836,115       4,205       849       839,471  
  Due after five years and through ten years
  ---       ---       ---       ---  
  Due after ten years
  12,889       ---       ---       12,889  
  $ 1,010,979     $ 5,213     $ 849     $ 1,015,343  

 
      During the three and nine months ended December 31, 2010 and the nine months ended December 31, 2009, the Company had an immaterial amount of realized gains and losses from sales of available-for-sale securities.  During the three months ended December 31, 2009, the Company had no realized gains or losses from sales of available-for-sale securities.
 
Marketable Equity Investments
 
The Company acquired investments in public companies as part of the SST acquisition valued at $47.1 million at the time of acquisition.  These public companies are listed on the Taiwan Stock Exchange and include: King Yuan Electronics Company Limited (KYE); Insyde Software Corporation (Insyde); Powertech Technology, Incorporated (PTI); and Professional Computer Technology, Ltd. (PCT).  During the quarter ended December 31, 2010, Apacer Technology, Inc. (Apacer) completed an Initial Public Offering on the Taiwan Stock Exchange and is now publicly traded.  The Company reclassified this investment out of non-marketable equity investments to marketable equity investments resulting in an increase in the fair value of the marketable equity investments of $9.0 million as of December 31, 2010.  As of the quarter ended December 31, 2010, approximately $0.3 million and $53.3 million of these investments have been included in short-term and long-term available-for-sale investments, respectively, based upon management's intent to hold such securities until recovery.  Cash dividends and other distributions of earnings from the investees, if any, are included in other income at the date of record.  The Company has classified the shares owned in these companies as marketable securities.  As of December 31, 2010, the Company had an unrealized loss in other comprehensive income of $2.9 million on these marketable securities, which the Company has determined to be a temporary impairment.
 
 
11 
 

 
 
 
 
Non-marketable Equity Investments
 
The Company has certain investments in privately held companies with a carrying value of $19.3 million at December 31, 2010.  As part of the acquisition of SST, the Company acquired certain investments in privately held companies with a carrying value of $29.7 million at the date of the acquisition.  These investments had a carrying value of $17.1 million at December 31, 2010 as a result of sales of investments of $4.5 million and a reclassification to marketable equity investments of $8.1 million.  The investments in privately held companies are accounted for using the cost or the equity method of accounting, as appropriate.  Each period the Company evaluates whether an event or change in circumstances has occurred that may indicate an investment has been impaired.  If upon further investigation of such events the Company determines the investment has suffered a decline in value that is other than temporary, the Company writes down the investment to its estimated fair value.  At December 31, 2010, the Company determined there were no such impairments.  These investments are included in other assets on the condensed consolidated balance sheet.
 
The following is a summary of the non-marketable equity investments at December 31, 2010 and March 31, 2010 (amounts in thousands):

 
December 31, 2010
   
 
March 31, 2010
 
Grace Semiconductor Manufacturing Corp
$ 15,200       $ ---  
Apacer Technology, Inc.
  ---         ---  
Others
  4,121         1,000  
Total
$ 19,321       $ 1,000  
 
The Company's non-marketable equity investments include an investment in Grace Semiconductor Manufacturing Corporation (GSMC), a privately held Cayman Islands company.  GSMC has a wholly owned subsidiary, Grace, which is a wafer foundry with operations in Shanghai, China.  The investment in GSMC had a fair-value of $15.2 million as of April 8, 2010, the acquisition date of SST.  At December 31, 2010, the investment is valued at cost.  The investment in GSMC includes Series D preferred shares valued at $14.4 million, common shares valued at $0.6 million and Series D options valued at $0.2 million.  The Company does not have any long-term obligations to purchase products from GSMC and is not obligated to provide GSMC with any additional financing.
 
(8)           Fair Value Measurements

Accounting rules for fair value clarify that fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants.  As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability.  As a basis for considering such assumptions, the Company utilizes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value as follows:
 
 
Level 1 – Observable inputs such as quoted prices in active markets;
 
 
Level 2 – Inputs, other than the quoted prices in active markets, that are observable either directly or indirectly; and
 
 
Level 3 – Unobservable inputs in which there is little or no market data, which require the reporting entity to develop its own assumptions.
 

 
 
12 
 

 

Assets and Liabilities Measured at Fair Value on a Recurring Basis
 
Assets and liabilities measured at fair value on a recurring basis at December 31, 2010 are as follows (amounts in thousands):

 
 
Quoted Prices
in Active
Markets for
 Identical
Instruments
(Level 1)
   
Significant
Other
Observable
Inputs
(Level 2)
   
Significant Unobservable
Inputs
(Level 3)
   
Total
Balance
 
Assets
                     
Money market fund deposits
$ 182,329     $ ---     $ ---     $ 182,329  
Marketable equity securities
  53,557       ---       ---       53,557  
Corporate bonds & debt
  ---       499,147       3,500       502,647  
Government agency bonds
  ---       466,501       ---       466,501  
Deposit accounts
  ---       318,287       ---       318,287  
Municipal bonds
  ---       36,806       ---       36,806  
Auction Rate Securities
  ---       ---       12,889       12,889  
Total assets measured at fair value
$ 235,886     $ 1,320,741     $ 16,389     $ 1,573,016  
 
 
Assets and liabilities measured at fair value on a recurring basis at March 31, 2010 are as follows (amounts in thousands):

 
Quoted Prices
in Active
Markets for Identical Instruments
(Level 1)
   
Significant
Other
Observable
Inputs
(Level 2)
   
Significant
Unobservable
Inputs
(Level 3)
   
Total
Balance
 
Assets
                     
Money market fund deposits
$ 206,376     $ ---     $ ---     $ 206,376  
Deposit accounts
  ---       285,754       ---       285,754  
Government agency bonds
  ---       389,394       ---       389,394  
Municipal bonds
  ---       157,705       ---       157,705  
ARS
  ---       ---       37,237       37,237  
Put option on ARS
  ---       ---       1,814       1,814  
Corporate bonds
  ---       394,856       ---       394,856  
Marketable equity securities
  58,402       ---       ---       58,402  
Total assets measured at fair value
$ 264,778     $ 1,227,709     $ 39,051     $ 1,531,538  
 

 
For Level 3 valuations, the Company estimated the fair value of its ARS based on the following: (i) the underlying structure of each security; (ii) the present value of future principal and interest payments discounted at rates considered to reflect current market conditions; (iii) consideration of the probabilities of default, auction failure, or repurchase at par for each period; and (iv) estimates of the recovery rates in the event of default for each security.  The estimated fair values that are categorized as Level 3 as well as the marketable equity securities could change significantly based on future market conditions.
 
The following tables present a reconciliation for all assets and liabilities measured at fair value on a recurring basis, excluding accrued interest components, using significant unobservable inputs (Level 3) for the three and nine months ended December 31, 2010, and the three and nine months ended December 31, 2009 (amounts in thousands):

 
 
13 
 

 

Three months ended December 31, 2010
 
Auction Rate Securities
   
Put Option on Auction Rate Securities
   
Corporate
Debt
   
Total Gains (Losses)
 
Balance at September 30, 2010
  $ 13,311     $ ---     $ 3,500     $ ---  
Total gains or losses (realized and unrealized):
                               
Included in earnings
    (422 )     ---       ---       (422 )
Included in other comprehensive income (loss)
     ---        ---        ---        ---  
Purchases, sales, issuances, and settlements, net
     ---        ---        ---        ---  
Transfer into Level 3
    ---       ---       ---       ---  
Transfer out of Level 3
    ---       ---       ---       ---  
Balance at December 31, 2010
  $ 12,889     $ ---     $ 3,500     $ (422 )


Nine months ended December 31, 2010
 
Auction Rate Securities
   
Put Option on Auction Rate Securities
   
Corporate
Debt
   
Total Gains (Losses)
 
