F-1 1 df1.htm FORM-F1 Form-F1
Table of Contents

As filed with the Securities and Exchange Commission on December 5, 2005

Registration No.333-            


SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


FORM F-1

REGISTRATION STATEMENT

UNDER

THE SECURITIES ACT OF 1933


PIXELPLUS CO., LTD.

(Exact name of registrant as specified in its charter)


The Republic of Korea   3674   Not Applicable

(State or other jurisdiction

of incorporation or organization)

 

(Primary Standard Industrial

Classification Code Number)

 

(I.R.S. Employer

Identification Number)

5th Floor, Intellige I, KINS Tower

25-1 Jeongja-dong, Bundang-gu, Seongnam-si

Gyeonggi-do 463-811, The Republic of Korea

+82-31-600-5300

(Address, including zip code, and telephone number, including area code, of registrant’s principal executive offices)


CT Corporation System

111 Eighth Avenue, 13th Floor

New York, New York 10011

+1-212-894-8400

(Name, address, including zip code, and telephone number, including area code, of agent for service)


Copies to:

Jong Han Kim, Esq.

Paul, Hastings, Janofsky & Walker

22nd Floor, Bank of China Tower

1 Garden Road, Central, Hong Kong

+852-2867-1288

 

Eugene C. Gregor, Esq.

Davis Polk & Wardwell

33rd Floor, Izumi Garden Tower

1-6-1 Roppongi, Minato-ku

Tokyo 106-6033, Japan

+813-5561-4421


Approximate date of commencement of proposed sale to the public:    As soon as practicable after the effective date of this Registration Statement.

If any of the securities being registered on this Form are offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box.  ¨                 

If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨                 

If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨                   

If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨                 

CALCULATION OF REGISTRATION FEE


Title of Each Class of

Securities to be Registered

  Amount to be
Registered(2)
  Proposed Maximum
Offering Price Per Share(3)
 

Proposed Maximum

Aggregate Offering Price

  Amount of
Registration Fee

Common shares, par value (Won)500 per share(1)

  2,587,500   US$ 29.00   US$ 75,037,500   US$ 8,030.00

(1)   American Depositary Shares, or ADSs, evidenced by American Depositary Receipts issuable on deposit of the common shares registered hereby will be registered under a separate registration statement on Form F-6. Each ADS will represent one-half of a common share.
(2)   Includes (a) common shares represented by ADS that may be purchased by the underwriters pursuant to an over-allotment option, and (b) all common shares represented by ADSs initially offered or sold outside the United States that are thereafter sold or resold in the United States. Offers or sales of common shares represented by ADS outside the United States are being made pursuant to Regulation S under the Securities Act and are not covered by this Registration Statement.
(3)   Estimated solely for purposes of computing the amount of the registration fee pursuant to Rule 457(a) under the Securities Act.

The registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933, as amended, or until the Registration Statement shall become effective on such date as the Commission, acting pursuant to Section 8(a), may determine.



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The information in this prospectus is not complete and may be changed. Neither we nor the selling shareholders may sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities, and neither we nor the selling shareholders are soliciting an offer to buy these securities, in any jurisdiction where the offer or sale is not permitted.

 

SUBJECT TO COMPLETION, DATED DECEMBER 5, 2005

 

LOGO

 

4,500,000 American Depositary Shares

 

Representing 2,250,000 Common Shares

 

This is the initial public offering of American Depositary Shares, or ADSs, representing common shares of Pixelplus Co., Ltd. We are offering 4,500,000 ADSs. Each ADS will represent the right to receive one-half of a common share, par value (Won)500 per share, or common share. The estimated initial public offering price is between US$12.50 and US$14.50 per ADS.

 

Prior to this offering, there has been no public market for our ADSs or common shares.

 

We have applied for the quotation of our ADSs on the Nasdaq National Market under the symbol “PXPL”.

 


 

Investing in our ADSs involves risks.

See “ Risk Factors” beginning on page 8.

 


 

     Per ADS

   Total

Initial Public Offering Price

   US$                 US$             

Underwriting Discounts and Commissions

   US$      US$  

Proceeds to Pixelplus, before Expenses

   US$      US$  

 

Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or passed upon the adequacy or accuracy of this prospectus. Any representation to the contrary is a criminal offense.

 

The selling shareholders have granted the underwriters an option for a period of 30 days from the date of this prospectus to purchase up to 675,000 ADSs, solely to cover any over-allotments. We will not receive any proceeds from the sale of ADSs by the selling shareholders.

 


 

Jefferies Broadview

 

WR Hambrecht + Co

 

The date of this Prospectus is                     , 2005


Table of Contents

 

 

LOGO

 

 


Table of Contents

TABLE OF CONTENTS

 

 

 

     Page

Prospectus Summary

   1

Risk Factors

   8

Exchange Rate Information

   27

Use of Proceeds

   28

Dividend Policy

   29

Capitalization

   30

Dilution

   31

Selected Consolidated Financial Information and Other Data

   33

Management's Discussion and Analysis of Financial Condition and Results of Operations

   36

Business

   63

Management

   81

Principal and Selling Shareholders

   89

Related Party Transactions

   92

Description of Share Capital

   95

Description of American Depositary Receipts

   101

Shares Eligible for Future Sale

   112

Korean Foreign Exchange Controls and Securities Regulations

   115

Taxation

   117

Underwriting

   125

Legal Matters

   132

Experts

   132

Forward-Looking Statements

   133

Enforceability of Civil Liabilities

   133

Where You Can Find More Information

   134

Index to Consolidated Financial Statements

   F-1

 


 

Unless the context otherwise requires, references in this prospectus to:

 

    “Korea” are to the Republic of Korea;

 

    “Government” are to the government of Korea;

 

    “China” or the “PRC” are to the People’s Republic of China;

 

    “Taiwan” are to Taiwan, the Republic of China;

 

    “U.S.” or the “United States” are to the United States of America;

 

    “Pixelplus,” “we,” “us,” “our” or “our company” are to Pixelplus Co., Ltd. and its subsidiaries;

 

    “Korean Won,” “Won” or “(Won)” are to the currency of Korea; and

 

    “U.S. dollars,” “US$” or “$” are to the currency of the United States.

 

For your convenience, this prospectus contains translations of certain Won amounts into U.S. dollars at the noon buying rate of the Federal Reserve Bank of New York for Won in effect on September 30, 2005 which was (Won)1,042.4 to US$1.00. On December 2, 2005, the noon buying rate was (Won)1,035.2 to US$1.00. See “Exchange Rate Information.”

 

References to “2002,” “2003” and “2004” are, where appropriate, references to the years ended December 31, 2002, 2003 and 2004, respectively. References to the “first nine months of 2004” and “the first nine months of 2005” are, where appropriate, references to the nine months ended September 30, 2004 and 2005, respectively.

 

Discrepancies in tables between totals and sums of the amounts listed are due to rounding.

 

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PROSPECTUS SUMMARY

 

This summary highlights information contained elsewhere in this prospectus and does not contain all the information you should consider before investing in our ADSs. You should read the entire prospectus carefully, including “Risk Factors,” beginning on page 8, and our consolidated financial statements and notes thereto, beginning on page F-1, before making an investment decision.

 

Overview

 

We design, develop and market high-performance, high-resolution and cost-effective complementary metal oxide semiconductor, or CMOS, image sensors for use primarily in mobile camera phones. Our image sensors are used to capture and convert images into digital signals for display or transmission. As a fabless semiconductor company, we are focused on creating proprietary design technologies to develop image sensors with sharp, colorful and enhanced image quality, size efficiency and low power consumption, while outsourcing our manufacturing, testing and assembly requirements to independent companies.

 

Our product family consists of CMOS image sensors of various specifications, which are sold as stand-alone products or incorporated into camera modules. Our customers include some of the leading designers and manufacturers of mobile phones and camera modules, such as BYD Co., Ltd., China TechFaith Wireless Communication Technology Ltd., or China TechFaith, DART Express Incorporated, DK Semicon, Ningbo Bird Co., Ltd., Pantech Co., Ltd., ROHM Co., Ltd., Seiko Precision Inc. and Sharp Corporation, or Sharp. We generally market and sell our products through our domestic direct sales force and through a network of authorized international sales agents and distributors. During the first nine months of 2005, our top five customers accounted for 64.7% of our total revenues. During the same period, our customers in Asia accounted for 99.0% of our revenues, with 51.2% from China, 26.5% from Korea and 21.3% from other Asian countries, such as Japan and Taiwan. In addition to mobile phones, we provide CMOS image sensors for use in personal computer cameras, or PC cameras, and security and surveillance system applications. In the future, we intend to develop and market our products for integration into emerging applications requiring high-resolution image sensors, such as automobiles, biometrics, pattern recognition, medical devices and toys.

 

We first sold product samples in January 2002, and our revenues have increased from (Won)73 million in 2002 to (Won)17,806 million in 2003 and to (Won)35,796 million (US$34.3 million) in 2004. In the first nine months of 2005, we recognized revenues of (Won)30,418 million (US$29.2 million). We further recognized net income of (Won)804 million in 2003 and net losses of (Won)4,065 million (US$3.9 million) in 2004 and net income of (Won)1,257 million (US$1.2 million) in the first nine months of 2005, respectively. In 2004, we shipped approximately 10.8 million CMOS image sensors worldwide, of which 7.7 million CMOS image sensors were sold through DongbuAnam Semiconductor Inc., or DongbuAnam, to Sharp under our services arrangements with DongbuAnam, and during the first nine months of 2005, we shipped approximately 14.8 million CMOS image sensors and camera modules worldwide, of which 5.6 million CMOS image sensors were sold through DongbuAnam to Sharp.

 

According to a November 2005 report issued by IDC, a leading provider of research and analysis on the information technology industry, worldwide mobile camera phone shipments are expected to grow from 270.1 million units in 2004 to 372.6 million units in 2005 and 765.9 million units by 2009.

 

Our Strengths

 

We believe the following strengths set us apart from our competitors and allow us to offer cost-effective and superior-quality products and solutions to our customers:

 

   

Our Design and Engineering Expertise. We leverage our engineering team’s extensive experience with charge-coupled device, or CCD, image sensors, to develop our core technologies. We have developed a

 

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proprietary 3-transistor pixel structure, through which we have successfully reduced noise levels and improved the light sensitivity of our CMOS image sensors to achieve higher quality images.

 

    Our Process Engineering Know-How. We use our process engineering know-how and CCD image sensor experience to modify standard CMOS process technologies to achieve manufacturing yields that we believe are higher than the yields achieved by our competitors using conventional pixel structures, thereby reducing our product costs.

 

    Our Ability to Integrate Multiple Advanced Features. We apply our proprietary design technology to integrate multiple functions, such as auto focus, mechanical shutter and image processing, into a single chip-based image sensor. This allows our customers to build small, cost-effective and power-efficient consumer electronics and other end-products.

 

    Our Close Relationships with Customers. Our close relationships with our customers provide us with valuable knowledge and industry insights into trends in the image sensor industry. We use this information to establish an early market position in products that feature enhanced design and functions for incorporation into new products and applications.

 

Our Strategy

 

Our objective is to be a leading global supplier of image sensor-related semiconductor products for a broad range of applications. In order to achieve our objective, we intend to pursue the following strategies:

 

    Pursue Customer Diversification and International Expansion. We are implementing a customer development strategy across all levels of our organization with the objective of enhancing our brand image, strengthening our existing customer base and acquiring new customers. To execute our plan, we are creating a new marketing department, engaging additional sales agents with valuable local networks in the United States and Europe and realigning our sales organization.

 

    Diversify Our Product Offerings for Use in New Applications. We are leveraging our core competency in CMOS image sensor technology and our strong market position in the mobile camera phone market to extend our product offerings to PC cameras and security and surveillance system applications. We believe that by providing high-quality and competitively-priced image sensors, we will continue to find new market opportunities in automobiles, biometrics, pattern recognition, medical devices, toys and digital still cameras.

 

    Maintain Technological Competitiveness to Better Serve Our Customers. We believe the combination of our core technologies and our experience in device engineering, circuit engineering and process engineering are our key competitive advantages. Since maintaining our technological competitiveness will be critical to attracting and retaining customers, we plan to increase our investment in research and development to enhance and develop fundamental image sensing technologies and introduce new products in a timely manner.

 

    Continue to Focus Our Design Efforts on Integrated Multi-Functional Chip Design. In line with the miniaturization and application convergence trends in the consumer electronics industry, we will continue to focus on developing cost-effective chips with integrated multiple functions, such as advanced digital signal processing and image signal processing, Joint Photographic Experts Group, or JPEG, image compression and motor controller capabilities, on a single chip.

 

   

Further Develop Cooperative Relationships. We are seeking to establish and expand cooperative relationships with other leading foundries to ensure steady access to wafer capacity, as well as to further

 

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improve manufacturing yield. We are in the process of partnering with leading mobile phone designers and developing cross-marketing and product development relationships with leading mobile communications companies to deliver superior solutions to our customers.

 

Challenges and Risks

 

Notwithstanding our competitive strengths and strategies, we expect to face significant challenges and risks in our business, including:

 

    Our dependence on a few key customers in the mobile communications industry and our ability to acquire new customers.

 

    Our ability to compete successfully with larger and more established and financially stable CMOS image sensor suppliers.

 

    Our ability to develop new products with higher gross margins to offset continuing declines in the average sales prices of our existing products.

 

    Our ability to forecast accurately customer demand and not suffer significant inventory write-downs.

 

    Our dependence on a single third-party wafer foundry to manufacture all of our products.

 

    Our dependence on the continued growth of the mobile camera phone market.

 

Prospective investors should carefully consider the risks described in “Risk Factors,” beginning on page 8, before making an investment decision.

 

Contact Information

 

Our principal executive offices are located at 5th Floor, Intellige I, KINS Tower, 25-1 Jeongja-dong, Bundang-gu, Seongnam-si, Gyeonggi-do 463-811, Korea. Our telephone number in Korea is +82-31-600-5300. We maintain a website at http://www.pixelplus.com. Information contained in our website does not constitute a part of this prospectus.

 

Our agent for service of process is CT Corporation System, located at 111 Eighth Avenue, 13th Floor, New York, New York 10011. Its telephone number is +1-212-894-8400.

 

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The Offering

 

ADSs offered by us

4,500,000 ADSs

 

ADSs outstanding after this offering

4,500,000 ADSs. Unless otherwise noted, the information in this prospectus assumes no exercise of the underwriters’ over-allotment option and no exercise of outstanding stock options.

 

Common shares outstanding after this offering

6,055,333 common shares. The number of common shares that will be outstanding immediately after this offering reflects the conversion of all of our outstanding preferred shares into an aggregate of 1,201,333 common shares immediately prior to the completion of this offering, and excludes 1,177,591 common shares issuable upon exercise of outstanding options under our stock option plan as of September 30, 2005.

 

Offering price

We currently estimate that the initial public offering price will be between US$12.50 and US$14.50 per ADS.

 

Use of proceeds

Assuming an initial public offering price of US$13.50, the mid-point of the estimated public offering price range shown on the front cover of this prospectus, we expect to use the net proceeds we receive from this offering, approximately US$53.5 million, for (i) repayments of outstanding debt, (ii) expansion of our sales, distribution and technical support network, (iii) capital expenditures, (iv) research and development, and (v) working capital and general corporate purposes. See “Use of Proceeds” for more information regarding our expected use of the net proceeds we receive from this offering.

Listing

We have applied for the quotation of our ADSs on the Nasdaq National Market under the symbol “PXPL”.

 

Over-allotment option

The selling shareholders have granted the underwriters an option for a period of 30 days from the date of this prospectus to purchase up to 675,000 ADSs, solely to cover any over-allotments. We will not receive any proceeds from the sale of ADSs by the selling shareholders.

 

Trading market for common shares

Our common shares are not listed on any stock exchange or organized trading market, including Korea. There is no public market for our common shares or ADSs.

 

The ADSs

Each ADS represents one-half of a common share, par value (Won)500 per share. Our ADSs will be evidenced by American Depositary Receipts, or ADRs.

 

    The depositary will be the holder of the common shares underlying your ADSs, and you will have rights provided in the deposit agreement.

 

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    Although we do not expect to pay dividends in the foreseeable future, in the event we declare dividends on our common shares, the depositary will pay you the cash dividends and other distributions it receives on our common shares, after deducting its fees and expenses.

 

    You may turn in your ADSs to the depositary in exchange for the common shares underlying your ADSs. The depositary will charge you fees for exchanges.

 

    We may amend or terminate the deposit agreement without your consent, and if you continue to hold your ADSs, you agree to be bound by the deposit agreement as amended. You should carefully read the section in this prospectus entitled “Description of American Depositary Receipts” to better understand the terms of the ADSs. You should also read the deposit agreement, which is an exhibit to the registration statement that includes this prospectus.

 

Depositary

JPMorgan Chase Bank, N.A.

 

Voting rights

Subject to the provisions of the deposit agreement, you will be entitled to instruct the depositary on how to vote the common shares underlying your ADSs.

 

Dividends

We have not paid any dividend on our share capital since inception and any decision to pay dividends in the future will be subject to a number of commercial factors, such as the interests of our shareholders, our cash requirements for future capital expenditures and investments, as well as relevant industry and market practice. We have no intention to pay dividends in the near future.

 

Lock-up

We, the selling shareholders and certain of our shareholders, collectively holding in the aggregate approximately 93% of our outstanding common shares, assuming the conversion of all outstanding preferred shares, and all of our option holders holding options exercisable during the 180 days following the date of this prospectus have agreed with the underwriters that, without the prior written consent of Jefferies & Company, Inc., subject to certain exceptions, neither we, the selling shareholders nor any such shareholder or option holder will, for a period of at least 180 days following the date of this prospectus, offer, sell, or contract to sell, directly or indirectly, or otherwise dispose of, any of our ADSs, our common shares or any economic interests therein. See “Underwriting.”

 

Risk factors

For a discussion of certain factors that should be considered in evaluating an investment in our ADSs, see “Risk Factors,” beginning on page 8 of this prospectus.

 

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Summary Consolidated Financial Information

and Other Data

 

The following table contains our summary consolidated financial information and other data. The financial information has been derived from our audited and unaudited financial statements as of and for the periods indicated below. You should read this information together with our consolidated financial statements and related notes thereto, “Selected Financial Information and Other Data” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this prospectus.

 

    For the Years Ended December 31,

  For the Nine Months
Ended September 30,


    2002

  2003

  2004

  2004(1)

  2004

  2005

  2005(1)

                (unaudited)   (unaudited)   (unaudited)   (unaudited)
    (in millions of Korean Won and thousands of US$, except share and per share data)

Statement of Operations Data:

                                         

Revenues:

                                         

Products

  (Won) 73   (Won) 17,806   (Won) 31,356   $ 30,081   (Won) 22,204   (Won) 28,124   $ 26,980

Services

            4,440     4,260     3,183     2,294     2,201
   

 

 

 

 

 

 

Total revenues

    73     17,806     35,796     34,341     25,387     30,418     29,181
   

 

 

 

 

 

 

Cost of revenues:

                                         

Products

    296     14,562     31,457     30,178     23,713     22,585     21,666

Services

            831     797     577     386     371
   

 

 

 

 

 

 

Total cost of revenues

    296     14,562     32,288     30,975     24,290     22,971     22,037
   

 

 

 

 

 

 

Gross profit (loss)

    (223)     3,244     3,508     3,366     1,097     7,447     7,144

Operating expenses:

                                         

Selling, general and administrative

    310     1,136     3,966     3,804     3,057     3,550     3,405

Research and development, net of government grants

    666     1,335     3,211     3,080     2,064     2,498     2,396
   

 

 

 

 

 

 

Total operating expenses

    976     2,471     7,177     6,884     5,121     6,048     5,801
   

 

 

 

 

 

 

Income (loss) from operations

    (1,199)     773     (3,669)     (3,518)     (4,024)     1,399     1,343

Other income (expense):

                                         

Interest income (expense), net

    (49)     1     (230)     (221)     (120)     (389)     (373)

Foreign exchange gain, net

        138     337     323     209     63     60

Others, net

    (23)     (2)     3     4     5     (9)     (9)
   

 

 

 

 

 

 

Total other income (expense)

    (72)     137     110     106     94     (335)     (322)
   

 

 

 

 

 

 

Income (loss) before income taxes and loss from equity method investments

    (1,271)     910     (3,559)     (3,412)     (3,930)     1,064     1,021

Income tax expenses

        106     234     225     259        
   

 

 

 

 

 

 

Income (loss) before loss from equity method investments

    (1,271)     804     (3,793)     (3,637)     (4,189)     1,064     1,021

Gain (loss) from equity method investments, net

            (272)     (261)     (189)     (218)     (209)

Dilution gain from equity method investments

                        411     394
   

 

 

 

 

 

 

Net income (loss)

  (Won) (1,271)   (Won) 804   (Won) (4,065)   $ (3,898)   (Won) (4,378)   (Won) 1,257   $ 1,206
   

 

 

 

 

 

 

Accretion of preferred shares

        (1,149)     (1,569)     (1,505)     (1,270)     (1,495)     (1,435)
   

 

 

 

 

 

 

Net loss attributable to common shareholders

    (1,271)     (345)     (5,634)     (5,403)     (5,648)     (238)     (229)
   

 

 

 

 

 

 

Loss per share—basic and diluted

    (488)     (283)     (2,353)     (2.26)     (2,310)     (233)     (0.22)
   

 

 

 

 

 

 

Weighted average number of shares— basic and diluted

    2,604,000     2,604,000     2,604,000     2,604,000     2,604,000     2,604,000     2,604,000
   

 

 

 

 

 

 

Cash Flow Data:

                                         

Net cash used in operating activities

  (Won) (766)   (Won) (4,568)   (Won) (5,364)   $ (5,148)   (Won) (4,477)   (Won) (1,196)   $ (1,147)

Depreciation and amortization

    88     146     308     295     220     310     297

Net cash provided by (used in) investing activities

    100     (858)     (1,499)     (1,438)     (1,203)     (1,244)     (1,194)

Net cash provided by financing activities

    114     5,649     7,718     7,404     6,027     1,987     1,906

 

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     As of December 31,

   As of September 30, 2005

     2003

   2004

   2004(1)

   Actual

   Actual(1)

   As Adjusted(2)

               (unaudited)    (unaudited)    (unaudited)    (unaudited)
    

(in millions of Korean Won and thousands of US$, except share and

per share data)

Balance Sheet Data:

                                         

Cash and cash equivalents

   (Won) 286    (Won) 1,194    $ 1,145    (Won) 715    $ 686    (Won) 715

Accounts receivable, net

     5,695      5,446      5,225      14,070      13,498      14,070

Inventories, net

     6,374      6,818      6,541      3,843      3,687      3,843

Total assets

     15,299      17,666      16,948      26,205      25,139      26,205

Long-term borrowings

     1,217      1,259      1,208      730      700      730

Total liabilities

     10,410      17,156      16,458      23,931      22,957      23,931

Series A convertible redeemable preferred shares

     5,975      6,776      6,500      8,233      7,899     

Shareholders’ deficit(3)

     (1,086)      (6,266)      (6,010)      (5,959)      (5,717)      2,274

 

     For the Years
Ended December 31,


   For the Nine Months
Ended September 30,


     2002

   2003

   2004

   2004

   2005

     (in millions of image sensor units)

Operating Data:

                        

Units sold

                        

Products

         –    1.4    3.1    2.1    9.2

Services(4)

         7.7    5.1    5.6
    
  
  
  
  

Total

      1.4    10.8    7.2    14.8
    
  
  
  
  

 


 

(1) For convenience, the Korean Won amounts are expressed in U.S. dollars at the rate of (Won)1,042.4 to US$1.00, the noon buying rate in effect on September 30, 2005 as quoted by the Federal Reserve Bank of New York.

 

(2) Amounts are presented as adjusted for the automatic conversion of our 1,441,600 shares of Series A preferred shares into 1,201,333 common shares immediately prior to the completion of this offering, but excludes 1,177,591 common shares underlying options granted under our stock option plan and outstanding as of September 30, 2005 at a weighted average exercise price of (Won)1,867, or US$1.79, per common share.

 

(3) Shareholders’ deficit does not include our Series A convertible redeemable preferred shares.

 

(4) Equals the total number of image sensors sold by DongbuAnam to Sharp under our services arrangements with DongbuAnam, for each relevant period.

 

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RISK FACTORS

 

You should carefully consider these risk factors, together with all of the other information included in this prospectus, before you decide to purchase our ADSs. Additional risks and uncertainties not presently known to us, or that we currently deem immaterial, may also harm our business. If any of the material risks or uncertainties we face were to occur, our business, financial condition and results of operations could be materially and adversely affected and as a result, the trading price of our ADSs could decline, and you may lose all or a part of your investment.

 

Risks Related to Our Business

 

We depend on a few key customers to generate a majority of our revenues, and if any key customer was to discontinue, reduce or cancel its purchases of our products, or become insolvent or declare bankruptcy, our revenues could be significantly reduced.

 

A significant portion of our revenues is currently derived from a relatively small number of customers. Our top five customers accounted for approximately 97%, 79% and 65% of our revenues in 2003, 2004 and the first nine months of 2005, respectively. In addition, our business with Sharp through our services arrangement with DongbuAnam accounted for 71.3% of our total CMOS image sensor unit volume and 12.4% of our total revenues for 2004. See “Business—Services.” In the event one or more of our top customers were to delay or cancel their production of products incorporating our CMOS image sensors or reduce or discontinue their dealings with us, we could suffer a significant decline in revenues. See “Business—Customers.”

 

In addition, our customers conduct business in highly competitive and rapidly changing industries, such as mobile communications and consumer electronics. If any of our customers was to become insolvent or declare bankruptcy, we could be forced to write off related accounts receivables which were booked as revenues. For example, two of our top ten customers in 2004 based on revenues, Maxon Telecom Co., Ltd., or Maxon, and Telson Electronics Co., Ltd., or Telson, experienced financial difficulties in the second quarter of 2004 and are undergoing reorganization and bankruptcy, respectively. The total current receivable amounts outstanding from Maxon is approximately (Won)1,250 million. We cannot guarantee when or if we will recover any of such outstanding amounts. In addition, we have written off the entire amount of receivables payable to us from Telson, which totaled (Won)191 million. See “Business—Legal Proceedings” for additional information about our claims against Maxon and Telson.

 

Intense competition from larger and more established CMOS image sensor manufacturers could reduce our market share, our revenues and our profits.

 

The CMOS image sensor market is very competitive and is characterized by rapid technological changes, evolving standards, short product life cycles and decreasing prices. As a result, we are not able to assess our exact competitive position relative to our main competitors. We face competition from well-established companies, such as MagnaChip Semiconductor, Ltd., or MagnaChip, Micron Technology Inc., or Micron, OmniVision Technologies, Inc., or OmniVision, STMicroelectronics N.V. and Toshiba Corporation, that sell highly integrated single chip CMOS image sensors, as well as from other competitors. We expect competition in the CMOS image sensor market to continue to increase. For our higher-end image sensors, such as our planned 3.2 megapixel product, we also expect to compete with CCD image sensor manufacturers, such as Sony Corporation.

 

In addition, Samsung Electronics Co., Ltd., or Samsung Electronics, one of the world’s leading mobile phone manufacturers and an affiliate of our customer, Samsung Electro-Mechanics Co., Ltd., or Samsung Electro-Mechanics, which has accounted for 40% and 25% of our total revenues in 2003 and 2004, respectively, has a long history of working with CCD and has recently commenced the production of CMOS image sensors for mobile phones. Samsung Electronics’ successful entry into the CMOS image sensor market will increase competition in the markets we target.

 

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Compared to us, many of our competitors have longer operating histories, greater presence in key markets, stronger name recognition, more established access to a large customer base and significantly greater financial, sales, marketing, manufacturing, distribution and technical resources. As a result, our competitors may be able to adapt more quickly to new or emerging technologies and customer requirements, devote greater resources to the promotion and sale of their products, or price their products more aggressively and competitively, than us.

 

We cannot assure you that we will be able to compete successfully against current or potential competitors, or that competition will not seriously harm our business by reducing our market share, our revenues and our profits. See “Business—Competition” for additional information about our competitors and competition in our market.

 

Continuing declines in our average sales prices may result in declines in our gross margins and profits.

 

The CMOS image sensor market is characterized by intense price competition. As a result, we have experienced market driven pricing pressures and a decline in average sales prices for our products, which we expect will continue in the future. For example, from the first nine months of 2004 to the first nine months of 2005, the average sales price for our video graphic array, or VGA, image sensors, our top selling product for those periods, declined by approximately 65.7%. Our competitors, such as Micron and Samsung Electronics, have significantly greater financial resources to withstand pricing pressures and declining margins. If we are unable to offset declining average sales prices by achieving manufacturing cost efficiencies, developing new products incorporating more advanced technology or adding new features, our gross margins and profits will decline.

 

If we cannot develop and introduce new CMOS image sensors, we may not generate sufficient revenues to offset our initial product design, development, production and marketing costs, and our gross margins and profitability will decline.

 

The development of new CMOS image sensors is highly complex, and we have experienced delays in completing the development and introduction of new products in the past. As our products integrate new and more advanced functions, they become more complex and increasingly difficult to design. Our future ability to develop and introduce new products depends on a number of factors, including:

 

    our accurate prediction of market requirements and evolving standards, including pixel resolution, pixel size, power requirements, optical size and other special features;

 

    our timely completion and introduction of new product designs;

 

    our successful partnerships with foundries to achieve timely and high manufacturing yields; and

 

    market acceptance of our new products and consumer acceptance of our customers’ end-products which incorporate our CMOS image sensors.

 

If we cannot successfully develop and introduce new CMOS image sensors, we may not be able to generate sufficient revenues to offset our costs, and our gross margins and profitability will decline.

 

We may not accurately forecast customer demand and the number of wafers we need, and therefore we may not be able to react to fluctuations in demand for our products, which could result in unsold inventory, lower revenues and declines in our gross margins.

 

We forecast customer demand based on a number of factors, including customer data, market intelligence and historical data. However, accurate forecasting is a difficult process because actual customer demand often varies from customer data and projections, unexpected events occur, market intelligence can

 

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be wrong and historical data may not be reliable due to the relatively short history of the CMOS image sensor industry. It is critical that we accurately forecast customer demand and the number of wafers we need because if customer demand falls below our forecasts, we may be required to retain excess wafer inventories, which could increase our operating expenses and reduce our gross margins. For example, in 2004, two of our top customers unexpectedly faced financial difficulties and canceled orders after our products had been made.

 

In addition, rapid market driven declines in the value of image sensors may result in inventory write-downs, if the estimated realizable value for our goods in inventory is determined to be below our cost and the number of units on hand is determined to exceed the number of units that we had forecasted to sell over a certain period of time. As a result of unsold lower grade image sensors, canceled orders from financially-troubled customers, unsold image sensors manufactured in anticipation of future orders and a rapid decline in the value of our goods in inventory, we recognized a loss on valuation of inventory of (Won)2,009 million and (Won)7,349 million (US$7.1 million) in 2003 and 2004, respectively. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Certain Principal Factors Affecting Our Results of Operations and Financial Condition—Inventory Loss” for additional information about our cost of revenues and loss on valuation of inventory. If we are unable to more accurately forecast product demand, we face a higher risk of excess inventory and product obsolescence, which could increase our cost of revenue and reduce our gross margins. We also may not meet customers’ demands in a timely manner.

 

Because we depend on a single wafer foundry to manufacture all of our products, we have less control over the wafer manufacturing process and the allocation of manufacturing capacity. If our current wafer foundry experiences any disruption, we may not be able to find a replacement foundry. This dependence may limit our ability to respond promptly to increased customer demands, which could result in unforeseen manufacturing and operations delays and costs, harm our relationships with our key customers and lower our future revenues.

 

We do not own or operate a semiconductor fabrication facility. Currently, we rely on DongbuAnam, located in Korea, to produce all of our integrated circuit wafers. Although we have recently entered into a second manufacturing outsource agreement with United Microelectronics Corporation, or UMC, we expect our reliance on DongbuAnam to continue until the second half of 2006. We are still at a testing phase with UMC and expect to commence the actual manufacturing of our products at the time we release our 0.13 µm process technology based CMOS image sensors, currently scheduled to be in the second half of 2006. Our current reliance on DongbuAnam involves a number of significant risks, including:

 

    the sudden loss of all manufacturing services;

 

    the lack of guaranteed production capacity or product supply;

 

    reduced control over delivery schedules, quality assurance, manufacturing yields and production costs; and

 

    unavailability of, or delayed access to, next generation or key process technologies.

 

We do not have a long-term supply agreement with DongbuAnam. Instead, we secure manufacturing capacity on a rolling six-month forecast and purchase order basis. DongbuAnam has no obligation to supply products to us for any specific period, in any specific quantity or at any specific price, except as set forth in a particular purchase order based on our rolling six-month forecast. Our requirements represent a small portion of DongbuAnam’s total manufacturing capacity, and it may reallocate capacity to more preferred customers during periods of high demand.

 

If our independent foundries are unable or unwilling, for any reason, to continue to manufacture our wafers in the required volumes, at acceptable quality, yields and costs and in a timely manner, our business will be adversely affected. As a result, we would have to identify and qualify one or more substitute foundries, a time consuming and complex process that could result in unforeseen manufacturing and operations delays and costs.

 

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In addition, if competition for foundry capacity increases, we may be required to incur additional production costs to secure access to alternative manufacturing services, which may result in reduced manufacturing yields and quality. If we fail to meet our wafer supply requirements in the future, our ability to win large customer orders and respond promptly to any increase in demand could be adversely affected, which could harm our relationships with our key customers and lower our future revenues.

 

Problems with wafer manufacturing yields or back-end processing yields could increase our product costs and lower our gross margins.

 

If our independent wafer foundries cannot achieve the high yields we expect, our per unit costs will increase and our product availability will decrease. Wafer yields are a function both of our design technology and the particular foundry’s manufacturing process technology. Low yields may result from design errors or manufacturing failures. Unlike many other semiconductor products, optical products can be effectively tested only at the end of the manufacturing process. Accordingly, we perform a final test of our products only after they are assembled. As a result, yield problems may not be identified until our products are well into the production process. For example, we experienced lower yields during a period from the fourth quarter of 2004 to the first quarter of 2005 due to hardware upgrades at DongbuAnam. The risks associated with low yields are exacerbated because we rely on a single independent wafer foundry and have only recently engaged an alternative foundry. In addition to wafer manufacturing yields, our products are subject to yield loss in subsequent manufacturing steps, often referred to as back-end processing, such as dicing, cutting the wafer into individual devices, or die, and packaging. Any of these potential problems with wafer manufacturing or back-end processing yields could increase our unit costs and lower our gross margins.

 

If the mobile camera phone market fails to grow and develop as we anticipate, our future revenues and profits could decline.

 

We derived approximately 97.0% of our revenues from the mobile camera phone market in each of 2004 and the first nine months of 2005. Our current business model and our future success depend in large part on the continued growth of the mobile camera phone market. If the mobile camera phone market does not grow as anticipated, or if demand for our image sensors in this market decreases, our future revenues and profits could decline.

 

We have a limited number of patents and pending patent applications compared to our competitors, and we may be unable to protect adequately our existing intellectual property, which could have an adverse effect on our competitive position, and adversely impact our ability to generate revenues and profits.

 

Compared to our well-established competitors, we have a relatively limited number of patents and pending patent applications. We cannot assure you that our limited number of patents, combined with trade secret laws, nondisclosure agreements and other protective methods, will be effective in protecting our proprietary technologies.

 

We currently have six patents issued in Korea and four patents issued outside of Korea, and 12 patent applications pending in Korea and three patent applications pending in China and Japan. We cannot assure you that any patent application will be successful or, if a patent is issued, that it will be sufficiently broad to protect our technology. In addition, it is possible that existing or future patents may be challenged, invalidated or circumvented. It may be possible for a third party to copy or otherwise obtain and use our products or technology without authorization, develop similar technology independently or design around our patents. To minimize this risk, we may need to spend significant resources to monitor and protect our intellectual property rights. We may not be able to detect infringement, and we may lose our competitive advantage before we detect any such infringement, which could adversely impact our ability to generate revenues and profits.

 

Furthermore, our limited number of patents and pending patent applications may limit our ability to compete effectively against our competitors with larger patent portfolios or defend against any patent infringement claims brought by those competitors. Our competitors may have developed or may develop

 

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technologies that are protected by patents, thereby making those technologies unavailable to us or available only under unfavorable terms and conditions.

 

We may not be able to effectively enforce our intellectual property rights.

 

Although our products are generally protected through patents and other forms of intellectual property rights protection, our ability to enforce those rights may vary substantially in both degree and quality among the various jurisdictions in which we operate. As a result, our efforts to protect our intellectual property may not be adequate, and we may be unable to enforce our rights in a timely manner. See “—Risks Related to Specific Countries—The uncertain legal environment in China could adversely affect our ability to provide our products and generate revenues in China.”

 

We rely upon trade secrets and other unpatented proprietary know-how to maintain our competitive position in the CMOS image sensor industry and any loss of our rights to, or unauthorized disclosure of, our trade secrets or other unpatented proprietary know-how could have an adverse effect on our competitive position, which could adversely impact our ability to generate revenues and profits.