Balance at March 31, 2010
  $ 37,237     $ 1,814     $ ---     $ ---  
Total gains or losses (realized and unrealized):
                               
Included in earnings
    552       (1,814 )     ---       (1,262 )
Included in other comprehensive income (loss)
     ---        ---        ---        ---  
Purchases, sales, issuances, and settlements, net
    (24,900 )      ---        3,500        ---  
Transfer into Level 3
    ---       ---       ---       ---  
Transfer out of Level 3
    ---       ---       ---       ---  
Balance at December 31, 2010
  $ 12,889     $ ---     $ 3,500     $ (1,262 )


Three months ended December 31, 2009
 
Auction Rate Securities
   
Put Option on Auction Rate Securities
   
Corporate
Debt
   
Total Gains (Losses)
 
Balance at September 30, 2009
  $ 45,280     $ 2,504     $ ---     $ ---  
Total gains or losses (realized and unrealized):
                               
Included in earnings
    (724 )     196       ---       (528 )
Included in other comprehensive income (loss)
     ---        ---        ---        ---  
Purchases, sales, issuances, and settlements, net
    (1,325 )      ---        ---        ---  
Transfer into Level 3
    ---       ---       ---       ---  
Transfer out of Level 3
    ---       ---       ---       ---  
Balance at December 31, 2009
  $ 43,231     $ 2,700     $ ---     $ (528 )


Nine months ended December 31, 2009
 
Auction Rate Securities
   
Put Option on Auction Rate Securities
   
Corporate
Debt
   
Total Gains (Losses)
 
Balance at March 31, 2009
  $ 46,800     $ 4,026     $ ---     $ ---  
Total gains or losses (realized and unrealized):
                               
Included in earnings
    (844 )     (1,326 )     ---       (2,170 )
Included in other comprehensive income (loss)
     ---        ---        ---        ---  
Purchases, sales, issuances, and settlements, net
    (2,725 )      ---        ---        ---  
Transfer into Level 3
    ---       ---       ---       ---  
Transfer out of Level 3
    ---       ---       ---       ---  
Balance at December 31, 2009
  $ 43,231     $ 2,700     $ ---     $ (2,170 )



 
14 
 

 
 
 
 
Assets and liabilities measured at fair value on a recurring basis are presented/classified on the condensed consolidated balance sheets at December 31, 2010 as follows (amounts in thousands):

 
Quoted Prices
 in Active
Markets for
Identical
Instruments
(Level 1)
 
Significant
Other
Observable
Inputs
(Level 2)
 
Significant Unobservable
Inputs
(Level 3)
 
Total
Balance
 
Assets
               
Cash and cash equivalents
$ 182,329   $ 318,287   $ ---   $ 500,616  
Short-term investments
  272     690,296     ---     690,568  
Long-term investments
  53,285     312,158     16,389     381,832  
Total assets measured at fair value
$ 235,886   $ 1,320,741   $ 16,389   $ 1,573,016  

 
Assets and liabilities measured at fair value on a recurring basis are presented/classified in the consolidated balance sheets at March 31, 2010 as follows (amounts in thousands):
 
 
Quoted Prices
in Active
Markets for
Identical
Instruments
(Level 1)
 
Significant
Other
Observable
Inputs
(Level 2)
 
Significant
Unobservable
Inputs
 (Level 3)
 
Total
Balance
 
Assets
               
Cash and cash equivalents
$ 206,376   $ 285,754   $ ---   $ 492,130  
Short-term investments
  58,402     638,891     24,900     722,193  
Long-term investments
  ---     303,064     14,151     317,215  
Total assets measured at fair value
$ 264,778   $ 1,227,709   $ 39,051   $ 1,531,538  

Financial Assets Not Recorded at Fair Value on a Recurring Basis
 
The Company's non-marketable equity and cost method investments are not recorded at fair value on a recurring basis.  These investments were recorded at fair-value as of April 8, 2010, the date of the SST acquisition, and are monitored on a quarterly basis for impairment charges.  The investments will only be recorded at fair value when an impairment charge is recognized.  These investments are included in other assets on the condensed consolidated balance sheet.  No non-recurring fair value measurements were recorded during the period. See further discussion of non-marketable investments in Note 7.

(9)           Fair Value of Financial Instruments
 
The carrying amount of cash equivalents approximates fair value because their maturity is less than three months.  The carrying amount of short-term and long-term investments approximates fair value as the securities are marked to market as of each balance sheet date with any unrealized gains and losses reported in stockholders' equity.  The carrying amount of equity and cost-method investments approximates fair value at December 31, 2010 due to the short period of time that has elapsed since the recognition of these assets at fair value.  There were no equity and cost–method investments at March 31, 2010.  The carrying amount of accounts receivable, accounts payable and accrued liabilities approximates fair value due to the short-term maturity of the amounts.  The fair value of the Company's junior subordinated convertible debentures was $1,418.8 million at December 31, 2010, based on the trading price of the bonds, compared to the carrying value of $345.6 million.  See Note 15 for additional information regarding the carrying value of the Company's junior subordinated convertible debentures.
 
 
15 
 

 
 
 
 
(10)           Accounts Receivable
 
Accounts receivable consists of the following (amounts in thousands):

 
December 31, 2010
 
March 31, 2010
 
Trade accounts receivable
$ 188,804   $ 140,340  
Other
  1,321     575  
    190,125     140,015  
Less allowance for doubtful accounts
  2,858     3,109  
  $ 187,267   $ 137,806  

(11)
Inventories
 
The components of inventories consist of the following (amounts in thousands):
 
 
December 31, 2010
 
March 31, 2010
 
Raw materials
$ 6,768   $ 4,912  
Work in process
  139,801     100,607  
Finished Goods
  31,136     11,060  
  $ 177,705   $ 116,579  

Inventory impairment charges establish a new cost basis for inventory and charges are not subsequently reversed to income even if circumstances later suggest that increased carrying amounts are recoverable.

(12)        Intangible Assets and Goodwill
 
Intangible assets consist of the following (amounts in thousands):
 
 
December 31, 2010
 
 
Gross Amount
 
Accumulated Amortization
 
Net Amount
 
Developed technology
$ 82,602   $ (25,530 ) $ 57,072  
Customer-related
  14,000     (951 )   13,049  
Trademarks and trade names
  1,730     (164 )   1,566  
Backlog
  2,310     (1,104 )   1,206  
In-process technology
  4,600     ---     4,600  
Distribution rights
  5,236     (4,022 )   1,214  
Covenants not to compete
  400     (33 )   367  
  $ 110,878   $ (31,804 ) $ 79,074  


 
March 31, 2010
 
 
Gross Amount
 
Accumulated Amortization
 
Net Amount
 
Developed technology
$ 49,009   $ (17,979 ) $ 31,030  
In-process technology
  2,900     ---     2,900  
Distribution rights
  5,236     (3,639 )   1,597  
  $ 57,145   $ (21,618 ) $ 35,527  

During the three-month period ended December 31, 2010, the Company completed an acquisition with total purchase consideration of approximately $5.5 million, including contingent consideration valued at approximately $2.0 million.  This purchase resulted in the recognition of $4.3 million of intangible assets, comprised of $2.2 million of developed technology, $0.8 million of in-process technology, $0.9 million of customer related intangible assets and $0.4 million of covenants not to compete.

The Company amortizes intangible assets over their expected useful lives, which range between 1 and 20 years.  In the nine-month period ended December 31, 2010, the Company acquired $33.6 million of developed technology which has a weighted average amortization period of 10 years, $14.0 million of customer-related intangible assets with an amortization period of 10 years, $1.7 million of trademarks and trade names with an amortization period of 5 years, $2.3 million of intangible assets related to backlog with an amortization period of six months to one year, $1.7 million of in-process technology which will begin amortization once the technology reaches technological feasibility, and $0.4 million of intangible assets related to covenants not to compete with an amortization of three years.  The following is an expected amortization schedule for the intangible assets for the remainder of fiscal year 2011 through fiscal year 2015, absent any future acquisitions or impairment charges (amounts in thousands):
 
 
16 
 

 
 
 
 
Year ending March 31,
Projected Amortization Expense
2011
$3,617
2012
13,058
2013
13,124
2014
12,621
2015
12,464
 
 
Amortization expense attributed to intangible assets was $3.5 million and $10.2 million for the three and nine months ended December 31, 2010, respectively, and $0.9 million and $2.7 million for the three and nine months ended December 31, 2009, respectively.  The Company found no indication of impairment of its intangible assets for the nine months ended December 31, 2010.
 
Goodwill activity for the nine months ended December 31, 2010 was as follows (amounts in thousands):
 

Balance at March 31, 2010
$ 40,338  
Additions due to the acquisition of SST
  9,017  
Additions due to contingent consideration payments to previous owners of R & E International
   9,272  
Additions due to other acquisition
  830  
Balance at December 31, 2010
$ 59,457  
 
The Company is still in the process of allocating goodwill to its reporting units as it relates to the acquisition of SST.
 
In the quarter ended December 31, 2010, the Company made contingent consideration payments to the previous owners of R&E International in the amount of $11.7 million.  The Company acquired R&E International on March 31, 2009.  The contingent consideration payment resulted in the de-recognition of negative goodwill in the amount of approximately $2.4 million recorded on the acquisition date and the recognition of approximately $9.3 million of goodwill which was allocated to the semiconductor products reporting unit.
 
The Company found no indication of impairment on its goodwill balance during the nine-month periods ended December 31, 2010 or 2009, and, absent future indicators of impairment, the annual impairment test will be performed in the fiscal fourth quarter. 

(13)           Property, Plant and Equipment

Property, plant and equipment consists of the following (amounts in thousands):

 
December 31, 2010
 
March 31, 2010
 
Land
$ 39,789   $ 39,671  
Building and building improvements
  370,969     349,964  
Machinery and equipment
  1,284,377     1,190,548  
Projects in process
  100,601     84,254  
    1,795,736     1,664,437  
Less accumulated depreciation and amortization
   1,267,521      1,171,398  
  $ 528,215   $ 493,039  
 
Depreciation expense attributed to property, plant and equipment was $23.6 million and $69.9 million for the three and nine months ended December 31, 2010, respectively, and $21.8 million and $65.0 million for the three and nine months ended December 31, 2009, respectively.
 
(14)           Income Taxes
 
The provision for income taxes reflects tax on foreign earnings and federal and state tax on U.S. earnings.  The Company had an effective tax rate from continuing operations of 12.4% for the nine-month period ended December 31, 2010 and an effective tax rate of 8.2% for the nine-month period ended December 31, 2009.  The Company's effective tax rate is lower than statutory rates in the U.S. due primarily to its mix of earnings in foreign jurisdictions with lower tax rates, changes in tax regulations and the reinstatement of the R&D tax credit in the quarter ended December 31, 2010.  In the nine-month period ended December 31, 2010, the Company's effective tax rate was lowered as a result of a tax settlement with the I.R.S. in the three months ended December 31, 2009.
 
 
17
 

 
 
 
 
At March 31, 2010, the Company had $57.1 million of unrecognized tax benefits.  Unrecognized tax benefits increased by $50.5 million in the nine months ended December 31, 2010 compared to March 31, 2010 primarily as a result of the unrecognized tax benefits acquired in the acquisition of SST, the ongoing accrual for uncertain tax positions and the accrual of deficiency interest on these positions.
 
The Company files U.S. federal, U.S. state, and foreign income tax returns.  For U.S. federal, and in general for U.S. state tax returns, the fiscal 2006 through fiscal 2010 tax years remain open for examination by tax authorities.  The I.R.S. is currently auditing the Company's fiscal years ended March 31, 2006, 2007 and 2008.  For foreign tax returns, the Company is generally no longer subject to income tax examinations for years prior to fiscal 2002.
 
The Company recognizes liabilities for anticipated tax audit issues in the U.S. and other tax jurisdictions based on its estimate of whether, and the extent to which, additional tax payments are more likely than not.  The Company believes that it has appropriate support for the income tax positions taken on its tax returns and that its accruals for tax liabilities are adequate for all open years based on an assessment of many factors including past experience and interpretations of tax law applied to the facts of each matter.
 
The Company believes that it maintains adequate reserves to offset any potential income tax liabilities that may arise upon final resolution of matters for open tax years.  If such reserve amounts ultimately prove to be unnecessary, the resulting reversal of such reserves would result in tax benefits being recorded in the period the reserves are no longer deemed necessary.  If such amounts prove to be less than an ultimate assessment, a future charge to expense would be recorded in the period in which the assessment is determined.  Although the timing of the resolution and/or closure of audits is highly uncertain, the Company does not believe it is reasonably possible that its unrecognized tax benefits would materially change in the next 12 months.
 
(15)           2.125% Junior Subordinated Convertible Debentures
 
The Company's $1.15 billion principal amount of 2.125% junior subordinated convertible debentures due December 15, 2037, are subordinated in right of payment to any future senior debt of the Company and are effectively subordinated in right of payment to the liabilities of the Company's subsidiaries.  The debentures are convertible, subject to certain conditions, into shares of the Company's common stock at an initial conversion rate of 29.2783 shares of common stock per $1,000 principal amount of debentures, representing an initial conversion price of approximately $34.16 per share of common stock.  As of December 31, 2010, none of the conditions allowing holders of the debentures to convert had been met.  As a result of cash dividends paid since the issuance of the debentures, the conversion rate has been adjusted to 34.4383 shares of common stock per $1,000 of principal amount of debentures, representing a conversion price of approximately $29.04 per share of common stock.
 
As the debentures can be settled in cash upon conversion, for accounting purposes, the debentures were bifurcated into a liability component and an equity component, which are initially recorded at fair value.  The carrying value of the equity component at December 31, 2010 and at March 31, 2010 was $822.4 million.  The estimated fair value of the liability component of the debentures at the issuance date was $327.6 million, resulting in a debt discount of $822.4 million.  The unamortized debt discount was $803.6 million at December 31, 2010 and $808.7 million at March 31, 2010.  The carrying value of the debentures was $345.6 million at December 31, 2010 and $340.7 million at March 31, 2010.  The remaining period over which the unamortized debt discount will be recognized as non-cash interest expense is 27 years.  In the three and nine months ended December 31, 2010, the Company recognized $1.7 million and $5.1 million, respectively, in non-cash interest expense related to the amortization of the debt discount.  In the three and nine months ended December 31, 2009, the Company recognized $1.6 million and $4.7 million, respectively, in non-cash interest expense related to the amortization of the debt discount.  The Company recognized $6.1 million and $18.3 million of interest expense related to the 2.125% coupon on the debentures in the three and nine months ended December 31, 2010 and 2009, respectively.
 
The debentures also include certain embedded features related to the contingent interest payments, the Company making specific types of distributions (e.g., extraordinary dividends), the redemption feature in the event of changes in tax law, and penalty interest in the event of a failure to maintain an effective registration statement.  These features qualify as derivatives and are bundled as a compound embedded derivative that is measured at fair value.  The fair value of the derivative as of December 31, 2010 was $0.4 million, compared to the value at September 30, 2010 and March 31, 2010 of $0.7 million.  These changes in the fair value of the derivatives resulted in a reduction of interest expense in the three and nine-month periods ended December 31, 2010 of approximately $0.3 million.  The fair value of the derivatives as of December 31, 2009 and September 30, 2009 was $0.6 million, compared to the value at March 31, 2009 of $0.5 million.  These changes in the fair value of the derivatives resulted in an increase in interest expense in the nine-month period ending December 31, 2009 of $0.1 million.  The balance of the debentures on the Company's condensed consolidated balance sheet at December 31, 2010 of $345.6 million includes the fair value of the embedded derivative.
 