 

We rely upon trade secrets, unpatented proprietary know-how and continuing technological innovation in our business. We enter into confidentiality agreements with each of our employees and consultants upon the commencement of an employment or consulting relationship. These agreements generally provide that all inventions, ideas, discoveries, improvements and copyrightable material made or conceived by the individual arising out of the employment or consulting relationship, and all confidential information developed or made known to the individual during the term of the relationship, is our exclusive property. We also enter into confidentiality agreements with each of our independent contractors to ensure that all of our confidential or proprietary information made known to the contractor during the term of the relationship is protected and not disclosed or used without our authorization. However, we cannot assure the enforceability of these types of agreements, or that they will not be breached. We also cannot be certain that we will have adequate remedies for any breach. The disclosure of our trade secrets or other know-how as a result of such a breach could adversely affect our business. Disputes may arise concerning the ownership of intellectual property or the applicability or enforceability of our confidentiality agreements, and there can be no assurance that any such disputes would be resolved in our favor. Further, others may acquire or independently develop similar technology, or if patents are not issued with respect to products arising from research, we may not be able to maintain information pertinent to such research as proprietary technology or trade secrets and that could have an adverse effect on our competitive position within the CMOS image sensor industry. In addition, effective trade secret protection may not be available or may be limited in certain foreign countries where we conduct our business, such as in China, which could further adversely affect our competitive position in those countries. See “—Risks Related to Specific Countries—The uncertain legal environment in China could adversely affect our ability to provide our products and generate revenues in China.”

 

We could become subject to litigation regarding intellectual property infringement, which could divert management attention, be costly and time-consuming to defend and prevent us from using the challenged technology and selling some or all of our products.

 

Although we take, and will continue to take, steps to ensure that our new products do not infringe upon third party intellectual property rights, the rapid technological changes that characterize our industry require that we quickly implement new processes and components with respect to our products. Often with respect to recently developed processes and components, a degree of uncertainty exists as to who may rightfully claim ownership rights in such processes and components. Uncertainty of this type increases the risk that claims alleging infringement of third party rights may be brought against us.

 

The semiconductor industry is characterized by frequent litigation regarding patent and other intellectual property rights. On June 10, 2005, we received a letter from MagnaChip asserting that one of our CMOS image sensors infringes two of its Korean patents. On July 29, 2005, we sent a response letter to MagnaChip requesting

 

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further elaboration of the claims mentioned in its original letter and a specific identification of the areas of alleged infringement. On August 8, 2005, MagnaChip sent a follow-up letter to us continuing to assert the patent infringement claims, along with alleged technical support material for its claims. On November 14, 2005, we initiated cancellation proceedings in the Korean Intellectual Property Office, or KIPO, to invalidate both of the subject patents of MagnaChip. In response, MagnaChip may pursue litigation against us in a civil court with respect to these claims, in addition to defending its patents at KIPO. Although we believe that these claims are invalid and our cancellation proceedings will be successful, if MagnaChip’s patents are found to be valid and we are held to have infringed those patents, all of our products and our core technology could be held to be infringing MagnaChip’s patents. In such an event, we may be required to pay substantial damages, develop alternative non-infringing intellectual property, or enter into intellectual license agreements with MagnaChip which may not be available on acceptable terms or at all. If such intellectual property were to become unavailable, our business could be materially and adversely affected. Protracted litigation could also cause our customers, or potential customers to defer or limit the purchase of our products until the resolution of such litigation. In addition, MagnaChip may seek to obtain an injunction to prevent us from selling our products or using technology that employs the allegedly infringing intellectual property.

 

In addition, other companies may pursue litigation against us with respect to other claims in the future. An adverse result in any litigation regarding patent and other intellectual property rights may cause us to incur significant expenses, subject us to liability for damages, including treble damages if we are held to have willfully infringed, and invalidate our proprietary rights. These lawsuits, regardless of their outcome, would likely be expensive to resolve and could divert management’s time and attention.

 

We may in the future initiate claims or litigation against third parties for infringement of our intellectual property rights or to determine the scope and validity of our proprietary rights or the proprietary rights of competitors. These claims could also result in significant expense and the diversion of the attention of our management and technical personnel.

 

We have incurred significant losses since our inception, and our failure to achieve profitability in the future could cause the market price of our ADSs to decline.

 

We incurred a net loss of approximately (Won)4,065 million (US$3.9 million) in 2004. In the future, we expect our research and development expenses to increase as we develop new products. In addition, we expect our selling, general and administrative expenses to increase as we hire additional personnel and open new sales and representative offices outside Korea. If our costs and expenses exceed our revenues, we may continue to incur net losses and may not achieve profitability in the future. Our failure to achieve profitability or delayed profitability could cause the market price of our ADSs to decline.

 

Our business depends on the growth of emerging applications for CMOS technology, and any delay in the growth of emerging applications could adversely affect our ability to increase our revenues and earnings.

 

Our business strategy depends on the growth of various markets in which our CMOS image sensors are used. The following factors may delay the emergence of new markets for our products, any of which could impact our ability to grow or sustain our future revenues and earnings:

 

    the failure of the emergence of a universal platform for imaging solutions for various consumer and industrial emerging applications relating to automobiles, biometrics, pattern recognition, medical devices, security and surveillance systems and toys;

 

    the failure to develop user friendly and affordable new products using CMOS image sensors or the lack of market acceptance of such new products; and

 

    the development of alternative technology, such as the hybrid image sensor technology combining CMOS and CCD technologies, and improvements in or price reductions for CCD image sensors.

 

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Fluctuations in our quarterly operating results make it difficult to predict our future performance and may result in volatility in the market price of our ADSs.

 

Our quarterly operating results have varied significantly from quarter to quarter in the past and are likely to vary significantly in the future based on a number of factors related to how we manage our business and other industry-related factors. These factors, many of which are more fully discussed in other risk factors, include:

 

    our ability to introduce, market and sell new products;

 

    our ability to realize acceptable margins from product sales;

 

    the ability of our third party foundries to achieve and maintain high manufacturing yields, especially for new products;

 

    the ability of our contractors to provide manufacturing, testing, packaging and assembly services at competitive rates;

 

    the growth rate of the mobile camera phone market and emergence of other applications for our CMOS image sensors;

 

    the timing and amount of orders from our customers, including order delays in anticipation of new products or enhancements by us or our competitors;

 

    our ability to accurately forecast demand for our products;

 

    our gain or loss of a large customer and a design win or loss from a potential large customer;

 

    quarterly fluctuation in the demand for mobile phone production; and

 

    the announcement and introduction of competing products and technologies.

 

In addition, our introduction of new products and changes in our product mix may continue to affect our gross margins and quarterly operating results.

 

These factors are difficult to forecast and could cause our quarterly operating results to fluctuate which could in turn adversely affect the price of our ADSs in a manner unrelated to our long term operating performance. Due to the potential volatility of our ADS price, you should not rely on the results of any one quarter as an indication of our future performance. It is likely that our quarterly operating results will at times fall below the expectations of security analysts and investors. In such event, our ADS price will likely decrease. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Quarterly Results.”

 

Failure to manage our growth effectively could adversely affect our ability to increase our revenues and improve our earnings.

 

We are experiencing a period of significant growth that will continue to place a great strain on our management and other resources. We have grown from 6 employees in April 2000 to 86 employees worldwide as of September 30, 2005. We have only recently hired our chief technology officer and our chief financial officer and we expect to grow by another 43 employees by the first quarter of 2006. To manage our growth effectively, we must, among other things:

 

    implement and improve operational, financial and internal control systems;

 

    implement employee training programs and facilitate integration;

 

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    attract and retain qualified personnel with relevant experience; and

 

    expand our sales and marketing, research and development and administrative support personnel.

 

We must also manage a growing number of relationships with customers, business partners, international and domestic sales agents and other third parties such as wafer foundries and testing, packaging and assembly vendors. Our growth may significantly overburden our management and financial systems and other resources. We also cannot assure you that we have made adequate allowances for the costs and risks associated with our expansion. If our systems, procedures or controls are not adequate to support our operations and we are not able to expand quickly enough to capitalize on potential market opportunities, our future growth could be adversely affected and our future revenues will be reduced.

 

Unforeseen operational delays by our third party contractors in testing, packaging, and assembling our products can impact our ability to fulfill customer orders in time and ultimately harm our relationship with our customers and lower our revenues.

 

We depend on independent contractors for testing and packaging of our CMOS image sensors and for assembly of our camera modules. We do not receive service or capacity guarantees from our third-party contractors. Instead, we obtain services from them on a purchase order basis. Our reliance on these third-party contractors involves risks such as reduced control over delivery schedules, quality assurance and costs. These risks could result in product shortages or could increase our manufacturing, testing or packaging costs. If these contractors are unable or unwilling to continue to provide testing and packaging services or fail to deliver products of acceptable quality at an acceptable cost and in a timely manner, our business would be seriously harmed. We would have to identify and qualify substitute contractors, which could be costly, time consuming and difficult, particularly given the limited number of alternative contractors providing the services we need. Any such unforeseen operational delays could impact our ability to fulfill customer orders in time and ultimately harm our relationship with our customers and lower our revenues.

 

If we do not succeed in hiring and retaining candidates with appropriate qualifications, our product development efforts and sales and marketing strategies could be delayed, which could reduce our future revenues and profitability.

 

Our success depends to a significant extent upon the continued contributions of our key management, technical and sales personnel, many of whom would be difficult to replace. The loss of one or more of these employees could seriously harm our business. We have no agreements that obligate our employees to continue working for us. Our success also depends on our ability to identify, attract and retain qualified technical personnel, particularly analog or mixed signal design engineers, as well as sales, marketing, finance and management personnel. In particular, as CMOS image sensors have been recently commercialized, there are a limited number of engineering experts in this sector. Intense competition for qualified personnel has made retaining our key personnel and recruiting new qualified personnel a challenge and may result in increased compensation costs. If we do not succeed in hiring and retaining candidates with appropriate qualifications, our product development efforts and sales and marketing strategies could be negatively affected, which could reduce our future revenues and profitability.

 

As a growing percentage of our products are manufactured and sold outside of Korea, we will face foreign business, political and economic risks that could result in inefficiencies and increased costs, as well as lower revenues and reduced profitability.

 

Exports accounted for approximately 30.5% and 83.9% of our revenues in 2004 and the first nine months of 2005, respectively. We anticipate that exports will continue to account for a substantial portion of our revenues in the future. As we expand our overseas operations, we may further increase our reliance on third-party

 

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contractors for manufacturing, testing, packaging and assembly of our products, a significant portion of which may be conducted outside of Korea. In addition, our customers are located in China, Japan, Taiwan, Europe and the United States. Accordingly, we will be subject to increased foreign risks, including risks related to:

 

    staffing and managing foreign operations;

 

    monitoring compliance with local laws;

 

    managing third party foundries and contractors;

 

    managing sales agents and distributors; and

 

    collecting accounts receivables from foreign customers.

 

Any of these factors could result in inefficiencies and increased costs of conducting business outside of Korea and reduce our revenues and profitability.

 

Fluctuations in exchange rates could result in foreign currency exchange losses.

 

Approximately 97.0% of our revenues in the first nine months of 2005 were denominated in U.S. dollars and approximately 93.2% of our selling, general and administrative expenses and 44.8% of our cost of revenues in the first nine months of 2005 were denominated in Korean Won. As a result, decreases in the value of the U.S. dollar against the Korean Won will decrease our revenues and increase the costs of making and selling our products, leading to a reduction in operating margin and profitability.

 

To date, we have not engaged in any foreign currency hedging activities to reduce our exposure to exchange rate fluctuations. We may enter into hedging transactions in the future to mitigate our exposure to foreign currency exchange risks, but we may not be able to do so in a timely or cost-effective manner or at all.

 

We and our auditors have identified certain material weaknesses in our internal controls, and if we fail to create an effective system of internal controls, we may be unable to report accurate financial results or prevent fraud, and investor confidence and the market price of our ADSs may be adversely affected.

 

We are a private company incorporated in Korea and we have been subject only to minimum corporate governance and reporting standards applicable to unlisted companies in Korea.

 

In connection with the preparation of our financial statements under U.S. GAAP, we have discovered material weaknesses of our internal controls and financial reporting. For example, our expertise in U.S. GAAP reporting is limited, and we have not yet implemented an enterprise accounting system. As a result, in connection with the preparation of our financial statements under U.S. GAAP, we have used external consultants to assist us in the preparation of our financial statements, and we have had to rely on manual procedures in preparing our financial statements.

 

In connection with their audit of our financial statements prepared under U.S. GAAP, our independent registered public accountants identified certain material weaknesses, as defined under standards of the Public Company Accounting Oversight Board (United States), in our finance team’s ability to support the financial reporting requirements of a U.S. registrant. As a result of, among other things, the significant growth in our business, our lack of a computerized accounting system for tracing inventory, and our lack of qualified accounting personnel, our independent accountants have specifically identified the following material weaknesses:

 

    our reliance on external resources for preparation of U.S. GAAP financial statements and bookkeeping support;

 

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    our ability to prepare timely consolidated financial statements under U.S. GAAP;

 

    our reliance on spreadsheet programs, which are generally more prone to errors due to the absence of effective controls over the access and use of spreadsheets, to perform consolidation and prepare Korean GAAP and U.S. GAAP financial statements; and

 

    our lack of regular timely reporting from our manufacturing, testing and assembly contractors.

 

Although our management is currently executing a range of actions to address the weaknesses identified by us and our auditors in our internal controls and financial statement reporting procedures, including hiring personnel with U.S. GAAP experience and implementing an enterprise system to support U.S. GAAP reporting, we cannot be certain that these measures will ensure that we implement and maintain adequate controls over our financial processes and reporting in the future. As a U.S. reporting company, we will be subject to the reporting and other obligations under U.S. federal securities laws, including the Sarbanes-Oxley Act of 2002, and we will be subject to more stringent obligations than those applicable to unlisted companies in Korea. If we fail to create an effective system of internal controls, we may be unable to report accurate financial results or prevent fraud, and investor confidence and the market price of our ADSs may be adversely affected.

 

We may be considered a passive foreign investment company, which could lead to additional taxes for U.S. holders of our ADSs.

 

Special U.S. federal income tax rules apply to U.S. holders of shares of a non-U.S. corporation that is classified as a passive foreign investment company, or PFIC, for U.S. federal income tax purposes. The determination of our PFIC status principally depends upon the composition of our assets, including goodwill, and the amount and nature of our income, from time to time. The amount of goodwill will depend in part on the market value of our ADSs or common shares, which may be especially volatile for a technology-related enterprise such as ours. We have limited control over these variables. Accordingly, there can be no assurance that we will not be considered a PFIC for any taxable year.

 

If we are treated as a PFIC during any year of a U.S. holder’s holding period with respect to our ADSs or common shares, the U.S. holder will generally be required to treat certain excess distributions and any gain on the sale or other disposition of our ADSs or common shares as ordinary income and an interest charge may also apply, unless the U.S. holder makes a mark-to-market election. For a more detailed description of the U.S. federal income tax consequences of the ownership of our ADSs and common shares, please see “Taxation—U.S. Federal Income Tax Considerations.”

 

We may be required to take significant actions that are contrary to our business objectives in order to avoid being deemed an investment company as defined under the Investment Company Act of 1940, as amended.

 

Generally, the Investment Company Act of 1940, as amended, or the Investment Company Act, provides that a company is not an investment company and is not required to register under the Investment Company Act as an investment company if:

 

    the company is primarily engaged, directly or through a wholly-owned subsidiary or subsidiaries, in a business or businesses other than that of investing, reinvesting, owning, holding or trading in securities, and

 

    40% or less of the fair market value of the company’s total assets is represented by investment securities.

 

We are primarily engaged, directly and through our subsidiaries, in the business of designing, developing and marketing CMOS image sensors and camera modules, and believe that currently less than 40% of

 

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the fair market value of our total assets is represented by investment securities. Consequently, we believe that we are not an investment company as that term is defined under the Investment Company Act. However, in the future, we may be required to take actions to avoid the requirement to register as an investment company, such as shifting a significant portion of our long- and short-term investment portfolio into low-yielding bank deposits or other short-term securities which are not considered to be investment securities due to their liquidity and certain other characteristics. These types of investments may reduce the amount of interest or other income that we could otherwise generate from investment activities. We may need to acquire additional income or loss generating assets that we might not otherwise have acquired or forego opportunities to acquire minority interests in companies that could be important to our strategy. In addition, we hold minority equity interests in Pixelplus Technology Inc., or PTI, and Tesna Co., Ltd., or Tesna, which are companies that we do not control. If the value of these investment securities increases in the future, we may need to dispose some or all of these investment securities to avoid being deemed an investment company.

 

Regulations adopted under the Investment Company Act also impose limitations on the activities of investment companies, including restrictions on their capital structure, operations, transactions with affiliates and other matters, any of which would be incompatible with our operations as currently conducted. If we were to be deemed an investment company in the future, we would, among other things, effectively be precluded from making public offerings in the United States. We could also be subject to administrative or legal proceedings and, among other things, contracts to which we are a party might be rendered unenforceable or subject to rescission.

 

Risks Related to Our Regulatory Environment

 

Restrictions on currency exchange in certain of the jurisdictions in which our products are distributed may limit our ability to receive and remit revenues effectively, which would adversely affect our financial condition and liquidity.

 

The governments in certain jurisdictions in which our products are distributed, including China and Taiwan, impose controls on the convertibility of the local currency into foreign currencies and, in some cases, the external remittance of currency. Under current foreign exchange transaction regulations, shortages in the availability of foreign currency may restrict the ability of our overseas customers to make payments to us in U.S. dollars. Restrictions on our ability to receive payments from our overseas customers would adversely affect our financial condition and liquidity.

 

The discontinuation of any of our preferential Korean tax treatment could materially reduce our net income.

 

Under Korean law and regulations, a small- and medium-sized venture company may be entitled to enjoy preferential tax treatment from the Korean government in the form of a 50% reduction in corporate income tax rates for the year in which it first generates taxable income and the following five years if the company satisfies a number of financial and non-financial criteria, including the maintenance of its status as a designated venture company. We first generated taxable income in 2003, and we were subject to a reduced tax rate of 14.85% for 2003 and 2004. For 2005, the reduced rate of 14.85% will be further reduced to 13.75% due to a reduction in the tax rate from 29.7% to 27.5%. We expect to be qualified for this reduced tax rate until December 31, 2008, subject to our continuing need to meet a number of financial and non-financial criteria, including maintenance of our status as a venture company. Our status as a venture company is subject to evaluation and renewal in November of each year and there is no guarantee that we will qualify for the renewal in the future. If we fail to so qualify, our tax rate will increase to the standard tax rate. The discontinuation of this preferential tax treatment could lead to a material reduction in our net income. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Certain Principal Factors Affecting Our Results of Operations and Financial Condition—Income Tax Expenses.”

 

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Risks Related to Specific Countries

 

Increased tensions with North Korea could adversely affect our business, financial condition and results of operations.