 
18
 

 
 
 
 
(16)           Contingencies
 
In the ordinary course of the Company's business, it is involved in a limited number of legal actions, both as plaintiff and defendant, and could incur uninsured liability in any one or more of them.  The Company also periodically receives notifications from various third parties alleging infringement of patents, intellectual property rights or other matters.  With respect to pending legal actions to which the Company is a party, although the outcomes of these actions are not generally determinable, the Company believes that the ultimate resolution of these matters will not have a material adverse effect on its financial position, cash flows or results of operations.  Litigation relating to the semiconductor industry is not uncommon, and the Company is, and from time to time has been, subject to such litigation.  No assurances can be given with respect to the extent or outcome of any such litigation in the future.
 
The Company's technology license agreements generally include an indemnification clause that indemnifies the licensee against liability and damages (including legal defense costs) arising from any claims of patent, copyright, trademark or trade secret infringement by the Company's proprietary technology.  The terms of these guarantees approximate the terms of the technology license agreements, which typically range from five to ten years.  The Company's current license agreements expire from 2011 through 2030.  The possible amount of future payments the Company could be required to make based on agreements that specify indemnification limits, if such indemnifications were required on all of these agreements, is approximately $85 million.  There are some licensing agreements in place that do not specify indemnification limits.  The Company had not recorded any liabilities related to these indemnification obligations as of December 31, 2010.
 
(17)           Derivative Instruments
 
The Company has international operations and is thus subject to foreign currency rate fluctuations.  To manage the risk of changes in foreign currency rates, the Company periodically enters into derivative contracts comprised of foreign currency forward contracts to hedge its asset and liability foreign currency exposure and a portion of its foreign currency operating expenses.  Approximately 99% of the Company's sales are U.S. Dollar denominated.  To date, the exposure related to foreign exchange rate volatility has not been material to the Company's operating results.  As of December 31, 2010 and March 31, 2010, the Company had no foreign currency derivatives outstanding.  The Company recognized an immaterial amount of net realized losses on foreign currency derivatives in the three months ended December 31, 2010 and an immaterial amount of net realized gains on foreign currency derivatives in the nine months ended December 31, 2010 and the three and nine-month periods ended December 31, 2009.
 
(18)
Comprehensive Income
 
Comprehensive income consists of net income offset by net unrealized gains and losses on available-for-sale investments.  The components of other comprehensive income and related tax effects were as follows (amounts in thousands):

 
Three Months Ended
December 31,
   
Nine Months Ended
December 31,
 
 
2010
   
2009
   
2010
   
2009
 
Change in unrealized gains and losses on investments,
   net of tax effect of $1,344, $(641), $(1,909) and $(1,616), respectively.
$  984     $ (1,637 )   $ (258 )   $ (1,600 )

Comprehensive income was $101.8 million and $293.2 million for the three and nine-month periods ended December 31, 2010, respectively, and $67.8 million and $139.7 million for the three and nine-month periods ended December 31, 2009, respectively.
 
 
19
 

 
 
 
 
(19)           Employee Benefit Plans
 
Share-Based Compensation Expense
 
The following table presents the details of the Company's share-based compensation expense (amounts in thousands):
 
 
Three Months Ended
December 31,
   
Nine Months Ended
December 31,
 
 
2010
   
2009
   
2010
   
2009
 
Cost of sales
$ 1,708 (1)   $ 1,266 (1)   $ 5,416 (1)   $ 4,845 (1)
Research and development
  3,324       3,108       9,516       9,205  
Selling, general and administrative
  4,377       4,463       12,854       13,285  
Pre-tax effect of share-based compensation
  9,409       8,837       27,786       27,335  
Income tax benefit
  1,166       1,180       3,442       3,585  
Net income effect of share-based compensation
$  8,243     $  7,657     $  24,344     $  23,750  
 
(1) During the three and nine months ended December 31, 2010, $1.7 million and $5.4 million, respectively, was capitalized to inventory and $1.7 million and $5.4 million, respectively, of previously capitalized inventory was sold.  During the three and nine months ended December 31, 2009, $1.7 million and $4.5 million, respectively, was capitalized to inventory and $1.3 million and $4.8 million, respectively, of previously capitalized inventory was sold.
 
The amount of unearned share-based compensation currently estimated to be expensed in the remainder of fiscal 2011 through fiscal 2015 related to unvested share-based payment awards at December 31, 2010 is $61.5 million.  The weighted average period over which the unearned share-based compensation is expected to be recognized is approximately 2.24 years.
 
Combined Incentive Plan Information
 
The total intrinsic value of restricted stock units (RSUs) which vested during the three and nine months ended December 31, 2010 was $6.9 million and $20.5 million, respectively.  The aggregate intrinsic value of RSUs outstanding at December 31, 2010 was $180.5 million, calculated based on the closing price of the Company's common stock of $34.21 per share on December 31, 2010.  At December 31, 2010, the weighted average remaining expense recognition period was 2.27 years.
 
The weighted average fair value per share of the RSUs awarded is calculated based on the fair market value of the Company's common stock on the respective grant dates discounted for the Company's expected dividend yield.  The weighted average fair value per share of RSUs awarded in the three and nine-month periods ended December 31, 2010 was $27.30 and $25.16, respectively.  The weighted average fair value per share of RSUs awarded in the three and nine-month periods ended December 31, 2009 was $20.77 and $18.85, respectively.
 
The total intrinsic value of options exercised during the three and nine months ended December 31, 2010 was $14.4 million and $20.1 million, respectively.  This intrinsic value represents the difference between the fair market value of the Company's common stock on the date of exercise and the exercise price of each equity award.
 
The aggregate intrinsic value of options outstanding and options exercisable at December 31, 2010 was $57.1 million.  The aggregate intrinsic values were calculated based on the closing price of the Company's common stock of $34.21 per share on December 31, 2010.
 
As of December 31, 2010 and 2009, the number of option shares exercisable was 6,209,925 and 8,768,254, respectively, and the weighted average exercise price per share was $25.04 and $24.36, respectively.
 
There were no stock options granted in the three-month periods ended December 31, 2010 and December 31, 2009.  The weighted average fair value per share of stock options granted in the nine-month period ended December 31, 2009 was $5.90.
 
(20)           Net Income Per Common Share
 
The following table sets forth the computation of basic and diluted net income per common share from continuing operations (in thousands, except per share amounts):

 
 
20 
 

 
 
 
   
Three Months Ended
December 31,
   
Nine Months Ended
December 31,
 
   
2010
   
2009
   
2010
   
2009
 
Net income from continuing operations
  $ 101,930     $ 69,403     $ 298,555     $ 141,256  
Weighted average common shares outstanding
    187,488       183,856       186,444       183,301  
Dilutive effect of stock options and RSUs
    4,335       4,005       4,423       3,469  
Dilutive effect of convertible debt
    4,432       ---       1,477       ---  
Weighted average common and potential common shares outstanding
     196,255        187,861        192,344        186,770  
Basic net income per common share – continuing operations
  $  0.54     $  0.38     $  1.60     $  0.77  
Diluted net income per common share – continuing operations
  $  0.52     $  0.37     $  1.55     $  0.76  

 
Diluted net income per common share for continuing operations for the three and nine-month periods ended December 31, 2010 include 4,431,774 shares and 1,477,258 shares, respectively, issuable upon the exchange of the debentures (see Note 15).  Diluted net income per common share for continuing operations for the three and nine-month periods ended December 31, 2009 does not include any incremental shares issuable upon the exchange of the debentures.  The debentures have no impact on diluted net income per common share unless the average price of the Company's common stock exceeds the conversion price because the principal amount of the debentures will be settled in cash upon conversion.  Prior to conversion, the Company will include, in the diluted net income per common share calculation, the effect of the additional shares that may be issued when the Company's common stock price exceeds the conversion price using the treasury stock method.  The weighted average conversion price per share used in calculating the dilutive effect of the convertible debt for the three and nine months ended December 31, 2010 was $29.42 and $29.80, respectively.
 
Diluted net loss per common share for discontinued operations for the three and nine-month periods ended December 31, 2010 was $(0.01) and $(0.03), respectively.
 
Weighted average common shares exclude the effect of anti-dilution option shares.  As of the three and nine-month periods ended December 31, 2010, the number of option shares that were antidilutive was 134,598 and 235,667, respectively.  As of the three and nine-month periods ended December 31, 2009, the number of option shares that were antidilutive was 3,552,862 and 5,289,097, respectively.
 
(21)
Dividends
 
A quarterly cash dividend of $0.344 per share was paid on December 2, 2010 in the aggregate amount of $64.5 million.  A second cash dividend of $0.345 per share was paid on December 27, 2010 in the aggregate amount of $65.0 million.  The second cash dividend was an acceleration of the dividend that would normally have been paid in March 2011.
 







 
 
21 
 

 
 
 
Item 2.                      Management's Discussion and Analysis of Financial Condition and Results of Operations
 
This report, including "Part I – Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Part II - Item 1A Risk Factors" contains certain forward-looking statements that involve risks and uncertainties, including statements regarding our strategy, financial performance and revenue sources.  We use words such as "anticipate," "believe," "plan," "expect," "future," "intend" and similar expressions to identify forward-looking statements.  Our actual results could differ materially from the results anticipated in these forward-looking statements as a result of certain factors including those set forth under "Risk Factors," beginning at page 40 and elsewhere in this Form 10-Q.  Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements.  You should not place undue reliance on these forward-looking statements.  We disclaim any obligation to update information contained in any forward-looking statement.  These forward-looking statements include, without limitation, statements regarding the following:
 
· 
The effects that adverse global economic conditions and fluctuations in the global credit and equity markets may have on our financial condition and results of operations;
· 
The effects and amount of competitive pricing pressure on our product lines;
· 
Our ability to moderate future average selling price declines;
· 
The effect of product mix, capacity utilization, yields, and fixed cost absorption on gross margin;
· 
The amount of changes in demand for our products and those of our customers;
· 
The level of orders that will be received and shipped within a quarter;
· 
The effect that distributor and customer inventory holding patterns will have on us;
· 
Our belief that customers recognize our products and brand name and use distributors as an effective supply channel;
· 
Our belief that deferred cost of sales will have low risk of material impairment;
· 
Our belief that our direct sales personnel combined with our distributors provide an effective means of reaching our customer base;
· 
Our ability to increase the proprietary portion of our analog and interface product lines and the effect of such an increase;
· 
The impact of any supply disruption we may experience;
· 
Our ability to effectively utilize our facilities at appropriate capacity levels and anticipated costs;
· 
That we adjust capacity utilization to respond to actual and anticipated business and industry-related conditions;
· 
That our existing facilities and planned expansion activities provide sufficient capacity to respond to increases in demand;
· 
That manufacturing costs will be reduced by transition to advanced process technologies;
· 
Our expectation that our wafer fabs will operate at high levels with no under-absorption of fixed costs;
· 
Our ability to maintain manufacturing yields;
· 
Continuing our investments in new and enhanced products;
· 
Our ability to attract and retain qualified personnel;
· 
The cost effectiveness of using our own assembly and test operations;
· 
Our anticipated level of capital expenditures;
· 
Continuation and amount of quarterly cash dividends;
· 
The sufficiency of our existing sources of liquidity;
· 
The impact of seasonality on our business;
· 
The accuracy of our estimates used in valuing employee equity awards;
· 
That the resolution of legal actions will not harm our business, and the accuracy of our assessment of the probability of loss and range of potential loss;
· 
That the idling of assets will not impair the value of such assets;
· 
The recoverability of our deferred tax assets;
· 
The adequacy of our tax reserves to offset any potential tax liabilities, having the appropriate support for our income tax positions and the accuracy of our estimated tax rate;
· 
Our belief that the expiration of any tax holidays will not have a material impact;
· 
The accuracy of our estimates of the useful life and values of our property, assets, and other liabilities;
· 
The adequacy of our patent strategy;
 
 
 

 
 
 
 
· 
Our ability to obtain patents and intellectual property licenses and minimize the effects of litigation;
· 
The level of risk we are exposed to for product liability claims;
· 
The amount of labor unrest, public health issues, political instability, governmental interference and changes in general economic conditions that we experience;
· 
The effect of fluctuations in market interest rates on income and/or cash flows;
· 
The effect of fluctuations in currency rates;
· 
Our ability to collect accounts receivable;
· 
Our ability to hold our fixed income investments and certain auction rate securities (ARS) until the market recovers, and the immaterial impact this will have on our liquidity;
· 
The accuracy of our estimates used in valuing our available-for-sale securities;
· 
Our belief that unrealized losses in our investment portfolio do not represent other-than-temporary impairment;
· 
The accuracy of our estimation of the cost effectivity of our insurance coverage;
· 
Our belief that our activities are conducted in compliance with various regulations not limited to environmental and export compliance; and
· 
Our ability and intent to settle the principal amount of the junior subordinated convertible debentures in cash.
 
We begin our Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) with a summary of Microchip's overall business strategy to give the reader an overview of the goals of our business and the overall direction of our business and products.  This is followed by a discussion of the Critical Accounting Policies and Estimates that we believe are important to understanding the assumptions and judgments incorporated in our reported financial results.  We then discuss our Results of Operations for the three and nine months ended December 31, 2010 compared to the three and nine months ended December 31, 2009.  We then provide an analysis of changes in our balance sheet and cash flows, and discuss our financial commitments in sections titled "Liquidity and Capital Resources," "Contractual Obligations" and "Off-Balance Sheet Arrangements."
 
Strategy
 
Our goal is to be a worldwide leader in providing specialized semiconductor products for a wide variety of embedded control applications.  Our strategic focus is on embedded control products, which include microcontrollers, high-performance linear and mixed signal devices, power management and thermal management devices, interface devices, Serial EEPROMs, and our patented KeeLoq® security devices.  We provide highly cost-effective embedded control products that also offer the advantages of small size, high performance, low voltage/power operation and ease of development, enabling timely and cost-effective embedded control product integration by our customers.  With the acquisition of SST, we have added Flash-IP solutions and SuperFlash memory products to our strategic focus.  Our Flash-IP is targeted for use in the manufacture of advanced microcontroller products.
 
We sell our products to a broad base of domestic and international customers across a variety of industries.  The principal markets that we serve include consumer, automotive, industrial, office automation and telecommunications.  Our business is subject to fluctuations based on economic conditions within these markets. 
 
Our manufacturing operations include wafer fabrication and assembly and test.  The ownership of our manufacturing resources is an important component of our business strategy, enabling us to maintain a high level of manufacturing control resulting in us being one of the lowest cost producers in the embedded control industry.  By owning our wafer fabrication facilities and our assembly and test operations, and by employing statistical process control techniques, we have been able to achieve and maintain high production yields.  Direct control over manufacturing resources allows us to shorten our design and production cycles.  This control also allows us to capture the wafer manufacturing and a portion of the assembly and test profit margin.
 
We employ proprietary design and manufacturing processes in developing our embedded control products.  We believe our processes afford us both cost-effective designs in existing and derivative products and greater functionality in new product designs.  While many of our competitors develop and optimize separate processes for their logic and memory product lines, we use a common process technology for both microcontroller and non-volatile memory products.  This allows us to more fully leverage our process research and development costs and to deliver new products to market more rapidly.  Our engineers utilize advanced computer-aided design (CAD) tools and software to perform circuit design, simulation and layout, and our in-house photomask and wafer fabrication facilities enable us to rapidly verify design techniques by processing test wafers quickly and efficiently.