 

Relations between Korea and North Korea have been tense over most of Korea’s modern history. The level of tension between Korea and North Korea has fluctuated and may increase or change abruptly as a result of current and future events, including ongoing contacts at the highest levels of the governments of Korea and North Korea. The level of tension between Korea and North Korea, as well as between North Korea and the United States, has increased as a result of a public announcement that North Korea possesses nuclear weapons and has declared that it will not participate in the six-party talks with Korea, the United States, China, Japan and Russia. Since then, the parties to the six-party talks have individually and collectively attempted to persuade North Korea to rejoin the six-party talks aimed at disarming the North Korea’s nuclear weapons program. There can be no assurance that the level of tensions will not escalate. We derived 69.5% and 26.5% of our revenues in 2004 and the first nine months of 2005, respectively, from our customers located in Korea. Any further increase in tensions, which may occur, for example, if high-level contacts break down or military hostilities occur, could harm our business, financial condition and results of operations.

 

Adverse economic, political or social developments or a decrease in domestic demand in China could result in a reduction in international trade activities involving China, which could in turn reduce the demand for our products and our future revenues.

 

We derived 21.4% and 51.2% of our revenues in 2004 and the first nine months of 2005, respectively, from our customers located in China. Accordingly, our operating results and financial condition are affected by economic, political, social and legal developments in China, as well as changes in the demand for our CMOS image sensors by customers in China. We cannot predict the future direction of the economic reform measures that have been adopted by the PRC government or the effects these measures may have on our business, results of operations or financial position. In addition, China’s economy differs from the economies of most countries belonging to the Organisation for Economic Co-operation and Development, or OECD. These differences include:

 

    economic structure;

 

    level of government involvement in the economy;

 

    level of development;

 

    level of capital reinvestment;

 

    control of foreign exchange;

 

    methods of allocating resources; and

 

    balance of payments position.

 

As a result of these differences, our business and the businesses of our customers in China may not develop in the same way or at the same rate as might be expected if China’s economy were similar to those of other OECD member countries.

 

In addition, there can be no assurance that any growth in China’s economy will be stable or that any slowdown will not have a negative effect on our business; that deflation will not reoccur in the foreseeable future; or that the level of international trade to and from China will not cease to grow at historical rates or even decrease, which could negatively impact demand for our products. Finally, our PRC customers’ business and our

 

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results of operations and financial condition could be negatively affected by adverse changes in government monetary policies, import-export polices and regulations, tax regulations or policies and regulations affecting the high technology industry. Most recently, the PRC government implemented a number of measures, such as raising bank reserves against deposit rates, to place additional limitations on the ability of commercial banks to make loans, in order to slow growth in certain segments of its economy it believed to be overheating. These actions, as well as future actions and policies of the PRC government, could result in a reduction in international trade activities involving China, which could in turn reduce the demand for our CMOS image sensors and reduce our future revenues.

 

The uncertain legal environment in China could adversely affect our ability to provide our products and generate revenues in China.

 

A significant portion of our business comes from our customers in China. To serve such customers and future customers in China, we established Pixelplus Shanghai Ltd. in September 2004 to serve as our sales and marketing headquarters in China. Pixelplus Shanghai Ltd. is wholly-owned by Pixelplus Asia Co., Limited, our Hong Kong holding company, which in turn is wholly-owned by us. Somewhat similar to Korea, the legal system of China is a civil law system based on written statutes. Unlike the common law system of the United States, it is a system in which decided legal cases have little precedential value. In recent years, the PRC government has promulgated a comprehensive system of laws and regulations governing economic matters. However, these laws, regulations and legal requirements are relatively new and are evolving rapidly, and their interpretation and enforcement involve uncertainties. As a result, the legal protections available to foreign investors and entities, including you and us, such as the right of foreign-invested enterprises to hold licenses and permits for customs-related business, and approvals necessary to conduct our business in China, are uncertain and, to a large degree, untested. As the PRC legal system matures, changes in its legislation or interpretation of its legislation may adversely affect our ability to provide our products and generate revenues in China.

 

Disruptions in Taiwan’s political environment could seriously harm the businesses of our customers in Taiwan and, in turn, our results of operations in Taiwan.

 

The government of China asserts sovereignty over mainland China and Taiwan, and does not recognize the legitimacy of the government of Taiwan. The government of China has indicated that it may use military force to gain control over Taiwan if Taiwan declares independence or a foreign power interferes in Taiwan’s internal affairs. On March 14, 2005, the government of China passed an anti-secession law which provides that in the event that the “Taiwan independence” secessionist forces should act to cause Taiwan’s secession from China, or any major incident causing Taiwan’s secession from China should occur, or that possibilities for a peaceful reunification should be completely exhausted, China will employ non-peaceful means and other necessary measures to protect China’s sovereignty and territorial integrity.

 

During the first nine months of 2005, we derived approximately 5.2% of our total revenues from our customers in Taiwan, including our Taiwan equity investee, PTI. Deterioration of the relationship between Taiwan and China, and other factors affecting Taiwan’s political environment, may materially and adversely affect our Taiwanese customers’ businesses and, in turn, our results of operations in Taiwan.

 

Risks Related to this Offering and Our Common Shares and ADSs

 

There has been no prior market for our common shares or ADSs and this offering may not result in an active or liquid market for our ADSs, in which case you may be unable to resell your ADSs and, as a result, you may lose all or part of your investment.

 

Our common shares are not listed on any stock exchange or organized trading market. Prior to this offering, there has not been a public market for our common shares and ADSs. While we have applied for the quotation of our ADSs on the Nasdaq National Market, we can provide no assurance that an active or liquid

 

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public market for our ADSs will develop or be sustained. The initial public offering price of our ADSs will be determined through negotiations among us, the selling shareholders and the underwriters, and it may not necessarily be indicative of the market price after the completion of this offering. You may be unable to resell your ADSs at or above the initial public offering price and, as a result, you may lose all or part of your investment. The price at which our ADSs will trade after the completion of this offering will be determined by the marketplace and may be influenced by many factors, including:

 

    our financial results;

 

    the history of, and the prospects for, us and our industry in which we compete;

 

    an assessment of our management, our past and present operations, and the prospects for, and timing of, our future revenues and cost structures;

 

    the present state of our development; or

 

    the valuation of other publicly traded companies in our industry.

 

In addition, from time to time, Nasdaq has experienced significant price and volume fluctuations that have affected the market prices for the securities of technology companies. As a result, investors in our ADSs may experience a decrease in the value of our ADSs regardless of our operating performance or prospects. In the past, following periods of volatility in the market price of a company’s securities, shareholders have often instituted securities class action litigation against that company. If we were involved in a class action suit, it could divert the attention of our senior management, and an adverse ruling could have a material adverse effect on our business, financial condition and results of operations.

 

The sale or availability for sale of substantial amounts of our ADSs could adversely affect their market price.

 

Sales of substantial amounts of ADSs in the public market after the completion of this offering, or the perception that substantial sales could occur, could adversely affect the market price of our ADSs and could materially impair our ability to raise capital through future sales of our ADSs.

 

There will be 6,055,333 common shares, equivalent to 12,110,666 ADSs, outstanding immediately after the completion of this offering, assuming no exercise of the underwriters’ over-allotment option and no exercise of outstanding stock options. All of the ADSs sold in this offering will be freely tradable without restriction or further registration under the U.S. Securities Act of 1933, as amended, or the Securities Act, unless held by our “affiliates” as that term is defined in Rule 144 under the Securities Act. Immediately after the completion of this offering, approximately 32% of our outstanding common shares, assuming no exercise of the underwriters’ over-allotment option and no exercise of outstanding stock options, will be held by shareholders who are not our “affiliates” as that term is defined in Rule 144 under the Securities Act, and may be freely tradable without restriction under the Securities Act.

 

In connection with this offering, we, the selling shareholders and certain of our shareholders, collectively holding in the aggregate approximately 93% of our outstanding common shares, assuming the conversion of all outstanding preferred shares, and all of our option holders holding options exercisable during the 180 days following the date of this prospectus have agreed, subject to specified exceptions, not to sell any of our common shares, ADSs or similar securities for at least 180 days after the date of this prospectus without the prior written consent of the underwriters. However, the underwriters may release these restrictions at any time. We cannot predict what effect, if any, market sales of securities held by these shareholders or the availability of these securities for future sale will have on the market price of our ADSs.

 

In addition, certain holders of our common shares, upon completion of this offering, will have right to cause us to register under the Securities Act the sale of an aggregate of up to 1,201,333 shares, subject to the

 

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180-day lock-up period in connection with this offering. Registration of these shares under the Securities Act would result in these shares becoming freely tradable without restriction under the Securities Act immediately upon the effectiveness of the registration. Sales of these registered shares in the public market could cause the price of our ADSs to decline.

 

We will incur increased costs as a result of being a public company, which could reduce our net income.

 

We are a company incorporated in Korea and our securities are not listed on any stock exchange. As such, we are not subject to any public reporting requirements and we are subject only to minimum corporate governance and reporting standards applicable to unlisted companies in Korea. After the completion of this offering, we will be subject to the reporting obligations of the Securities and Exchange Commission, or SEC, which many consider to be more stringent, rigorous and expensive than those of Korea. As a result, we will incur greater costs for legal, accounting and other services than we have incurred as a private company. We will also incur costs associated with recently adopted corporate governance requirements, including requirements under the Sarbanes-Oxley Act of 2002, as well as new rules implemented by the SEC and the National Association of Securities Dealers, or NASD. We expect these rules and regulations will increase our legal, accounting and financial compliance costs, will make some compliance activities more time consuming and costly and, in turn, will increase our operating expenses and reduce our net income.

 

Failure to achieve and maintain effective internal control over financial reporting in accordance with the requirements of the Sarbanes-Oxley Act of 2002 could have a material adverse effect on our business, results of operations and the trading price of our ADSs.

 

The SEC, pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, adopted rules requiring public companies to include a report of management on such companies’ internal control over financial reporting in its annual report on Form 10-K or Form 20-F, as the case may be, that contains an assessment by management of the effectiveness of such company’s internal control over financial reporting. In addition, a public company’s independent registered public accounting firm must attest to and report on management’s assessment of the effectiveness of the company’s internal control over financial reporting. These requirements will first apply to our annual report on Form 20-F for 2006. In connection with the audit of our financial statements, our independent registered public accounting firm identified certain material weaknesses in our finance team’s ability to support the financial reporting requirements of a U.S. registrant. See “—Risks Related to Our Business—We and our auditors have identified certain material weaknesses in our internal controls, and if we fail to create an effective system of internal controls, we may be unable to report accurate financial results or prevent fraud, and investor confidence and the market price of our ADSs may be adversely affected. If we are not able to properly address the material weaknesses of our internal controls or if our independent registered public accounting firm is not satisfied with our internal control over our financial reporting or the level at which our internal controls are documented, designed, operated or reviewed, or if our independent registered public accounting firm interprets the requirements, rules or regulations differently from us, then it may decline to attest to our management’s assessment or may issue a qualified report. In addition, during the course of such evaluation, documentation and testing, we may identify deficiencies which we may not be able to remedy in time to meet the deadline imposed by the Sarbanes-Oxley Act for compliance with the requirements of Section 404. Any of these outcomes could cause investors to lose confidence in the reliability of our financial statements, which ultimately could harm our business and negatively impact the trading price of our ADSs.

 

The holders of our common shares and our ADSs may have more difficulty protecting their interests than they would as shareholders of a U.S. corporation.

 

Our corporate affairs are governed by our articles of incorporation and by the laws and regulations governing Korean corporations. The rights and responsibilities of our shareholders and members of our board of directors under Korean law may be different from those that apply to shareholders and directors of a U.S. corporation. For example, minority shareholder rights afforded under Korean law often require the minority

 

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shareholder to meet minimum shareholding requirements in order to exercise certain rights. Under applicable Korean law, a shareholder must own at least:

 

    1% of a company’s total issued shares to bring a shareholders’ derivative lawsuit;

 

    3% to demand an extraordinary meeting of shareholders, demand removal of directors or inspect the books and related documents of a company; and

 

    10% to apply to the court for dissolution if there is gross improper management or a deadlock in corporate affairs likely to result in significant and irreparable injury to the company or to apply to the court for reorganization in the case of an insolvency.

 

In addition, while the facts and circumstances of each case will differ, the duty of care required of a director under Korean law may not be the same as the fiduciary duty of a director of a U.S. corporation. Although the concept of the “business judgment rule” exists in Korea, there is insufficient case law or precedent to provide guidance to the management and shareholders as to how it should be applied or interpreted in a particular circumstance. Holders of our ADSs may have more difficulty protecting their interests against actions of our management, members of our board of directors or controlling shareholder than they would as shareholders of a U.S. corporation.

 

Any dividend paid on our common shares will be in Korean Won, and fluctuations in the exchange rate between the Won and the U.S. dollar may affect the amount of any dividend received by you.

 

If and when we declare cash dividends, the dividends will be paid to the depositary in Korean Won and then converted by the depositary into U.S. dollars. Fluctuations in the exchange rate between the Won and the U.S. dollar will affect, among other things, the U.S. dollar amounts you receive from the depositary as dividends. Holders of ADSs may not receive dividends if the depositary does not believe it is reasonable or practicable to do so. In addition, the depositary may collect certain fees and expenses, at the sole discretion of the depositary, by billing the holders of ADSs for such charges or by deducting such charges from one or more cash dividends or other cash distributions we distribute to holders of our ADSs.

 

Your ability to deposit or withdraw common shares into and from the depositary facility may be limited, which may adversely affect the value of your investment.

 

Under the terms of our deposit agreement, holders of our common shares may deposit such shares with the depositary’s custodian in Korea and obtain ADSs, and holders of our ADSs may surrender the ADSs to the depositary and receive our common shares. However, to the extent that a deposit of common shares exceeds the difference between:

 

    2,850,000 common shares, which represent the aggregate number of common shares we have consented to be deposited for the issuance of ADSs, including deposits in connection with offerings of ADSs and stock dividends or other distributions relating to ADSs; and

 

    the number of common shares on deposit with the custodian for the benefit of the depositary at the time of such proposed deposit,

 

such common shares will not be accepted for deposit unless our consent with respect to such deposit has been obtained or our consent is no longer required under Korean laws and regulations or under the terms of the deposit agreement.

 

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As an ADS holder, you will not be treated as our shareholder, and you may be unable to exercise preemptive rights, voting rights or appraisal rights as a holder of our common shares do.

 

Under the Korean Commercial Code and our articles of incorporation, our shareholders have (i) the preemptive rights to subscribe for new common shares in proportion to their existing ownership percentages whenever we issue new common shares (except under certain circumstances as provided in our articles of incorporation), (ii) voting rights, and (iii) dissent and appraisal rights to require us to purchase their common shares in some limited circumstances. However, as an ADS holder, we will not treat you as one of our shareholders and you will not be able to exercise the above rights of our shareholders. Under Korean law, the depositary will be the shareholder of our common shares underlying your ADSs. As a holder of ADSs, you will have ADS holder rights. A deposit agreement among us, the depositary and you, as an ADS holder, sets out ADS holder rights as well as the rights and obligations of the depositary. New York law governs the deposit agreement and the ADSs.

 

With respect to the preemptive rights, if we issue new common shares to third parties based on any of the exceptions as provided in our articles incorporation, a holder of our ADSs will be diluted. See “Description of Share Capital.” If none of such exemptions is available under Korean law, we may be required to grant subscription rights to our shareholders, including the depositary, when issuing additional common shares. However, under U.S. law, we would not be able to make those rights available to investors in the United States unless we register the securities to which the rights relate or if an exemption from the registration requirements of the Securities Act is available. Under the deposit agreement, if we offer rights to subscribe for additional common shares, the depositary, after consultation with us, may make such rights available to you or dispose of such rights on your behalf and make the net proceeds available to you. If the depositary is unable to take such actions, it may allow the rights to lapse, in which case, you will receive no consideration for your rights. The depositary is generally not required to make rights available to ADS holders under any circumstance. We are under no obligation to file a registration statement under the Securities Act to enable you to exercise preemptive rights in respect of the common shares underlying your ADSs, and we cannot assure you that any registration statement would be filed or that an exemption from the registration requirements of the Securities Act would be available. Accordingly, you may not be entitled to exercise preemptive rights and your interest will be diluted.

 

With respect to the voting rights, you may not exercise voting rights of our shareholders. However, upon receipt of the necessary voting materials, you may instruct the depositary to vote the number of common shares represented by your ADSs and you may request the depositary to submit a request to convene a shareholders’ meeting. The depositary will notify you of shareholders’ meetings and arrange to deliver our voting materials to you only when we deliver such materials to the depositary with sufficient time under the terms of the deposit agreement. If there is a delay, we cannot ensure that you will receive our voting materials or otherwise learn of an upcoming shareholders’ meeting in time to ensure that you can instruct the depositary to vote common shares represented by your ADSs. In addition, the depositary and its agents are not responsible for failing to carry out voting instructions or for the manner of carrying out voting instructions.

 

Also, you may not request us to convene a shareholders’ meeting. However, the depositary will be able to request us to convene a shareholders’ meeting, provided the shares held in the name of the depositary represent at least 3% of our outstanding voting shares. See “Description of Share Capital.” Upon receipt of the necessary voting materials, you may instruct the depositary to vote the number of common shares represented by your ADSs and you may request the depositary to submit a request to convene a shareholders’ meeting. The depositary will notify you of shareholders’ meetings and arrange to deliver our voting materials to you only when we deliver such materials to the depositary with sufficient time under the terms of the deposit agreement. If there is a delay, we cannot ensure that you will receive our voting materials or otherwise learn of an upcoming shareholders’ meeting in time to ensure that you can instruct the depositary to vote your common shares. In addition, the depositary and its agents are not responsible for failing to carry out voting instructions or for the manner of carrying out voting instructions.

 

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With respect to the dissent and appraisal rights, in some limited circumstances under Korean law, including the transfer of the whole or any significant part of our business, our acquisition of a part of the business of any other company having a material effect on our business, or our merger or consolidation with another company, dissenting shareholders have the right to require us to purchase their common shares. However, if you hold our ADSs, you will not be able to exercise such dissent and appraisal rights unless you have withdrawn the underlying common shares from the depositary facility and become our direct shareholder prior to the record date for the shareholders’ meeting at which the relevant transaction is to be approved.

 

We may amend the deposit agreement and the ADRs without your consent and for any reason and, if you disagree with our amendments, your choices will be limited to selling the ADSs or withdrawing the underlying securities.

 

We may agree with the depositary to amend the deposit agreement and the ADRs without your consent and for any reason. If an amendment adds or increases fees or charges, except for taxes and other governmental charges or expenses of the depositary, for registration fees, facsimile costs, delivery charges or similar items, or prejudices a substantial right of ADS holders, it will not become effective for outstanding ADRs until 30 days after the depositary notifies ADS holders of the amendment. At the time an amendment becomes effective, you are considered, by continuing to hold your ADSs, to have agreed to the amendment and to be bound by the ADRs and the deposit agreement as amended. If you do not agree with an amendment to the deposit agreement or the ADRs, your choices will be limited to selling the ADSs or withdrawing the underlying securities. No assurance can be given that a sale of ADSs could be made at a price satisfactory to you in such circumstances. In addition, as of the date of this prospectus, the common shares underlying the ADSs are not listed on any stock exchange in Korea. Your ability to sell the underlying common shares following withdrawal and the liquidity of the common shares may be limited.

 

As a holder of our ADSs, you will have to indemnify us, the depositary and its custodian from any claims by any governmental authority with respect to taxes or other tax benefit obtained.

 

As an ADS holder, you will have agreed to indemnify us, the depositary and its custodian for any and all claims made against any or all of us by any governmental authority with respect to taxes owed, or benefit received, by you as a result of your investment. If the depositary, its custodian or we suffer any loss as a result of actions taken by any holder of our ADSs for tax purposes, such holder will have to indemnify the depositary, its custodian or us, as the case may be, for such loss, which may exceed the tax benefit such holder received.

 

We have significant discretion as to how we will use our net proceeds of this offering, and you may not agree with how we spend these funds.

 

The net proceeds we receive from this offering will be approximately US$53.5 million, assuming an initial public offering price of US$13.50 per ADS, the mid-point of the price range set forth on the cover page of this prospectus. You may not agree with the way our management spends these funds or these funds may be spent in ways that do not yield a favorable return to our shareholders. We plan to use our net proceeds from this offering for repayments of outstanding debt, expansion of our sales, distribution and technical support network, capital expenditures, research and development, and working capital and general corporate purposes. See “Use of Proceeds.” However, our management will have discretion as to the actual application of our net proceeds. You are entrusting your funds to our management, upon whose judgment you must depend, for the specific uses we will make of our net proceeds from this offering.

 

You may have difficulty bringing an original action or enforcing any judgment obtained outside Korea against us, our directors and officers or other offering participants, such as underwriters or experts, who are not U.S. persons.

 

We are organized under the laws of Korea, and most of our directors and officers reside in Korea. All or a significant portion of our assets, and the assets of such persons, are located outside of the United States. As a

 

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result, it may not be possible for you to effect service of process within the United States upon these persons or to enforce against them or us court judgments obtained in the United States that are predicated upon the civil liability provisions of the U.S. federal securities laws or of the securities laws of any state of the United States. We have, however, irrevocably appointed an agent in New York to receive service of process in any proceeding in the State of New York relating to our ADSs. Notwithstanding the foregoing, there is doubt as to the enforceability in Korea, either in original actions or in actions for enforcement of judgments of United States courts, of civil liabilities predicated on the U.S. federal securities laws or the securities laws of any state of the United States.

 

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EXCHANGE RATE INFORMATION

 

This prospectus contains translations of Korean Won amounts into U.S. dollars at a specific rate solely for the convenience of the reader. The conversion of Korean Won into U.S. dollars in this prospectus is based on the noon buying rate in The City of New York for cable transfers of Korean Won as certified for customs purposes by the Federal Reserve Bank of New York. Unless otherwise noted, all translations from Korean Won to U.S. dollars and from U.S. dollars to Korean Won in this prospectus were made at a rate of (Won)1,042.4 to US$1.00, the noon buying rate in effect as of September 30, 2005. The prevailing rate as of December 2, 2005 was (Won)1,035.2 to US$1.00. We make no representation that any Korean Won or U.S. dollar amounts could have been, or could be, converted into U.S. dollars or Korean Won, as the case may be, at any particular rate, the rates stated below, or at all.

 

The following table sets forth information concerning exchange rates between Korean Won and U.S. dollars for the periods indicated. These rates are provided solely for your convenience and are not necessarily the exchange rates that we used in this prospectus or will use in the preparation of our periodic reports or any other information to be provided to you.

 

     Noon Buying Rate

Years Ended December 31,    Low

   High

   Average(1)

   Period-end

     (Korean Won per US$1.00)

2000

   (Won) 1,105.5    (Won) 1,267.0    (Won) 1,130.9    (Won) 1,267.0

2001

     1,234.0      1,369.0      1,292.0      1,313.5

2002

     1,160.6      1,332.0      1,250.4      1,186.3

2003

     1,146.0      1,262.0      1,192.1      1,192.0

2004

     1,035.1      1,195.1      1,145.2      1,035.1

2005

                           

January

     1,024.0      1,058.0      1,038.0      1,026.9

February

     1,000.9      1,004.0      1,023.1      1,000.9

March

     997.5      1,023.9      1,007.8      1,015.4

April

     997.0      1,019.0      1,010.1      997.0

May

     997.0      1,009.0      1,001.8      1,005.0

June

     1,003.0      1,034.5      1,012.5      1,034.5

July

     1,018.5      1,054.0      1,036.6      1,026.5

August

     1,011.6      1,039.2      1,021.7      1,039.0

September

     1,024.3      1,042.4      1,029.8      1,042.4

October

     1,037.3      1,059.8      1,045.9      1,043.5

November

     1,034.4      1,049.0      1,040.8      1,037.4

December (through December 2, 2005)

     1,035.2      1,036.9      1,036.0      1,035.2

Source: Federal Reserve Bank of New York.

(1) Annual and monthly averages are calculated using the average of the daily rates during the relevant period.

 

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USE OF PROCEEDS

 

We estimate that we will receive approximately US$53.5 million in net proceeds from the sale of ADSs in this offering. Net proceeds are what we will receive after payment of our share of all underwriting discounts, commissions and our expenses relating to this offering, net of expense reimbursements, based upon an assumed initial public offering price of US$13.50 per ADS, the mid-point of the estimated public offering price range shown on the front cover of this prospectus. A US$1.00 increase in the assumed initial public offering price of US$13.50 per ADS would increase the net proceeds to us from this offering by US$4.2 million, assuming the number of ADSs offered by us, as set forth on the cover page of this prospectus, remains the same and after deducting the estimated underwriting discounts and commissions and estimated offering expenses, net of expense reimbursements, payable by us. We will not receive any of the proceeds from any sale of ADSs by the selling shareholders to cover over-allotments.

 

We expect to use our net proceeds from this offering approximately as follows:

 

    US$8.5 million for repayments of outstanding debt;

 

    US$5.0 million to expand our sales, distribution and technical support network;

 

    US$4.0 million for capital expenditures, such as the purchase of real estate and the construction of new facilities to be used as our new headquarters;

 

    US$2.0 million to expand our research and development efforts; and

 

    the balance to fund working capital and general corporate purposes.

 

The outstanding debt we intend to repay consists of US$8.5 million of short-term borrowings from various local financial institutions which have a maturity date of less than one-year and bear interest at a weighted average rate of 5.89%. All of such short-term borrowings that we intend to repay are currently guaranteed by Mr. Seo Kyu Lee, our chief executive officer.

 

The amount and timing of our actual expenditures of the net proceeds will depend on several factors, including:

 

    our need for specific capital expenditures;

 

    the progress of our research and development efforts; and

 

    the amount of cash generated or used by our ongoing operations.

 

Except as discussed above, we have not made any other specific expenditure plans with respect to our net proceeds. Accordingly, our management will have significant flexibility in applying our net proceeds. Pending their use, we intend to invest the net proceeds of the offering in short-term, interest-bearing debt instruments.

 

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DIVIDEND POLICY

 

Since our inception in April 2000, we have not declared or paid any dividends on our common shares. We currently intend to retain all available funds and any future earnings for use in the operation and expansion of our business and do not anticipate paying any cash dividends in the foreseeable future.

 

Holders of outstanding common shares on a dividend record date will be entitled to the full dividend declared without regard to the date of issuance of the common shares or any subsequent transfer of the common shares. Payment of dividends in respect of a particular year, if any, will be made in the following year after approval by our shareholders at our annual general meeting of shareholders, subject to certain provisions of the Korean Commercial Code. See “Description of Share Capital—Dividends.”

 

Subject to the terms of the deposit agreement for the ADSs, you will be entitled to receive dividends on common shares represented by ADSs to the same extent as the holders of common shares, less the fees and expenses payable under the deposit agreement in respect of, and any Korean tax applicable to, such dividends. See “Taxation—Korean Taxation—Dividends on the Common Shares or ADSs.” The depositary will generally convert the Korean Won it receives into U.S. dollars and distribute the U.S. dollar amounts to you.

 

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CAPITALIZATION

 

The following table sets forth our capitalization as of September 30, 2005:

 

    on an actual basis;

 

    on a pro forma basis to give effect to the conversion of all of our outstanding preferred shares into 1,201,333 common shares immediately prior to the completion of this offering; and

 

    on a pro forma basis as adjusted to give effect to (i) the conversion of all of our outstanding preferred shares into 1,201,333 common shares; (ii) the issuance and sale of 4,500,000 ADSs (equivalent to 2,250,000 common shares) in this offering, assuming no exercise of the underwriters’ over-allotment option, at an assumed initial public offering price of US$13.50 per ADS, the mid-point of the estimated offering price range set forth on the cover page of this prospectus, after deducting underwriting discounts, commissions and estimated offering expenses, net of expense reimbursements, payable by us; and (iii) the repayment of certain short-term borrowings in the aggregate amount of (Won)8.9 billion (US$8.5 million) with the proceeds from this offering.

 

You should read this table in conjunction with the information in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our financial statements and the notes thereto, included elsewhere in this prospectus.

 

    As of September 30, 2005

    Actual

   Pro Forma

   Pro Forma As
Adjusted(1)


    (in millions of Korean Won and thousands of US$)

Short-term borrowings

  (Won) 10,607    $ 10,175    (Won) 10,607    $ 10,175    (Won) 1,729    $ 1,659
   

  

  

  

  

  

Long-term borrowings

  (Won) 730    $ 700    (Won) 730    $ 700    (Won) 730    $ 700

Series A convertible redeemable preferred shares, par value (Won)500; 10,000,000 shares authorized; 1,441,600 shares issued and outstanding on an actual basis, and no shares issued and outstanding on a pro forma and pro forma as adjusted basis

    8,233      7,899                    

Shareholders’ equity:

                                        

Common shares, par value (Won)500; 10,000,000 shares authorized, 2,604,000, 3,805,333 and 6,055,333 shares issued and outstanding

    1,302      1,249      1,903      1,825      3,028      2,905

Additional paid-in-capital(2)

              7,632      7,323      62,273      59,740

Accumulated other comprehensive income

    (17)      (16)      (17)      (16)      (17)      (16)

Accumulated deficit

    (7,244)      (6,950)      (7,244)      (6,950)      (7,244)      (6,950)
   

  

  

  

  

  

Total shareholders’ equity (deficit)(2)

    (5,959)      (5,717)      2,274      2,182      58,040      55,679
   

  

  

  

  

  

Total capitalization(2)

  (Won) 3,004    $ 2,882    (Won) 3,004    $ 2,882    (Won) 58,770    $ 56,379
   

  

  

  

  

  

 


 

(1) Excludes 1,177,591 common shares underlying options granted under our stock option plan and outstanding as of September 30, 2005 at a weighted average exercise price of (Won)1,867, or US$1.79, per common share.
(2) A US$1.00 increase in the assumed initial public offering price of US$13.50 per ADS would increase each of pro forma as adjusted additional paid-in capital, pro forma as adjusted total shareholders’ equity and pro forma as adjusted total capitalization by US$4.2 million, assuming the number of ADSs offered by us, as set forth on the cover page of this prospectus, remains the same and after deducting the estimated underwriting discounts and commissions and estimated offering expenses, net of expense reimbursements, payable by us.

 

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DILUTION

 

If you invest in our ADSs through this offering, your interest will be diluted to the extent of the difference between the assumed initial public offering price per ADS and the net tangible book value per ADS immediately after the completion of this offering.

 

Net tangible book value per ADS represents the amount of our total tangible assets minus total liabilities, divided by the number of ADS equivalents of the total number of common shares outstanding. As of September 30, 2005, our net tangible book value was (Won)1.9 billion (US$1.8 million), or (Won)498 per common share (US$0.24 per ADS). After giving effect to the sale of 4,500,000 ADSs in this offering at an assumed initial public offering price of US$13.50 per ADS, the mid-point of the estimated offering price range set forth on the cover page of this prospectus, and after deducting the underwriting discounts and estimated offering expenses payable by us, our net tangible book value at September 30, 2005 is estimated to be (Won)57.7 billion (US$55.3 million), or approximately (Won)9,522 per common share (US$4.57 per ADS). This represents an immediate increase in net tangible book value of US$4.33 per ADS, to our existing shareholders and an immediate dilution in net tangible book value of US$8.93 per ADS, to our new public investors purchasing ADSs at the initial public offering price.

 

The following table illustrates this dilution on a per ADS basis:

 

Assumed Initial public offering price per ADS

          US$ 13.50

Net tangible book value per ADS as of September 30, 2005

   US$ 0.24       

Increase in net tangible book value per ADS attributable to the sale of ADSs in the offering

     4.33       
    

      

Net tangible book value per ADS after giving effect to the offering

            4.57
           

Dilution per ADS to new investors

          US$ 8.93
           

 

The following table sets forth, as of September 30, 2005, the differences between the existing shareholders and the new investors in respect of the number of ADSs or ADS equivalent purchased from us, the total consideration paid and the average price per ADS or ADS equivalent paid by existing shareholders and by new investors, before deducting the underwriting discounts and estimated offering expenses payable by us, at an assumed initial public offering price of US$13.50 per ADS.

 

     ADSs or ADS
equivalents purchased


    Total consideration

    Average price
per ADS or
ADS equivalent


     Number
(in thousands)


   Percent

    Amount
(in thousands)


   Percent

   

Existing shareholders

   7,611    62.8 %   US$ 9,147    13.1 %   US$ 2.40

New investors

   4,500    37.2       60,750    86.9       13.50
    
  

 

  

     

Total

   12,111    100.0     US$ 69,897    100.0        
    
  

 

  

     

 

The foregoing discussions and tables on the number of common shares and ADSs outstanding as of September 30, 2005:

 

    includes 1,201,333 common shares that will be issued upon conversion of all 1,441,600 shares of our outstanding convertible redeemable Series A preferred shares; but

 

    excludes 1,177,591 common shares that will be subject to issuance upon exercise of the stock options granted under our stock option plan and outstanding at September 30, 2005; and

 

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    excludes 675,000 ADSs subject to sale by the selling shareholders if the underwriters exercise their over-allotment option in full.

 

A US$1.00 increase in the assumed initial public offering price of US$13.50 per ADS would increase our net tangible book value after this offering by US$4.2 million, the net tangible book value per share after this offering by US$0.34 per ADS and the dilution in the net tangible book value to new investors in this offering by US$0.66 per ADS, assuming the number of ADSs offered by us, as set forth on the cover page of this prospectus, remains the same and after deducting the estimated underwriting discounts and commissions and estimated offering expenses payable by us.

 

A US$1.00 increase in the assumed initial public offering price of US$13.50 per ADS would increase total consideration paid by new investors and total consideration paid by all shareholders by US$4,500,000 and US$4,500,000, respectively, assuming the number of ADSs offered by us, as set forth on the cover page of this prospectus, remains the same and before deducting underwriting discounts and estimated offering expenses payable by us.

 

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SELECTED CONSOLIDATED FINANCIAL INFORMATION AND OTHER DATA

 

The statement of operations data and cash flow data for the years ended December 31, 2002, 2003 and 2004, and the balance sheet data as of December 31, 2003 and 2004, are derived from our audited consolidated financial statements and related notes thereto, which have been included elsewhere in this prospectus. The financial data as of September 30, 2005 and for the nine months ended September 30, 2004 and 2005 are derived from our unaudited consolidated financial statements and related notes thereto, which have been included elsewhere in this prospectus. The statement of operations data and cash flow data from inception (April 12, 2000) to December 31, 2001 are derived from unaudited consolidated financial statements, which have not been included in this prospectus. The balance sheet data as of December 31, 2000 and 2001 is derived from unaudited consolidated financial statements, which have not been presented in this prospectus. The balance sheet data as of December 31, 2002 is derived from audited consolidated financial statements, which have not been presented in this prospectus.

 

These audited and unaudited consolidated financial statements and the related notes thereto have been prepared in accordance with accounting principles generally accepted in the United States. The information set forth below is not necessarily indicative of the results of future operations and should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our financial statements and related notes thereto included elsewhere in this prospectus.