 
 
23 
 

 
 
 
We are committed to continuing our investment in new and enhanced products, including development systems, and in our design and manufacturing process technologies.  We believe these investments are significant factors in maintaining our competitive position.  Our current research and development activities focus on the design of new microcontrollers, digital signal controllers, memory and mixed-signal products, Flash-IP solutions, new development systems, software and application-specific software libraries.  We are also developing new design and process technologies to achieve further cost reductions and performance improvements in our products.
 
We market our products worldwide primarily through a network of direct sales personnel and distributors.  Our distributors focus primarily on servicing the product and technical support requirements of a broad base of diverse customers.  We believe that our direct sales personnel combined with our distributors provide an effective means of reaching this broad and diverse customer base.  Our direct sales force focuses primarily on major strategic accounts in three geographical markets: the Americas, Europe and Asia.  We currently maintain sales and support centers in major metropolitan areas in North America, Europe and Asia.  We believe that a strong technical service presence is essential to the continued development of the embedded control market.  Many of our field sales engineers (FSEs), field application engineers (FAEs), and sales management have technical degrees and have been previously employed in an engineering environment.  We believe that the technical knowledge of our sales force is a key competitive advantage in the sale of our products.  The primary mission of our FAE team is to provide technical assistance to strategic accounts and to conduct periodic training sessions for FSEs and distributor sales teams.  FAEs also frequently conduct technical seminars for our customers in major cities around the world, and work closely with our distributors to provide technical assistance and end-user support.
 
Critical Accounting Policies and Estimates
 
General
 
Our discussion and analysis of Microchip's financial condition and results of operations is based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the U.S.  We review the accounting policies we use in reporting our financial results on a regular basis.  The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent liabilities.  On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, business combinations, share-based compensation, inventories, investments, income taxes, property plant and equipment, impairment of property, plant and equipment, impairment of intangible assets, junior subordinated convertible debentures and contingencies.  We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources.  Our results may differ from these estimates due to actual outcomes being different from those on which we based our assumptions.  We review these estimates and judgments on an ongoing basis.  We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our condensed consolidated financial statements.  We also have other policies that we consider key accounting policies, such as our policy regarding revenue recognition to OEMs; however, we do not believe these policies require us to make estimates or judgments that are as difficult or subjective as our policies described below.
 
Revenue Recognition - Distributors
 
Our distributors worldwide generally have broad price protection and product return rights, so we defer revenue recognition until the distributor sells the product to their customer.  Revenue is recognized when the distributor sells the product to an end-customer, at which time the sales price becomes fixed or determinable.  Revenue is not recognized upon shipment to our distributors since, due to discounts from list price as well as price protection rights, the sales price is not substantially fixed or determinable at that time.  At the time of shipment to these distributors, we record a trade receivable for the selling price as there is a legally enforceable right to payment, relieve inventory for the carrying value of goods shipped since legal title has passed to the distributor, and record the gross margin in deferred income on shipments to distributors on our condensed consolidated balance sheets.
 
Deferred income on shipments to distributors effectively represents the gross margin on the sale to the distributor; however, the amount of gross margin that we recognize in future periods could be less than the deferred margin as a result of credits granted to distributors on specifically identified products and customers to allow the distributors to earn a competitive gross margin on the sale of our products to their end customers and price protection concessions related to market pricing conditions.

 
 
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We sell the majority of the items in our product catalog to our distributors worldwide at a uniform list price.  However, distributors resell our products to end customers at a very broad range of individually negotiated price points.  The majority of our distributors' resales require a reduction from the original list price paid.  Often, under these circumstances, we remit back to the distributor a portion of their original purchase price after the resale transaction is completed in the form of a credit against the distributors' outstanding accounts receivable balance.  The credits are on a per unit basis and are not given to the distributor until they provide information to us regarding the sale to their end customer.  The price reductions vary significantly based on the customer, product, quantity ordered, geographic location and other factors and discounts to a price less than our cost have historically been rare.  The effect of granting these credits establishes the net selling price to our distributors for the product and results in the net revenue recognized by us when the product is sold by the distributors to their end customers.  Thus, a portion of the "deferred income on shipments to distributors" balance represents the amount of distributors' original purchase price that will be credited back to the distributor in the future.  The wide range and variability of negotiated price concessions granted to distributors does not allow us to accurately estimate the portion of the balance in the deferred income on shipments to distributors account that will be credited back to the distributors.  Therefore, we do not reduce deferred income on shipments to distributors or accounts receivable by anticipated future concessions; rather, price concessions are typically recorded against deferred income on shipments to distributors and accounts receivable when incurred, which is generally at the time the distributor sells the product.  At December 31, 2010, we had approximately $207.8 million of deferred revenue and $65.1 million in deferred cost of sales recognized as $142.7 million of deferred income on shipments to distributors.  At March 31, 2010, we had approximately $148.4 million of deferred revenue and $49.5 million in deferred cost of sales recognized as $98.9 million of deferred income on shipments to distributors.  The deferred income on shipments to distributors that will ultimately be recognized in our income statement will be lower than the amount reflected on the balance sheet due to additional price credits to be granted to the distributors when the product is sold to their customers.  These additional price credits historically have resulted in the deferred income approximating the overall gross margins that we recognize in the distribution channel of our business.
 
Distributor advances, reflected as a reduction of deferred income on shipments to distributors on our condensed consolidated balance sheets, totaled $70.0 million at December 31, 2010 and $57.5 million at March 31, 2010.  On sales to distributors, our payment terms generally require the distributor to settle amounts owed to us for an amount in excess of their ultimate cost.  The sales price to our distributors may be higher than the amount that the distributors will ultimately owe us because distributors often negotiate price reductions after purchasing the product from us and such reductions are often significant.  It is our practice to apply these negotiated price discounts to future purchases, requiring the distributor to settle receivable balances, on a current basis, generally within 30 days, for amounts originally invoiced.  This practice has an adverse impact on the working capital of our distributors.  As such, we have entered into agreements with certain distributors whereby we advance cash to the distributors to reduce the distributor's working capital requirements.  These advances are reconciled at least on a quarterly basis and are estimated based on the amount of ending inventory as reported by the distributor multiplied by a negotiated percentage.  Such advances have no impact on our revenue recognition or our condensed consolidated statements of income.  We process discounts taken by distributors against our deferred income on shipments to distributors' balance and true-up the advanced amounts generally after the end of each completed fiscal quarter.  The terms of these advances are set forth in binding legal agreements and are unsecured, bear no interest on unsettled balances and are due upon demand.  The agreements governing these advances can be cancelled by us at any time.
 
We reduce product pricing through price protection based on market conditions, competitive considerations and other factors.  Price protection is granted to distributors on the inventory they have on hand at the date the price protection is offered.  When we reduce the price of our products, it allows the distributor to claim a credit against its outstanding accounts receivable balances based on the new price of the inventory it has on hand as of the date of the price reduction.  There is no immediate revenue impact from the price protection, as it is reflected as a reduction of the deferred income on shipments to distributors' balance.
 
Products returned by distributors and subsequently scrapped have historically been immaterial to our consolidated results of operations.  We routinely evaluate the risk of impairment of the deferred cost of sales component of the deferred income on shipments to distributors account.  Because of the historically immaterial amounts of inventory that have been scrapped, and historically rare instances where discounts given to a distributor result in a price less than our cost, we believe the deferred costs are recorded at their approximate carrying value.

 
 
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Business Combinations
 
All of our business combinations are accounted for at fair value under the acquisition method of accounting.  Under the acquisition method of accounting, (i) acquisition-related costs, except for those costs incurred to issue debt or equity securities, will be expensed in the period incurred; (ii) non-controlling interests will be valued at fair value at the acquisition date; (iii) IP R&D will be recorded at fair value as an intangible asset at the acquisition date and amortized once the technology reaches technological feasibility; (iv) restructuring costs associated with a business combination will be expensed subsequent to the acquisition date; and (v) changes in deferred tax asset valuation allowances and income tax uncertainties after the acquisition date will be recognized through income tax expense or directly in contributed capital.  We acquired SST on April 8, 2010 in a business combination that is accounted for under the acquisition method of accounting.  At June 30, 2010, we completed a preliminary purchase price allocation.  The estimated fair values of assets acquired and liabilities assumed were based on preliminary estimates and may change as we complete our analysis.  The difference between the purchase price and the preliminary fair value of net identifiable assets acquired was recorded as goodwill.  Upon finalization of the purchase price allocation, any resulting goodwill will be allocated to the reporting units.  Refer to Note 3 for a summary of the April 8, 2010 preliminary purchase price allocation.
 
Share-Based Compensation
 
We measure fair value and recognize compensation expense for all share-based payment awards, including grants of employee stock options, RSUs and employee stock purchase rights, to be recognized in our financial statements based on their respective grant date fair values.  Total share-based compensation during the nine months ended December 31, 2010 was $27.8 million, of which $22.4 million was reflected in operating expenses.  Total share-based compensation reflected in cost of sales during the nine months ended December 31, 2010 was $5.4 million.  Total share-based compensation included in our inventory balance was $3.2 million at December 31, 2010.
 
Determining the appropriate fair-value model and calculating the fair value of share-based awards at the date of grant requires judgment.  The fair value of our RSUs is based on the fair market value of our common stock on the date of grant discounted for expected future dividends.  We use the Black-Scholes option pricing model to estimate the fair value of employee stock options and rights to purchase shares under employee stock purchase plans.  Option pricing models, including the Black-Scholes model, also require the use of input assumptions, including expected volatility, expected life, expected dividend rate, and expected risk-free rate of return.  We use a blend of historical and implied volatility based on options freely traded in the open market as we believe this is more reflective of market conditions and a better indicator of expected volatility than using purely historical volatility.  The expected life of the awards is based on historical and other economic data trended into the future.  The risk-free interest rate assumption is based on observed interest rates appropriate for the terms of our awards.  The dividend yield assumption is based on our history and expectation of future dividend payouts.  We estimate the number of share-based awards which will be forfeited due to employee turnover.  Quarterly changes in the estimated forfeiture rate can have a significant effect on reported share-based compensation, as the effect of adjusting the rate for all expense amortization after April 1, 2006 is recognized in the period the forfeiture estimate is changed.  If the actual forfeiture rate is higher or lower than the estimated forfeiture rate, then an adjustment is made to increase or decrease the estimated forfeiture rate, which will result in a decrease or increase to the expense recognized in our financial statements.  If forfeiture adjustments are made, they would affect our gross margin, research and development expenses, and selling, general and administrative expenses.  The effect of forfeiture adjustments through the third quarter of fiscal 2011 was immaterial.
 
We evaluate the assumptions used to value our awards on a quarterly basis.  If factors change and we employ different assumptions, share-based compensation expense may differ significantly from what we have recorded in the past.  If there are any modifications or cancellations of the underlying unvested securities, we may be required to accelerate, increase or cancel any remaining unearned share-based compensation expense.  Future share-based compensation expense and unearned share-based compensation will increase to the extent that we grant additional equity awards to employees or we assume unvested equity awards in connection with acquisitions. 
 
 
Inventories
 
Inventories are valued at the lower of cost or market using the first-in, first-out method.  We write down our inventory for estimated obsolescence or unmarketable inventory in an amount equal to the difference between the cost of inventory and the estimated market value based on assumptions about future demand and market conditions.  If actual market conditions are less favorable than those we projected, additional inventory write-downs may be required.  Inventory impairment charges establish a new cost basis for inventory and charges are not subsequently reversed to income even if circumstances later suggest that increased carrying amounts are recoverable.  In estimating our inventory obsolescence, we primarily evaluate estimates of demand over a 12-month period and record impairment charges for inventory on hand in excess of the estimated 12-month demand.
 

 
 
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In periods where our production levels are substantially below our normal operating capacity, such as in the first half of fiscal 2010, the reduced production levels of our manufacturing facilities are charged directly to cost of sales.  Approximately $22.3 million was charged to cost of sales in the first nine months of fiscal 2010 as a result of decreased production in our wafer fabs.  There were no such charges in the first three quarters of fiscal 2011.
 
Investments – Available-for-Sale and Trading Securities
 
We classify our investments in debt and marketable equity securities as available-for-sale or trading securities based on management's intent with regard to the investments and the nature of the underlying securities. 
 
Our available-for-sale investments consist of government agency bonds, municipal bonds, ARS, corporate bonds, and marketable equity securities.  Our investments are carried at fair value with unrealized gains and losses reported in stockholders' equity.  Premiums and discounts are amortized or accreted over the life of the related available-for-sale security.  Dividend and interest income are recognized when earned.  The cost of securities sold is calculated using the specific identification method.
 
We include within our short-term investments our trading securities, as well as our income yielding available-for-sale securities that can be readily converted to cash and include within long-term investments those income yielding available-for-sale securities with maturities of over one year that have unrealized losses attributable to them or those that cannot be readily liquidated.  We have the ability to hold our long-term investments with temporary impairments until such time as these assets are no longer impaired.  Such recovery of unrealized losses is not expected to occur within the next year.
 
Due to the lack of availability of observable market quotes on certain of our investment portfolio of ARS, we utilize valuation models including those that are based on expected cash flow streams and collateral values, including assessments of counterparty credit quality, default risk underlying the security, discount rates and overall capital market liquidity.  The valuation of our ARS investment portfolio is subject to uncertainties that are difficult to predict.  Factors that may impact our ARS valuation include changes to credit ratings of the securities as well as to the underlying assets supporting those securities, rates of default of the underlying assets, underlying collateral value, discount rates, counterparty risk, the ongoing strength and quality of the credit markets and market liquidity.
 
The credit markets experienced significant deterioration and uncertainty beginning in the second half of fiscal 2008.  If these conditions recur, or we experience any additional ratings downgrades on any investments in our portfolio (including our ARS), we may incur additional impairments to our investment portfolio, which could negatively affect our financial condition, cash flow and reported earnings.
 
Non-Marketable Investments
 
Our non-marketable equity investments are recorded using adjusted cost basis or the equity method of accounting, depending on the circumstances of each investment.  Our non-marketable investments are classified within other assets on our condensed consolidated balance sheet.  Our non-marketable equity investments include:
 
Equity Method Investments:  When we have the ability to exercise significant influence, but not control, over the investee, we record equity method gain or loss as "gain or loss from equity investments."  Equity method adjustments include our proportionate share of the investee's income or loss.
 
Cost Method Investments:  When we do not have the ability to exercise significant influence over the investee, we record such investments at cost.
 
Non-marketable investments are inherently risky, and a number of the companies in which we invest could fail.  Their success is dependent on successful product development, market acceptance, operational efficiency, and other key business factors.  Depending on their future prospects, the companies may not be able to raise additional funds when the funds are needed or they may receive lower valuations, with less favorable investment terms than in previous financings, and our investments would likely become impaired.  Additionally, financial markets and credit markets are volatile, which could negatively affect the prospects of the companies we invest in, their ability to raise additional capital, and the likelihood of our being able to realize value in our investments through liquidity events such as initial public offerings, mergers, and private sales.
 