 

   

For the Years Ended December 31,


  For the Nine Months Ended
September 30,


  2000(1)

  2001

  2002

  2003

  2004

  2004(2)

  2004

  2005

  2005(2)

    (unaudited)   (unaudited)               (unaudited)   (unaudited)   (unaudited)   (unaudited)
    (in millions of Korean Won and thousands of US$, except share and per share data)

Statement of Operations Data:

                                                     

Revenues:

                                                     

Products

  (Won)   (Won)   (Won) 73   (Won) 17,806   (Won) 31,356   $ 30,081   (Won) 22,204   (Won) 28,124   $ 26,980

Services

                    4,440     4,260     3,183     2,294     2,201
   

 

 

 

 

 

 

 

 

Total revenues

            73     17,806     35,796     34,341     25,387     30,418     29,181
   

 

 

 

 

 

 

 

 

Cost of revenues:

                                                     

Products

            296     14,562     31,457     30,178     23,713     22,585     21,666

Services

                    831     797     577     386     371
   

 

 

 

 

 

 

 

 

Total cost of revenues

            296     14,562     32,288     30,975     24,290     22,971     22,037
   

 

 

 

 

 

 

 

 

Gross profit (loss)

            (223)     3,244     3,508     3,366     1,097     7,447     7,144

Operating expenses:

                                                     

Selling, general and administrative

    112     316     310     1,136     3,966     3,804     3,057     3,550     3,405

Research and development, net of government grants

    187     773     666     1,335     3,211     3,080     2,064     2,498     2,396
   

 

 

 

 

 

 

 

 

Total operating expenses

    299     1,089     976     2,471     7,177     6,884     5,121     6,048     5,801
   

 

 

 

 

 

 

 

 

Income (loss) from operations

    (299)     (1,089)     (1,199)     773     (3,669)     (3,518)     (4,024)     1,399     1,343

Other income (expense):

                                                     

Interest income (expense), net

    13     (1)     (49)     1     (230)     (221)     (120)     (389)     (373)

Foreign exchange gain, net

                138     337     323     209     63     60

Others, net

            (23)     (2)     3     4     5     (9)     (9)
   

 

 

 

 

 

 

 

 

Total other income (expense)

    13     (1)     (72)     137     110     106     94     (335)     (322)
   

 

 

 

 

 

 

 

 

Income (loss) before income taxes and loss from equity method investments

    (286)     (1,090)     (1,271)     910     (3,559)     (3,412)     (3,930)     1,064     1,021

Income tax expenses

                106     234     225     259        
   

 

 

 

 

 

 

 

 

 

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For the Years Ended December 31,


  For the Nine Months Ended
September 30,


  2000(1)

  2001

  2002

  2003

  2004

  2004(2)

  2004

  2005

  2005(2)

    (unaudited)   (unaudited)   (unaudited)   (unaudited)   (unaudited)   (unaudited)
    (in millions of Korean Won and thousands of US$, except share and per share data)

Income (loss) before loss from equity method investments

  (Won) (286)   (Won) (1,090)   (Won) (1,271)   (Won) 804   (Won) (3,793)   $ (3,637)   (Won) (4,189)   (Won) 1,064   $ 1,021

Gain (loss) from equity method investments, net

                    (272)     (261)     (189)     (218)     (209)

Dilution gain from equity method investments

                                411     394
   

 

 

 

 

 

 

 

 

Net income (loss)

  (Won) (286)   (Won) (1,090)   (Won) (1,271)   (Won) 804   (Won) (4,065)   $ (3,898)   (Won) (4,378)   (Won) 1,257   $ 1,206
   

 

 

 

 

 

 

 

 

Accretion of preferred shares

                (1,149)     (1,569)     (1,505)     (1,270)     (1,495)     (1,435)
   

 

 

 

 

 

 

 

 

Net loss attributable to common shareholders

    (286)     (1,090)     (1,271)     (345)     (5,634)     (5,403)     (5,648)     (238)     (229)
   

 

 

 

 

 

 

 

 

Loss per share—basic and diluted

    (143)     (418)     (488)     (283)     (2,353)     (2.26)     (2,310)     (233)     (0.22)
   

 

 

 

 

 

 

 

 

Weighted average number of shares—basic and diluted

    2,003,987     2,604,000     2,604,000     2,604,000     2,604,000     2,604,000     2,604,000     2,604,000     2,604,000
   

 

 

 

 

 

 

 

 

Cash Flow Data:

                                                     

Net cash used in operating activities

  (Won) (573)   (Won) (244)   (Won) (766)   (Won) (4,568)   (Won) (5,364)   $ (5,148)   (Won) (4,477)   (Won) (1,196)   $ (1,147)

Depreciation and amortization

    27     107     88     146     308     295     220     310     297

Net cash provided by (used in) investing activities

    (126)     (838)     100     (858)     (1,499)     (1,438)     (1,203)     (1,244)     (1,194)

Net cash provided by financing activities

    1,623     791     114     5,649     7,718     7,404     6,027     1,987     1,906
   

 

 

 

 

 

 

 

 

 

    As of December 31,

  As of September 30, 2005

  2000

  2001

  2002

  2003

  2004

  2004(2)

  Actual

  Actual(2)

  As
Adjusted(3)


    (unaudited)   (unaudited)               (unaudited)   (unaudited)   (unaudited)   (unaudited)
    (in millions of Korean Won and thousands of US$)

Balance Sheet Data:

                                                     

Cash and cash equivalents

  (Won) 924   (Won) 633   (Won) 81   (Won) 286   (Won) 1,194   $ 1,145   (Won) 715   $ 686     (Won)715

Accounts receivable, net

            37     5,695     5,446     5,225     14,070     13,498     14,070

Inventories, net

            1     6,374     6,818     6,541     3,843     3,687     3,843

Total assets

    1,455     1,460     659     15,299     17,666     16,948     26,205     25,139     26,205

Long-term borrowings

        500     425     1,217     1,259     1,208     730     700     730

Total liabilities

    191     1,286     1,757     10,410     17,156     16,458     23,931     22,957     23,931

Series A convertible redeemable preferred shares

                5,975     6,776     6,500     8,233     7,899    

Shareholders’ equity (deficit)(4)

    1,264     174     (1,098)     (1,086)     (6,266)     (6,010)     (5,959)     (5,717)     2,274

 

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     For the Years
Ended December 31,


   For the Nine Months
Ended September 30,


     2002

   2003

   2004

   2004

   2005

     (in millions of image sensor units)

Operating Data:

                        

Units sold:

                        

Products

         –    1.4    3.1    2.1    9.2

Services(5)

         7.7    5.1    5.6

Total

      1.4    10.8    7.2    14.8

 

(1) Represents operating activity from April 12, 2000, the date of our inception.
(2) For convenience, the Korean Won amounts are expressed in U.S. dollars at the rate of (Won)1,042.4 to US$1.00, the noon buying rate in effect on September 30, 2005 as quoted by the Federal Reserve Bank of New York.
(3) Amounts are presented as adjusted for the automatic conversion of our 1,441,600 shares of Series A preferred shares into 1,201,333 common shares immediately prior to the completion of this offering, but excludes 1,177,591 common shares underlying options granted under our stock option plan and outstanding as of September 30, 2005 at a weighted average exercise price of (Won)1,867, or US$1.79, per common share.
(4) Shareholders’ equity (deficit) does not include our Series A convertible redeemable preferred shares.
(5) Equals the total number of image sensors sold by DongbuAnam to Sharp under our services arrangements with DongbuAnam, for each relevant period.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

 

The following discussion of our financial condition and results of operations is based upon and should be read in conjunction with our consolidated financial statements and the related notes which have been included elsewhere in this prospectus. This discussion contains forward-looking statements that involve risks and uncertainties. We caution you that our business and financial performance are subject to substantial risks and uncertainties. Actual results could differ materially from those projected in the forward-looking statements. In evaluating our business, you should carefully consider the information provided under the caption “Risk Factors” beginning on page 8 of this prospectus.

 

Overview

 

We are a fabless semiconductor company that designs, develops and markets high-performance, high-resolution and cost-effective CMOS image sensors. Our uniquely designed 3-transistor CMOS image sensors provide high level system integration, multiple functionality, size efficiency and low power consumption for use in mobile camera phones and other emerging applications such as in PC cameras, security and surveillance systems and toys. In 2004, we shipped approximately 10.8 million CMOS image sensors and camera modules, of which 7.7 million CMOS image sensors were sold through DongbuAnam to Sharp under our arrangements with DongbuAnam, as compared to approximately 1.4 million in 2003, and during the first nine months of 2005, we shipped approximately 14.8 million CMOS image sensors and camera modules worldwide, of which 5.6 million CMOS image sensors were sold through DongbuAnam to Sharp.

 

We were incorporated as a company with limited liability under Korean law on April 12, 2000, and we developed our first CMOS image sensor for mass production in July 2003. We commercialized our first 1.3 megapixel CMOS image sensor in September 2003 and our first 2.0 megapixel image sensor with auto-focus capabilities in April 2005. We intend to continue developing new products aimed at providing the smallest image sensors with the highest picture quality and the highest integration of camera functions for use in mobile camera phones. We will also continue to focus on developing new types of image sensors to meet the advanced design requirements of new emerging applications, such as automobiles, biometrics, pattern recognition and medical devices.

 

Our revenues have grown significantly since we first sold product samples in January 2002. We recognized revenues of (Won)73 million in 2002 and (Won)17,806 million in 2003, primarily from sales of our camera modules incorporating CMOS image sensors to domestic customers. As we introduced new products and expanded our international and domestic sales and marketing efforts in 2004 and the first nine months of 2005, our revenues increased to (Won)35,796 million (US$34.3 million) and (Won)30,418 million (US$29.2 million), respectively.

 

A significant portion of our 2005 revenues will be generated from the sale of camera modules implementing our CMOS image sensors to be used in mobile camera phones. We expect revenues from sales of our camera modules to decrease significantly commencing in 2006 as we are currently undergoing a transition to form a new arrangement under which we will sell our CMOS image sensors to camera module assembly companies that will then assemble the camera modules and sell the camera modules directly to their customers. Our dependence on the mobile camera phone market is expected to continue for the foreseeable future although we expect revenues from the sale of CMOS image sensors used in PC camera applications to grow steadily in the second half of 2006. Similar to other semiconductor industries, the CMOS image sensor industry is highly cyclical and is subject to constant and rapid technological changes, product obsolescence, price erosion, evolving standards, short product life-cycles and fluctuations in product supply and demand.

 

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Certain Principal Factors Affecting Our Results of Operations and Financial Condition

 

Revenues

 

We generate revenues primarily from sales of our CMOS image sensors, which are sold as a standalone product or incorporated into a camera module, and from our services. In 2003, 2004 and the first nine months of 2005, we derived 4.5%, 17.6% and 41.4%, respectively, of our total revenues from sales of our CMOS image sensors and 92.6%, 68.9% and 51.1%, respectively, of our total revenues from sales of our camera modules and other related parts.

 

In addition, we derived 12.4% and 7.5% of our total revenues in 2004 and the first nine months of 2005, respectively, from our services arrangements with DongbuAnam, which we have categorized as “services.” CMOS image sensors sold pursuant to these arrangements accounted for 71.3% and 38.0% of our CMOS image sensor unit volume in 2004 and the first nine months of 2005, respectively. Our current agreement to provide these services to DongbuAnam, which was entered into on September 17, 2004, is for a term of one year and will be automatically renewed annually unless either party delivers a 30-day prior notice electing not to renew the agreement. Pursuant to this arrangement, we provide our CMOS image sensor design services, manufacturing process consultation, testing, customer support and other services and engineering know-how to DongbuAnam to facilitate its manufacture and sale of CMOS image sensors to Sharp. DongbuAnam pays us a certain percentage of fees based on a combination of the number of CMOS image sensors successfully passing the product probe test conducted by Tesna on our behalf and the sales price of the CMOS image sensors sold to Sharp. As our cost of revenues for services are primarily limited to wafer testing fees, our gross margin for services is relatively high. Presently, we do not expect to add additional customers to our services business.

 

We generally sell our products in Korea through a direct sales force and in other markets, through sales agents and distributors. Our CMOS image sensors and camera modules are predominantly sold to mobile phone manufacturers who market mobile camera phones under their own brands. We also sell to large manufacturing companies that produce mobile camera phones for others to market under different brand names.

 

We generally sell our products on a purchase order basis rather than using long term contracts. Our customers may not cancel their purchase orders but may defer their orders without significant penalty. We engage our wafer foundry and other independent contractors to manufacture, test, package and assemble the finished products for delivery to the customer, either after a customer order is received or in anticipation of prospective customer orders. In both circumstances, we are the primary obligor.

 

Declining Average Sales Price

 

Because the CMOS image sensor market is characterized by intense price competition, we have experienced, and expect to continue to experience, market driven pricing pressures and declining average sales prices for our products. Generally, prices for our products are determined based on the level of technological sophistication and the availability of the product in a specific market. As product availability increases in a market, the average sales price of the product generally declines quickly over a period of six to 18 months. For example, compared to the first nine months of 2004, the average sales price of our VGA image sensor, which was our top selling image sensor for those periods, fell 65.7% during the first nine months of 2005. We intend to address future declines in average sales prices by continually developing new products with higher margins, incorporating more advanced features to our existing products, and achieving manufacturing cost efficiencies by upgrading our process technology.

 

Manufacturing and Other Costs

 

As a fabless design company, we outsource all of our capital-intensive product manufacturing processes to independent third party contractors. Costs related to the wafer fabrication process, currently outsourced to

 

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DongbuAnam, account for the largest portion of our cost base, and is largely determined by (i) the cost of wafers, which is the principal raw material for image sensors and tends to be affected by the cyclical semiconductor industry and to a lesser extent by the pricing flexibility achieved through volume discounts, and (ii) the yield per wafer, which is the ratio of the number of functional dies on a wafer to the maximum number of dies that can be produced on that wafer. Higher yields result in reduced costs, which permits average selling price reductions. As yields are generally affected by the design and manufacturing process technology employed, we seek to continuously improve yields by improving our chip design and working closely with our current independent foundry on our process technology, which was upgraded from 0.25 microns, or µm, to 0.18 µm in January 2005 with further upgrades to 0.15 µm and 0.13 µm process technology.

 

Our other cost of revenues for our products consists principally of:

 

    the cost of outsourced testing and packaging of our products;

 

    the cost of salary and benefits, including stock-based compensation expenses, of our employees associated with product manufacturing, customization and support;

 

    loss on valuation of inventory; and

 

    the cost of transportation and distribution.

 

In addition to each of the cost items above, our cost of revenues for our camera modules also includes the cost of module assembly. As we endeavor to grow our sales volumes and transition to smaller process technology, we expect to further reduce the unit cost of our products through economies of scale and diversification of our outsourced manufacturing base. We expect our costs of international transportation and distribution to rise concurrently as we grow our international business. Our cost of revenues for our services consists mainly of wafer testing fees related to our business with DongbuAnam related to Sharp.

 

Inventory Loss

 

We recognize a charge to our cost of revenues for losses on valuation of inventory when the estimated realizable value for our goods in inventory is determined to be below our cost and when the number of units on hand exceeds the number of units that we forecast to sell over a certain period of time.

 

We have in the past recorded, and may continue to record, losses on valuation of inventory attributable to the following principal factors:

 

    excess inventory build up of image sensors caused by our need to anticipate future orders, as the lead time required by our foundry to fabricate our wafers is often longer than the lead time our customers provide to us for delivery of our products;

 

    the short-term nature of purchase commitments or order cancellations, reductions or delays by a significant customer or group of customers;

 

    larger write downs for excess camera modules due to higher per unit prices than wafers or dies and more customized specifications, which limit our ability to resell camera module inventory to other customers;

 

    difficulty of accurately forecasting CMOS image sensor demand as we depend on order forecasts from many of our customers who themselves are susceptible to fluctuating customer demand for mobile phones; and

 

    susceptibility to rapidly declining average sales prices and obsolescence.

 

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Gross Profit

 

Our gross profit is primarily affected by our revenues from our products and services and by our cost of revenues associated with our products and services. Our overall gross margin was 9.8% in 2004 and 24.5% in the first nine months of 2005. We expect our gross margin from sales of our products to increase as a result of an increase in sales of CMOS image sensors, generally our higher margin product, and a decrease in sales of camera modules, generally our lower margin product. We further expect our gross margin from sales of our products to improve as a result of higher average sales prices following the introduction of new higher margin CMOS image sensors and reduced costs from process technology upgrades. In 2004 and the first nine months of 2005, our gross margin for our services revenues was 81.3% and 83.2%, respectively. Although we cannot predict whether our revenue from our services will increase or decrease in the future, we expect our gross margin from this part of our business to remain relatively stable.

 

Operating Expenses

 

Operating expenses consist primarily of our selling, general and administrative expenses and our research and development expenses, net of government grants.

 

Selling, General and Administrative. Our selling, general and administrative expenses primarily include:

 

    salary and benefits for our sales, marketing and administration personnel;

 

    commissions to our sales agents;

 

    rent for our offices; and

 

    travel and entertainment expenses.

 

We expect our selling, general and administrative expenses to increase as we hire additional sales, marketing and administration personnel and further expand our business and marketing efforts, both domestically and internationally, and as we incur greater expenses for professional services, such as legal and accounting, after becoming a public company.

 

Research and Development, Net of Government Grants. The rapid technological change and product obsolescence that characterize our industry requires us to make regular investments in research and development. Our research and development expenses, net of government grants, consist primarily of:

 

    costs for the construction of masks, which are prototypes made for each new product in the development stage in order for our independent foundry to test for mass production viability;

 

    research and development personnel salary and benefits; and

 

    expenses for design tools and software.

 

We recognize all research and development expenses when incurred. Product development time frames vary, but in general we incur research and development costs six to 18 months before generating sales from new products.

 

As part of the Korean government’s initiative to promote and encourage the development of start-up companies in the semiconductor and other high technology industries, high technology start-up companies with industry leading technology or products are eligible for government grants. We have from time to time received such government research and development grants in recognition of our new technology inventions, such as our 1.3 megapixel CMOS image sensor. Grants received from the Korean government for research and development activities totaled (Won)535 million for 2002. These grants were used to offset our research and development costs in

 

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the amounts of (Won)333 million and (Won)44 million in 2002 and 2003, respectively. In 2004, we also received grants in the amount of (Won)26 million for the acquisition of fixed assets and intangible assets. These grants were used to offset our acquisition costs of the acquired assets in 2004. Grants amortized related to fixed assets and intangible assets were (Won)87 million, (Won)75 million and (Won)69 million for 2002, 2003 and 2004, respectively. As of December 31, 2003 and 2004, we recorded refundable government grants in the amount of (Won)359 million (US$0.3 million), of which (Won)132 million is due and payable in 2005 with the remaining (Won)227 million becoming due and payable in 2006.

 

Stock Option Compensation Expenses

 

We incurred stock option compensation expenses of (Won)357 million, (Won)494 million (US$0.5 million) and (Won)522 million (US$0.5 million), for 2003, 2004 and for the first nine months of 2005, respectively. Substantially all of these charges were related to the amortization of stock option compensation expenses related to options granted to attract and retain members of our senior management and certain employees. For the fourth quarter of 2005, we expect to record (Won)560 million (US$0.5 million) of stock compensation expenses for all stock options outstanding as of September 30, 2005. We may incur additional stock-based compensation expense in connection with future stock option grants. See note 7 to our consolidated financial statements as of December 31, 2004 and September 30, 2005 and for the nine months ended September 30, 2004 and 2005. See “—Critical Accounting Policies—Accounting for Stock Options.”

 

Income Tax Expenses

 

As a designated venture company under Korean law, we are entitled to a 50% reduction in corporate income tax rates for the year in which we first generate taxable income and the following five years if we satisfy a number of financial and non-financial criteria, including the maintenance of our status as a designated venture company. As we first generated taxable income in 2003, we were subject to a reduced tax rate of 14.85% for that fiscal year and the same rate applied to 2004. Our tax rate will be further reduced to 13.75% for 2005 due to a general reduction in the Korean corporate tax rate to 27.5% from 29.7%. The rate of 13.75% will be effective until December 31, 2008, provided we continue to qualify as a venture company. Our status as a designated venture company is subject to evaluation and renewal in November of each year.

 

To qualify as a designated venture company, a company must be a small- and medium-sized enterprise under the Framework Act on Small- and Medium-Sized Enterprises and be found to have, among other things, a superior ability to provide innovation in technology and business by the Small Business Corporation of Korea. In addition, qualified Korean venture capital investment firms must hold an aggregate of at least 10% of the outstanding shares of such venture company for at least six months prior to the filing of the venture company application. A company may qualify as a small- and medium-sized enterprise if, among other things, it hires less than 300 full-time employees or its paid-in-capital is (Won)8 billion or less.

 

Preferred Shares

 

In 2003, we issued our Series A preferred shares, which we have reflected as mezzanine equity on our balance sheet. Prior to the date of the pricing for this offering, all of our Series A preferred shares will be converted into 1,201,333 common shares.

 

Due to the redemption right of the holders of our Series A preferred shares, accretion was recorded to the preferred share entries on our balance sheet over various periods since their issuance dates, with corresponding non-cash charges reflected below net income on our statement of operations for relevant periods. Upon conversion of the Series A preferred shares into our common shares in connection with this offering, any amount in excess of the par value of our common shares to be issued will be recorded to additional paid-in

 

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capital and there will be no further effect on our statement of operations. For more information on these accretion charges, see note 10 to our consolidated financial statements as of and for the year ended December 31, 2004.

 

Critical Accounting Policies

 

Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates, judgments and assumptions that affect the reported amounts of assets and liabilities, contingent liabilities, and revenues and expenses during the reporting period. We evaluate our estimates on an ongoing basis based on historical experience and other assumptions we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. The policies discussed below are considered by our management to be critical because they are not only important to the portrayal of our financial condition and results of operations but also because application and interpretation of these policies require both judgment and estimates of matters that are inherently uncertain and unknown. As a result, actual results may differ materially from our estimates.

 

Revenue Recognition

 

Our revenues are derived from sales of CMOS image sensors and camera modules to our customers and from the provision of engineering, technology and other services to DongbuAnam. For products sold in Korea under agreements that do not allow for returns or credits for our customers, we recognize revenues upon product shipment. For products sold in Korea under agreements that allow for returns or credits for our customers, revenues are recognized upon product acceptance by the customer. For products sold outside of Korea, title and risk of loss are transferred to customers upon shipment, and at that point, there are no further customer acceptance requirements or rights of return. Accordingly, revenue is recognized upon product shipment.

 

We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers were to deteriorate, additional allowances may be required.

 

We record warranty liabilities for the estimated costs that may be incurred under our limited warranty. This warranty covers product defects based on compliance to our specifications and is normally applicable for 12 months from the date of purchase. These liabilities are accrued when revenues are recognized. Warranty costs include the costs to replace defective products. Factors that affect our warranty liability include historical and anticipated rate of warranty claims on those repairs and cost per claim to satisfy our warranty obligation.

 

Allowance for Inventory Valuation

 

Inventories are stated at the lower of cost, using the weighted-average method, or market value. If net realizable value is less than cost at the balance sheet date, the carrying amount is reduced to the realizable value, and the difference is recognized as a loss on valuation of inventories. We estimate the net realizable value for such finished goods and work-in-progress based primarily upon the latest invoice prices and current market conditions. Inventory reserves are established when conditions indicate that the net realizable value is less than cost due to physical deterioration, obsolescence, changes in price levels, or other causes. Reserves are also established for excess inventory based on inventory levels, as judged by management, for each specific product. The determination of reserves for obsolete and excess inventory involves significant judgment, including the ability to forecast customer demand, trends in the development of new technology, and other market forces affecting the price for our products. To date, we have used historical data and other industry trends to forecast customer demand and price levels. However, these estimates could vary significantly from actual results.

 

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Accounting for Stock Options

 

We account for stock options in accordance with the provisions of SFAS 123, Accounting for Stock Based Compensation, using the fair value method based on the Black-Scholes model. Under the fair value method, compensation cost for stock option grants is measured at the date of grant based on the fair value of the award and recognized over the service period on a straight-line basis. The determination of fair value of the award at the date of grant using the Black-Scholes model requires estimates about our expected dividend yield, expected risk free interest rate, expected volatility, expected life and the fair value of our common shares on the date of grant. See “—Certain Principal Factors Affecting Our Results of Operations and Financial Condition—Stock Option Compensation” for further discussion of our accounting for stock options.

 

We have used an independent appraisal firm, Duff & Phelps LLC, formerly Standard & Poor’s Corporate Value Consulting, to assist with the valuation of our common shares, and our stock options, at each date of grant. The determination of the fair value of our common shares on each date of grant was a two step process: first, it was necessary to calculate a deemed business enterprise value for our company, and second, it was necessary to calculate an estimated fair value of our common shares on a non-marketable, minority basis. The business enterprise value was determined based on an income approach, using the discounted cash flow method and an estimated weighted average cost of capital, utilizing a venture capital rate of return. Then, for benchmarking purposes only, implied revenue multiples were calculated based on the value determined under the income approach, and compared to the revenue multiples of comparable companies. The estimated fair value of our common shares was calculated using an option pricing model, using the business enterprise value, an estimated volatility, a time to liquidation and a risk free interest rate.

 

When applying the discounted cash flow method, which is a form of the income approach, the cash flows expected to be generated by a business are discounted to the present value equivalent using a rate of return that reflects the relative risk of the investment, as well as the time value of money. This rate of return is an overall rate based on the individual rates of return for invested capital, which consist of interest-bearing debt and equity capital. The return, known as the weighted average cost of capital, is calculated by weighting the required returns on interest-bearing debt, preferred equity capital, and common equity capital in proportion to the estimated percentages in an expected capital structure. In determining a discount rate using the weighted average cost of capital, we chose a venture capital rate of return because we are a privately-held company, and we are still in our initial growth and development stage. These rates are recommended by a task force report of the American Institute of Certified Public Accountants, or AICPA, that provides guidance on the rates of return commanded by venture capital investors at various stages of an investee company’s development.

 

When we used the income approach to determine our business enterprise value, we used projections of our cash flows for a ten year period, as a reasonable forecast horizon, and after ten years, we used a terminal value because we believe our business will have exited the initial growth and development stage at that time, and we will have established a normalized growth rate that is comparable to other more mature companies in our industry. Projected revenues assumed an expected annual growth rate based on our expectations and also the projected growth in our industry from analyst reports for our industry, such as Standard & Poor’s Industry Surveys. Projected cost of goods sold and projected operating expenses, as a percentage of projected revenues, are expected to decline over the projection period as our revenue grows, and as we are able to benefit from economies of scale. Our projected tax rate was based on the current corporate tax rate in Korea. The terminal value of our cash flows after the ten-year period was calculated using the Gordon Growth methodology, based on our long-term expected growth assumptions using our expectations and analyst reports for our industry. The Gordon Growth methodology, a commonly used methodology for determining the terminal value of a company which has reached a phase of growing at a constant rate, is based on calculations of the free cash flow in the year following the last year of the projection period and the appropriate capitalization rate to apply to the free cash flow. The capitalization rate is calculated by subtracting the long-term growth rate from the discount rate.

 

Our resulting business enterprise value was allocated between our common and preferred shares using the option pricing model. The primary assumptions in the option pricing model are an estimated volatility, based on expected time to the offering, and the risk free interest rate. We estimated volatility based on both the historical volatility of comparable publicly traded companies, over the anticipated time to liquidity assumption, and the implied volatility of such companies, based on publicly traded option prices in the market. We estimated

 

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the risk free interest rate based on the risk free rate for a U.S. treasury bond with a time to maturity equal to the expected time to the offering. Additionally, the model assumes that as the value of a company increases from zero to the liquidation preferences of preferred shares, all potential increase in value accrues to the preferred shares. As the value of the company increases beyond the liquidation preferences, all further potential increase in value accrues to the common shares until the value reaches a point at which the preferred shares convert to common shares. Any increase in the company’s value past this conversion point are shared pro-rata between common and preferred shares according to the post-conversion share ratio.

 

Determination of the fair value of our common shares involves complex and subjective judgments regarding projected financial and operating results, our unique business risks, the liquidity of our shares and our operating history and prospects at the time of grant. If we make different judgments or adopt different assumptions, material differences could result in the timing and amount of the share-based compensation expenses recorded because the estimated fair value of the underlying shares for the options granted would be different.

 

Commencing on January 1, 2006, we will adopt SFAS No. 123(R), Share-based Payment. See “—Recent Accounting Pronouncements.” We do not expect this change to have a significant impact on our results of operations and disclosures.

 

Deferred Income Taxes

 

We account for income taxes under the provisions of SFAS No. 109, Accounting for Income Taxes, which require the asset and liability method. We review our deferred tax assets on a regular basis to evaluate their recoverability based on the expected enacted tax rates and projections of the expected realization of our deferred tax liabilities, projections of future taxable income, and tax planning strategies that we might employ to utilize such assets. A valuation allowance is provided on deferred tax assets to the extent that it is more likely than not that such deferred tax assets will not be realized. Management judgment is required in determining our provision for income taxes, deferred tax assets and liabilities and the extent to which deferred tax assets can be recognized. Realization of future tax benefits related to the deferred tax assets is dependent on many factors, including our ability to generate taxable income within the period during which the temporary differences reverse, the outlook for the economic environment in which the business operates, and the overall future industry outlook.

 

Internal Controls

 

We and our independent registered public accountants have identified certain material weaknesses in our finance team’s ability to support the financial reporting requirements of a U.S. registrant. A material weakness, as defined under standards of the Public Company Accounting Oversight Board (United States), is a significant deficiency in the design or operation of internal controls, which does not reduce to a relatively low level the risk that misstatements caused by errors or fraud in amounts that would be material in relation to the consolidated reporting package being reviewed may occur and not be detected within a timely period by employees in the normal course of performing their assigned functions.

 

In connection with their audit of our financial statements prepared under U.S. GAAP, our independent accountants have specifically referenced, among other things, the following material weaknesses in our internal controls and financial statement reporting procedures:

 

    our lack of full-time staff members with U.S. GAAP expertise to timely prepare consolidated financial statements under U.S. GAAP;

 

    missing accounting records for certain transactions; and

 

    our lack of an automatic reporting system for financial transactions and our reliance on spreadsheet programs, which are generally more prone to errors.

 

Our management is currently executing a range of actions to address the weaknesses identified by us and our auditors in our internal controls and financial statement reporting procedures. On August 22, 2005, we hired two individuals with U.S. GAAP expertise and, on September 5, 2005, we hired an additional employee with accounting expertise to focus on inventory and cost management. In addition, we have adopted a new document retention policy and have begun implementing an enterprise reporting system to support U.S. GAAP reporting. We expect to begin utilizing our new enterprise reporting system in the first quarter of 2006.

 

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Although we expect to be able to address these weaknesses in a timely manner, we cannot be certain that these measures will ensure that we implement and maintain adequate controls over our financial processes and reporting in the future. See “Risk Factors.” If we fail to achieve and maintain an effective system of internal controls, we may be unable to accurately report our financial results or reduce our ability to prevent or detect fraud.

 

Quarterly Results

 

The following table presents unaudited consolidated financial information for the seven fiscal quarters ended September 30, 2005, prepared in accordance with U.S. GAAP. We believe that all the necessary adjustments, consisting mainly of normal recurring adjustments, have been included in the amounts stated below to fairly present the selected quarterly information when read in conjunction with our consolidated financial statements and the related notes included elsewhere in this prospectus.

 

    For the Three Months Ended

   

Mar. 31,

2004


 

Jun. 30,

2004


 

Sept. 30,

2004


 

Dec. 31,

2004


 

Mar. 31,

2005


 

Jun. 30,

2005


 

Sept. 30,
2005


    (unaudited)
    (in millions of Korean Won)

Revenues:

                                         

Products

  (Won) 10,099   (Won) 7,082   (Won) 5,023   (Won) 9,152   (Won) 6,543   (Won) 8,940   (Won) 12,641

Services

    196     1,999     988     1,257     977     591     726
   

 

 

 

 

 

 

Total revenues

    10,295     9,081     6,011     10,409     7,520     9,531     13,367
   

 

 

 

 

 

 

Cost of revenues:

                                         

Products

    12,400     6,162     5,151     7,744     6,504     7,652     8,429

Services

    40     376     161     254     207     85     94
   

 

 

 

 

 

 

Total cost of revenues

    12,440     6,538     5,312     7,998     6,711     7,737     8,523
   

 

 

 

 

 

 

Gross profit (loss)

    (2,145)     2,543     699     2,411     809     1,794     4,844

Operating expenses:

                                         

Selling, general and administrative

    404     1,931     722     909     1,098     1,102     1,350

Research and development, net of government grants

    615     644     805     1,147     912     510     1,076
   

 

 

 

 

 

 

Total operating expenses

    1,019     2,575     1,527     2,054     2,010     1,612     2,426
   

 

 

 

 

 

 

Income (loss) from operations

    (3,164)     (32)     (828)     357     (1,201)     182     2,418

Other income (expense):

                                         

Interest income (expense), net

    (15)     (44)     (61)     (110)     (112)     (132)     (145)

Foreign exchange gain, net

    122     76     11     128     (163)     346     (120)

Others, net

        5         (2)     (6)     (53)     50
   

 

 

 

 

 

 

Income (loss) before income taxes and loss from equity method investments

    (3,057)     5     (878)     371     (1,482)     343     2,203
   

 

 

 

 

 

 

Income tax expenses

    201         58     (25)            
   

 

 

 

 

 

 

Income (loss) before loss from equity method investments

    (3,258)     5     (936)     396     (1,482)     343     2,203

Gain (loss) from equity methods investments, net

        28     (217)     (83)     (11)     (116)     (91)

Dilution gain from equity method investments

                    74     337    
   

 

 

 

 

 

 

Net income (loss)

  (Won) (3,258)   (Won) 33   (Won) (1,153)   (Won) 313   (Won) (1,419)   (Won) 564   (Won) 2,112
   

 

 

 

 

 

 

Accretion of preferred shares

    (366)     (451)     (453)     (299)     (422)     (524)     (549)

Net income (loss) attributable to common shareholders

    (3,624)     (418)     (1,606)     14     (1,841)     40     1,563

 

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Our quarterly operating results have varied significantly during the seven quarters ended September 30, 2005.

 

Revenues Fluctuation

 

Revenues from sales of our CMOS image sensors and camera modules have fluctuated significantly as a result of the timing of new product releases, the relative short life cycles of our products, which range from six months to 18 months, changes in our customer base and a tendency for new product orders to be more concentrated during the first three months of a product life cycle.

 

    For each of the three months ended March 31, 2004, December 31, 2004, June 30, 2005 and September 30, 2005, our product sales were higher, primarily due to the release of new higher margin products and new customer acquisitions during those quarters.

 

    For the three months ended June 30, 2004, revenues from our product sales decreased due to financial difficulties suffered by two of our top customers, Maxon and Telson, partially offset by a significant increase in revenues from our services which we began providing to DongbuAnam in the previous quarter.

 

    For each of the three months ended September 30, 2004 and March 31, 2005, our revenues from product sales decreased due to the quarters coinciding with closing stages of product order cycles without new product orders to counterbalance the end of the order cycles.

 

Gross Profit

 

Our gross profits have fluctuated significantly during the seven quarters ended September 30, 2005, primarily as a result of order cancellations, volatility of manufacturing yields and timing of inventory write-downs.

 

    For the three months ended March 31, 2004 and June 30, 2004, we experienced the cancellation of a significant portion of our PO1030 inventory due to the bankruptcy of Maxon and Telson who were two of our top five customers, and as a result, we recorded a charge for excess inventories in the first and second quarters of 2004. In the three months ended September 30, 2005, we recorded (Won)1,111 million (US$1.1 million) on the sale of PO1030 inventory, which we had previously written off. We sold these inventories at a price that was less than our original cost of (Won)2,065 million, which we had written off prior to December 31, 2004.

 

    For the three months ended June 30, 2004, gross margin increased mainly due to the addition of our services business, which has benefited from an average gross margin of approximately 82% during the seven quarters ended September 30, 2005.

 

    For each of the three months ended September 30, 2004 and March 31, 2005, we experienced a decline in gross profits, primarily due to decreases in the average sales price of our products sold during those quarters, without corresponding decreases in our cost of revenues.

 

    For each of the three months ended June 30, 2005 and September 30, 2005, gross margin for our products increased mainly as a result of an increase in sales of our higher margin CMOS image sensors and a decrease in sales of our lower margin camera modules.

 

Operating Expenses Fluctuation

 

    Our selling, general and administrative expenses have generally increased during the seven quarters ended September 30, 2005, primarily due to increases in our sales, marketing and administration personnel and sales commissions paid to international sales agents. In the three months ended June 30, 2004, our selling, general and administrative expenses increased significantly mainly due to an increase in our allowance for doubtful accounts attributable to Maxon and Telson.

 

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    Our research and development expenses have generally increased during the first five quarters ended March 31, 2005, primarily due to increases in our headcount and research development activities in order to design and develop new products and technology. In the three months ended December 31, 2004, our research and development expenses increased significantly primarily due to additional expenses related to our process technology upgrade. In the three months ended June 30, 2005, our research and development expenses decreased primarily as a result of a significant decrease in our mask expenses, which was attributable to our research and development cycle entering a design phase for the next generation of products after a concentrated testing and development period during the preceding three quarters. As we began testing and developing the next generation of products, our research and development expense increased in the three months ended September 30, 2005.

 

For the foregoing factors, we believe that quarter to quarter comparisons of our operating results should not be relied upon as an indication of our future performance. In the past, our results of operations have fluctuated significantly, and we expect similar quarterly fluctuations in the future as a result of a number of factors beyond our control. In addition, because a significant percentage of our revenues has been and is expected to continue to be derived from a limited number of mobile camera phone manufacturers and distributors, any variation in the timing of orders from those large customers, or design wins or losses from potential large customers, can result in significant fluctuations in our quarterly operating results. Our anticipated research and development and selling, general and administrative expenses are based, in part, on future projections of revenues. As a result of these and other factors, it is likely that in some future period, our operating results or business outlook will be below the expectations of securities analysts or investors, which would likely result in a significant reduction in the market price of our ADSs. See “Risk Factors—Risks Related to Our Business—Fluctuations in our quarterly operating results make it difficult to predict our future performance and may result in volatility in the market price of our ADSs.”

 

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Results of Operations

 

The following table sets forth the results of our operations expressed as a percentage of our total sales for the periods indicated. Our historical operating results are not necessarily indicative of the results for any future period.