We review these investments quarterly for indicators of impairment.  The impairment review requires significant judgment and includes quantitative and qualitative analysis of identified events or circumstances that impact the fair value of the investment, such as:
 
 
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the investee's revenue and trends in earnings or losses relative to pre-defined milestones and overall business prospects;
 
the technological feasibility of the investee's products and technologies;
 
the general market conditions in the investee's industry or geographic area, including adverse regulatory or economic changes;
 
factors related to the investee's ability to remain in business, such as the investee's liquidity, debt ratios, and the rate at which the investee is using its cash; and
 
the investee's receipt of additional funding at a lower valuation.
 
If the fair value of an investment is below our carrying value, we determine if the investment is other than temporarily impaired based on our quantitative and qualitative analysis, which includes assessing the severity and duration of the impairment and the likelihood of recovery before disposal.  If the investment is considered to be other than temporarily impaired, we write down the investment to its fair value.  There were no impairments to our non-marketable investments during the quarter ended December 31, 2010.
 
Income Taxes
 
As part of the process of preparing our condensed consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate.  This process involves estimating our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes.  These differences result in deferred tax assets and liabilities, which are included within our condensed consolidated balance sheets.  We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income within the relevant jurisdiction and to the extent we believe that recovery is not likely, we must establish a valuation allowance.  We have not provided for a valuation allowance because we believe that it is more likely than not that our deferred tax assets will be recovered from future taxable income.  Should we determine that we would not be able to realize all or part of our net deferred tax asset in the future, an adjustment to the deferred tax asset would be charged to income in the period such determination was made.  At December 31, 2010, our gross deferred tax asset was $107.6 million.
 
Various taxing authorities in the U.S. and other countries in which we do business scrutinize the tax structures employed by businesses.  Companies of our size and complexity are regularly audited by the taxing authorities in the jurisdictions in which they conduct significant operations.  We are currently under audit by the U.S. Internal Revenue Service (IRS) for our fiscal years ended March 31, 2006, 2007 and 2008.  Our fiscal years ended March 31, 2009 and 2010 are open for examination by the tax authorities.  We recognize liabilities for anticipated tax audit issues in the U.S. and other tax jurisdictions based on our estimate of whether, and the extent to which, additional tax payments are probable.  We believe that we maintain adequate tax reserves to offset any potential tax liabilities that may arise upon these and other pending audits in the U.S. and other countries in which we do business.  If such amounts ultimately prove to be unnecessary, the resulting reversal of such reserves would result in tax benefits being recorded in the period the reserves are no longer deemed necessary.  If such amounts ultimately prove to be less than an ultimate assessment, a future charge to expense would be recorded in the period in which the assessment is determined. 
 
Property, Plant and Equipment
 
Property, plant and equipment are stated at cost.  Major renewals and improvements are capitalized, while maintenance and repairs are expensed when incurred.  At December 31, 2010, the carrying value of our property and equipment totaled $528.2 million, which represented 18.7% of our total assets.  This carrying value reflects the application of our property and equipment accounting policies, which incorporate estimates, assumptions and judgments relative to the useful lives of our property and equipment.  Depreciation is provided on a straight-line basis over the estimated useful lives of the related assets, which range from 5 to 7 years on manufacturing equipment, from 10 to 15 years on leasehold improvements and approximately 30 years on buildings.
 
We began production activities at Fab 4 on October 31, 2003.  We began to depreciate the Fab 4 assets as they were placed in service for production purposes.  As of December 31, 2010, all of the buildings and supporting facilities were being depreciated as well as the manufacturing equipment that had been placed in service.  All manufacturing equipment that was not being used in production activities was maintained in projects in process and is not being depreciated until it is placed into service since management believes there will be no change to its utility from the present time until it is placed into productive service.  The lives to be used for depreciating this equipment at Fab 4 will be evaluated at such time as the assets are placed in service.  We do not believe that the temporary idling of such assets has impaired the estimated life or carrying values of the underlying assets.
 
The estimates, assumptions and judgments we use in the application of our property and equipment policies reflect both historical experience and expectations regarding future industry conditions and operations.  The use of different estimates, assumptions and judgments regarding the useful lives of our property and equipment and expectations regarding future industry conditions and operations, could result in materially different carrying values of assets and results of operations.
 
 
 
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Impairment of Property, Plant and Equipment
 
We assess whether indicators of impairment of long-lived assets are present.  If such indicators are present, we determine whether the sum of the estimated undiscounted cash flows attributable to the assets in question is less than their carrying value.  If less, we recognize an impairment loss based on the excess of the carrying amount of the assets over their respective fair values.  Fair value is determined by discounted future cash flows, appraisals or other methods.  If the assets determined to be impaired are to be held and used, we recognize an impairment loss through a charge to our operating results to the extent the present value of anticipated net cash flows attributable to the asset are less than the asset's carrying value, which we depreciate over the remaining estimated useful life of the asset.  We may incur impairment losses, or additional losses on already impaired assets, in future periods if factors influencing our estimates change.
 
Impairment of Intangible Assets
 
We evaluate intangible assets for impairment when events or changes in economic circumstances indicate the carrying amount of such assets may not be recoverable.  The factors considered in deciding when to perform an impairment review include significant under-performance of a product line, significant negative industry or economic trends, and significant changes or planned changes in the use of the assets.  Recoverability of assets that will continue to be used in operations are measured by comparing the carrying amount of the asset grouping to the estimate of the related total future net cash flows.  If an asset carrying value is not recoverable through the related cash flows, the asset is considered to be impaired.  The impairment is measured by the difference between the asset grouping's carrying amount and its fair value, based on the best information available, including market prices or discounted cash flow analysis.  When we determine that the useful lives of assets are shorter than originally estimated, and there are sufficient cash flows to support the carrying value of the assets, we will accelerate the rate of amortization charges in order to fully amortize the assets over their new shorter useful lives.
 
Junior Subordinated Convertible Debentures
 
We separately account for the liability and equity components of our junior subordinated convertible debentures in a manner that reflects our nonconvertible debt (unsecured debt) borrowing rate when interest cost is recognized.  This results in a bifurcation of a component of the debt, classification of that component in equity and the accretion of the resulting discount on the debt to be recognized as part of interest expense in our condensed consolidated statements of operations.  Additionally, certain embedded features of the debentures qualify as derivatives and are bundled as a compound embedded derivative that is measured at fair value.  Lastly, we include the dilutive effect of the shares of our common stock issuable upon conversion of the outstanding junior subordinated convertible debentures in our diluted income per share calculation regardless of whether the market price trigger or other contingent conversion feature has been met.  We apply the treasury stock method as we have the intent and current ability to settle the principal amount of the junior subordinated convertible debentures in cash.  This method results in incremental dilutive shares when the average fair value of our common stock for a reporting period exceeds the conversion price per share which was $29.04 at December 31, 2010 and adjusts as dividends are recorded in the future.
 
Contingencies
 
In the ordinary course of our business, we are involved in a limited number of legal actions, both as plaintiff and defendant, and could incur uninsured liability in any one or more of them.  We also periodically receive notifications from various third parties alleging infringement of patents, intellectual property rights or other matters.  With respect to pending legal actions to which we are a party, although the outcomes of these actions are not generally determinable, we believe that the ultimate resolution of these matters will not have a material adverse effect on our financial position, cash flows or results of operations.  Litigation relating to the semiconductor industry is not uncommon, and we are, and from time to time have been, subject to such litigation.  No assurances can be given with respect to the extent or outcome of any such litigation in the future.
 
Significant Developments in Our Business
 
On April 8, 2010, we acquired Silicon Storage Technology, Inc. (SST), a public company based in Sunnyvale, California, in a merger transaction for $3.05 per share, or a total of $353.8 million, which included $295.4 million of cash consideration for the outstanding shares of SST common stock, and $58.4 million of SST shares acquired by us on March 8, 2010.  The fair value of the SST shares held by us on April 8, 2010, was equal to the fair value at March 8, 2010, the date the shares were acquired, and we did not recognize any gain or loss on such shares.  The SST business acquired included a variety of different business units including a licensing business focused on
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