 

     For the Years Ended December 31,

    For the
Nine Months Ended
September 30,


 
     2002

    2003

    2004

    2004

    2005

 

Revenues:

                              

Products

   100.0 %   100.0 %   87.6 %   87.5 %   92.5 %

Services

   0.0     0.0     12.4     12.5     7.5  
    

 

 

 

 

Total revenues

   100.0     100.0     100.0     100.0     100.0  
    

 

 

 

 

Cost of revenues:

                              

Products

   405.5     81.8     87.9     93.4     74.2  

Services

   0.0     0.0     2.3     2.3     1.3  
    

 

 

 

 

Total cost of revenues

   405.5     81.8     90.2     95.7     75.5  
    

 

 

 

 

Gross profit (loss)

   (305.5 )   18.2     9.8     4.3     24.5  

Operating expenses:

                              

Selling, general and administrative

   424.7     6.4     11.1     12.1     11.7  

Research and development, net of government grants

   912.3     7.5     8.9     8.1     8.2  
    

 

 

 

 

Total operating expenses

   1,337.0     13.9     20.0     20.2     19.9  
    

 

 

 

 

Income (loss) from operations

   (1,642.5 )   4.3     (10.2 )   (15.9 )   4.6  

Other income (expense):

                              

Interest income (expense), net

   (67.1 )   0.0     (0.6 )   (0.5 )   (1.3 )

Foreign exchange gain, net

   0.0     0.8     0.9     0.9     0.2  

Others, net

   (31.5 )   0.0     0.0     0.0     0.0  
    

 

 

 

 

Total other income (expense)

   (98.6 )   0.8     0.3     0.4     (1.1 )
    

 

 

 

 

Income (loss) before income taxes and loss from equity method investments

   (1,741.1 )   5.1     (9.9 )   (15.5 )   3.5  

Income tax expenses

   0.0     0.6     0.7     1.0     0.0  
    

 

 

 

 

Income (loss) before loss from equity method investments

   (1,741.1 )   4.5     (10.6 )   (16.5 )   3.5  

Gain (loss) from equity method investments, net

   0.0     0.0     (0.8 )   (0.7 )   (0.7 )

Dilution gain from equity method investments

   0.0     0.0     0.0     0.0     1.3  
    

 

 

 

 

Net income (loss)

   (1,741.1 )   4.5     (11.4 )   (17.2 )   4.1  
    

 

 

 

 

Accretion of preferred shares

   0.0     (6.4 )   (4.3 )   (5.0 )   (4.9 )
    

 

 

 

 

Net loss attributable to common shareholders

   (1,741.1 )   (1.9 )   (15.7 )   (22.2 )   (0.8 )

 

The First Nine Months of 2005 Compared to the First Nine Months of 2004

 

Revenues

 

We generated total revenues of (Won)30,418 million (US$29.2 million) in the first nine months of 2005, an increase of 19.8% from our total revenues of (Won)25,387 million in the first nine months of 2004.

 

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Products. Our revenues from sales of our products increased 26.7% to (Won)28,124 million (US$27.0 million) in the first nine months of 2005 from (Won)22,204 million in the first nine months of 2004, primarily due to an increase in sales volume of our CMOS image sensors, partially offset by a decrease in camera module sales and a decrease in the average sales price of our products.

 

    CMOS Image Sensors. Our revenues from sales of our CMOS image sensors increased 173.0% to (Won)12,582 million (US$12.1 million) in the first nine months of 2005 from (Won)4,608 million in the first nine months of 2004, primarily as a result of an increase in sales of our VGA 0.3 megapixel image sensors to our customers in China and Japan, partially offset by 77.0% decrease in the average sales price of our CMOS image sensors. We sold approximately 6.9 million CMOS image sensors in the first nine months of 2005, compared to approximately 0.6 million in the first nine months of 2004.

 

    Camera Modules. Our revenues from sales of our camera modules decreased 11.9% to (Won)15,302 million (US$14.7 million) in the first nine months of 2005 from (Won)17,363 million in the first nine months of 2004, primarily as a result of a 43.4% decrease in the average sales price of our camera modules, partially offset by an increase in our sales volume to approximately 2.3 million camera modules sold in the first nine months of 2005, compared to approximately 1.5 million in the first nine months of 2004.

 

Services. Our revenues from services decreased 27.9% to (Won)2,294 million (US$2.2 million) in the first nine months of 2005 from (Won)3,183 million in the first nine months of 2004, primarily as a result of a decrease in service fees received from DongbuAnam caused by a 39.0% decrease in the average sales price of CMOS image sensors DongbuAnam sold to Sharp, partially offset by an increase in DongbuAnam’s sales volume to approximately 5.6 million image sensors sold to Sharp in the first nine months of 2005, compared to approximately 5.1 million image sensors sold in the first nine months of 2004.

 

Cost of Revenues

 

Products. Our cost of revenues from sales of our products decreased 4.8% to (Won)22,585 million (US$21.7 million) in the first nine months of 2005 from (Won)23,713 million in the first nine months of 2004, primarily as a result of a decrease in our provision for losses on valuation of inventory and our cost of outsourced manufacturing in the first nine months of 2005, partially offset by increases in our costs of materials and salary and benefits in the first nine months of 2005.

 

    Total provision for losses on valuation of inventory decreased 67.2% to (Won)2,244 million (US$2.2 million) in the first nine months of 2005 from (Won)6,836 million in the first nine months of 2004, primarily due to a significant decrease in the amount of order cancellations from our customers in the first nine months of 2005. Our net loss on valuation of inventory in the first nine months of 2004 was primarily attributable to order cancellations from Maxon and Telson.

 

    Total cost of outsourced manufacturing, testing and assembly of our products decreased 15.5% to (Won)6,100 million (US$5.9 million) in the first nine months of 2005 from (Won)7,221 million in the first nine months of 2004, primarily due to a significant reduction in the per unit cost of outsourced assembly of our camera modules in the first nine months of 2005, partially offset by an increase in the volume of our products manufactured and an increase in our per unit wafer manufacturing cost, which was primarily attributable to temporary lower manufacturing yields caused by hardware upgrades at DongbuAnam, in the first nine months of 2005.

 

    Total cost of materials increased 37.2% to (Won)12,493 million (US$12.0 million) in the first nine months of 2005 from (Won)9,107 million in the first nine months of 2004, primarily due to increases in sales volume of our CMOS image sensors and camera modules.

 

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    Total cost of salary and benefits, including stock-based compensation expenses, of our employees associated with product manufacturing, customization and support increased 219.0% to (Won)1,748 million (US$1.7 million) in the first nine months of 2005 from (Won)548 million in the first nine months of 2004, primarily due to an increase in relevant employee headcount to 18 in the first nine months of 2005 from 6 in the first nine months of 2004.

 

Services. Our cost of revenues from our services decreased 33% to (Won)386 million (US$0.4 million) in the first nine months of 2005 from (Won)577 million in the first nine months of 2004, primarily due to a decrease in per unit testing fees and an increase in manufacturing yield by DongbuAnam which reduced the number of wafers required to be tested to achieve the same number of usable wafers sold to Sharp.

 

Gross Profit

 

Our gross profit increased to (Won)7,447 million (US$7.1 million) in the first nine months of 2005 from (Won)1,097 million in the first nine months of 2004, representing gross margins of 24.5% and 4.3%, respectively. Gross margins increased in the first nine months of 2005 primarily as a result of a shift in our product mix, whereby our sales of CMOS image sensors increased from 18.0% of our total revenues in the first nine months of 2004 to 41.4% of our total revenues in the first nine months of 2005, a decrease in our losses on valuation of inventory, a decrease in our module assembly costs and sales of products in our inventory previously recorded as a loss, partially offset by a decline in average sales prices of our CMOS image sensors and camera modules and temporary lower manufacturing yields. In addition, gross margin increased as we recorded (Won)1,111 million (US$1.1 million) in gross profit on the sale of PO1030 image sensor inventory, which had been previously written off at December 31, 2004. Costs of (Won)2,065 million were previously expensed prior to December 31, 2004 for these units. Our overall gross profit increase in the first nine months of 2005 was offset by a decrease in our gross profit from services to (Won)1,908 million (US$1.8 million) in the first nine months of 2005 from (Won)2,606 million in the first nine months of 2004, representing gross margins of 83.2% and 81.9%, respectively.

 

Operating Expenses

 

Our operating expenses increased 18.1% to (Won)6,048 million (US$5.8 million) in the first nine months of 2005 from (Won)5,121 million in the first nine months of 2004, primarily as result of increases in our selling, general and administrative and research and development expenses, net of government grants.

 

Selling, General and Administrative

 

Our selling, general and administrative expenses increased 16.1% to (Won)3,550 million (US$3.4 million) in the first nine months of 2005 from (Won)3,057 million in the first nine months of 2004, primarily due to increases in total salary and benefits to our sales, marketing and administration employees and sales commissions to our international sales agents, partially offset by a decrease in our provision for allowance for doubtful accounts.

 

    Total salary and benefits to our sales, marketing and administration employees increased 141% to (Won)2,117 million (US$2.0 million) in the first nine months of 2005 from (Won)877 million in the first nine months of 2004. This increase was primarily due to an increase in our sales, marketing and administration personnel to 47 employees in the first nine months of 2005 from 29 employees in the first nine months of 2004, and an increase in the average compensation of those employees.

 

    Total sales commissions to international sales agents increased 511% to (Won)232 million (US$0.2 million) in the first nine months of 2005 from (Won)38 million in the first nine months of 2004, almost exclusively due to an increase in sales to customers in China.

 

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    Total provision for allowance for doubtful accounts decreased 96.0% to (Won)67 million in the first nine months of 2005 from (Won)1,574 million in the first nine months of 2004, as none of our top customers failed to make required payments in the first nine months of 2005, unlike the first nine months of 2004 when Maxon and Telson failed to make required payments in the amount of (Won)1,567 million.

 

Research and Development, Net of Government Grants

 

Our research and development expenses, net of government grants, increased 21.0% to (Won)2,498 million (US$2.4 million) in the first nine months of 2005 from (Won)2,064 million in the first nine months of 2004, primarily as a result of our transition from 0.25 µm to 0.18 µm technology and an increase in salary and benefits for our research and development personnel, partially offset by a decrease in expenses for masks as we entered into a new design phase for our next generation of products, which generally precedes the prototype mask development phase, during the first nine months of 2005.

 

Other Income (Expense)

 

We recorded net other expense of (Won)335 million (US$0.3 million) in the first nine months of 2005 after recording net other income of (Won)94 million in the first nine months of 2004, principally as a result of an increase in interest expenses and a decrease in net foreign exchange gain.

 

Interest Expense, Net

 

Our net interest expense increased 224.0% to (Won)389 million (US$0.4 million) in the first nine months of 2005 from (Won)120 million in the first nine months of 2004, primarily due to an increase in our short-term borrowings.

 

Foreign Exchange Gain, Net

 

Our net foreign exchange gain decreased 70.0% to (Won)63 million in the first nine months of 2005 from (Won)209 million in the first nine months of 2004, which was attributable to currency fluctuations between the U.S. dollar and the Korean Won.

 

Income Tax Expenses

 

We did not recognize any income tax expenses in the first nine months of 2005, compared to recognized income tax expenses of (Won)259 million in the first nine months of 2004.

 

Loss from Equity Method Investments

 

Our loss from equity method investments increased 15.3% to (Won)218 million (US$0.2 million) in the first nine months of 2005 from (Won)189 million in the first nine months of 2004, primarily due to a loss of (Won)245 million from our 37.5% equity interest in PTI in Taiwan in the first nine months of 2005, primarily attributable to PTI’s startup costs and a decrease in our gain from our 13.9% equity interest in Tesna to (Won)26 million in the first nine months of 2005 from (Won)44 million in the first nine months of 2004.

 

Dilution Gain from Equity Method Investments

 

We recognized a dilution gain from equity method investments of (Won)411 million (US$0.4 million) in the first nine months of 2005 as a result of dilutions in our equity interests in our Tesna and PTI from 20.0% and

 

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42.9%, respectively, to 13.9% and 37.5%, respectively, in the first nine months of 2005. We did not recognize any dilution gain from equity method investments in the first nine months of 2004.

 

Net Income (Loss)

 

We recognized net income from operations of (Won)1,257 million (US$1.2 million) in the first nine months of 2005, compared to a net loss of (Won)4,378 million in the first nine months of 2004, as a result of the cumulative effect of the factors described above.

 

Accretion of Preferred Shares

 

We recorded a charge to retained earnings and additional paid-in capital for accretion of preferred shares of (Won)1,495 million (US$1.4 million) in the first nine months of 2005, compared to (Won)1,270 million in the first nine months of 2004, to account for the accretion related to the redemption amounts of our Series A preferred shares.

 

Net Loss Attributable to Common Shareholders

 

Our net loss attributable to common shareholders decreased to (Won)238 million (US$0.2 million) in the first nine months of 2005 from (Won)5,648 million in the first nine months of 2004, due to a recognition of a net income and an increase in accretion of preferred shares in the first nine months of 2005.

 

2004 Compared to 2003

 

Revenues

 

We generated total revenues of (Won)35,796 million (US$34.3 million) in 2004, an increase of 101.0% over our total revenues of (Won)17,806 million in 2003.

 

Products. Our revenues from sales of our products increased 76.1% to (Won)31,356 million (US$30.1 million) in 2004 from (Won)17,806 million in 2003, primarily due to an increase in sales of our CMOS image sensors and camera modules. Our revenues in 2003 reflect revenues from the second half of 2003 only, as we did not start mass producing our products until July 2003.

 

    CMOS Image Sensors. Our revenues from sales of our CMOS image sensors increased 679.2% to (Won)6,296 million (US$6.0 million) in 2004 from (Won)808 million in 2003, primarily as a result of an increase in domestic sales, attributable to stronger demand for our VGA 0.3 megapixel image sensors and commercialization of a new SXGA 1.3 megapixel image sensor in 2004, partially offset by a decline of approximately 20% in the average sales price of our VGA 0.3 megapixel image sensors in 2004. We sold approximately 0.9 million CMOS images sensors in 2004, compared to approximately 70,000 in 2003.

 

    Camera Modules. Our revenues from sales of our camera modules increased 49.6% to (Won)24,663 million (US$23.7 million) in 2004 from (Won)16,491 million in 2003, primarily as a result of increased sales of our VGA-based camera modules to China from (Won)207 million in 2003 to (Won)7,659 million (US$7.3 million) in 2004, partially offset by a decline of approximately 15% in the average sales price of our camera modules in 2004 and a 6.4% decrease in domestic sales of our camera modules. We sold approximately 2.2 million camera modules in 2004, compared to approximately 1.3 million in 2003.

 

Services. Our revenues from services in 2004 was (Won)4,440 million (US$4.3 million). This was attributable to service fees from our business arrangements with DongbuAnam related to Sharp. DongbuAnam

 

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sold approximately 7.7 million image sensors to Sharp under this arrangement. We did not recognize revenues from services in 2003.

 

Cost of Revenues

 

Products. Our cost of revenues from sales of our products increased 116.0% to (Won)31,457 million (US$30.2 million) in 2004 from (Won)14,562 million in 2003, primarily as a result of an increase in the sales of our CMOS image sensors and camera modules and increases in cost of materials, cost of manufacturing, losses on valuation of inventory, and salary and benefits.

 

    Total cost of materials increased by 127.4% to (Won)12,664 million (US$12.1 million) in 2004 from (Won)5,570 million in 2003, primarily as a result of an increase in the sales of our products.

 

    Total cost of outsourced manufacturing, testing and assembly of our products increased 69.2% to (Won)10,674 million (US$10.2 million) in 2004 from (Won)6,308 million in 2003, primarily due to a corresponding increase in the volume of our products manufactured in 2004 as compared to 2003.

 

    Total provision for loss on valuation of inventory increased 265.8% to (Won)7,349 million (US$7.1 million) in 2004 from (Won)2,009 million in 2003, primarily due to increases in:

 

    canceled purchase orders from financially-troubled customers, which accounted for 39.8% of our total loss on valuation of inventory in 2004;

 

    unsold lower grade image sensors, which accounted for 36.7% of our total loss on valuation of inventory in 2004; and

 

    unsold image sensors manufactured in anticipation of future orders, which accounted for 23.5% of our total loss on valuation of inventory in 2004.

 

    Total cost of salary and benefits, including stock-based compensation expenses, of our employees associated with product manufacturing, customization and support increased 13.9% to (Won)769 million (US$0.7 million) from (Won)675 million in 2003, primarily due to an increase in the headcount to 21 employees in 2004 from 6 employees in 2003.

 

Services. Our cost of revenues from our services was (Won)831 million (US$0.8 million) in 2004, which mainly consists of wafer testing fees related to our services business with DongbuAnam and Sharp.

 

Gross Profit (Loss)

 

Our gross profit increased 8.1% to (Won)3,508 million (US$3.4 million) in 2004 from (Won)3,244 million in 2003, representing gross margins of 9.8% and 18.2% in 2004 and 2003, respectively. Our gross margins decreased primarily due to a significant increase in our loss on valuation of inventory and partially due to a decline in average sales prices of our CMOS image sensors and camera modules and an increase in wafer manufacturing costs. The average sales prices of our products declined in 2004 mainly due to a decline in prices of our VGA and SXGA products and delays in the introduction of new products. Our gross profit from services was (Won)3,609 million (US$3.5 million) in 2004, representing a gross margin of 81.3%, which partially mitigated our overall gross margin decline in 2004.

 

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Operating Expenses

 

Our operating expenses increased 190.4% to (Won)7,177 million (US$6.9 million) in 2004 from (Won)2,471 million in 2003, primarily due to increases in our selling, general and administrative and our research and development expenses, net of government grants.

 

Selling, General and Administrative

 

Our selling, general and administrative expenses increased 249.1% to (Won)3,966 million (US$3.8 million) in 2004 from (Won)1,136 million in 2003, primarily due to increases in allowance for doubtful debts, total salary and benefits to our sales, marketing and administration employees and sales commissions to our international sales agents.

 

    Total provision for allowance for doubtful accounts increased to (Won)1,447 million (US$1.4 million) in 2004 from (Won)71 million in 2003, primarily due to the inability of two of our top customers, Maxon and Telson, to make required payments of (Won)1,240 million and (Won)191 million, respectively, in 2004.

 

    Total salary and benefits to our sales, marketing and administration employees increased 152.8% to (Won)1,292 million (US$1.2 million) in 2004 from (Won)511 million in 2003. This increase was primarily due to an increase in our sales, marketing and administration personnel to 32 employees in 2004 from 16 employees in 2003, and an increase in the average compensation of those employees.

 

    Total sales commissions to international sales agents increased to (Won)322 million (US$0.3 million) in 2004 from (Won)8 million in 2003, almost exclusively due to an increase in sales to customers in China.

 

Research and Development, Net of Government Grants

 

Our research and development, net of government grants, increased 140.5% to (Won)3,211 million (US$3.1 million) in 2004 from (Won)1,335 million in 2003, primarily due to increases in the number of new prototype masks produced, expenses for design tools and software, and salary and benefits for our research and development personnel.

 

    Total expenses for masks increased 142.8% to (Won)1,525 million (US$1.5 million) in 2004 from (Won)628 million in 2003, as a result of an increase in the number of new products in development which required more masks to be constructed.

 

    Total expenses for design tools and software increased 298.7% to (Won)949 million (US$0.9 million) in 2004 from (Won)238 million in 2003, as a result of tools and software purchased for designing technologically sophisticated new products.

 

    Total salary and benefits for our research and development personnel increased 45.7% to (Won)663 million (US$0.6 million) in 2004 from (Won)455 million in 2003, as we increased the number of our engineers to 16 in 2004 from 10 in 2003, in anticipation of new product development plans and process technology upgrade from 0.25 µm to 0.18 µm in 2005.

 

Other Income (Expense)

 

We recorded net other income of (Won)110 million (US$0.1 million) in 2004 after recording net other income of (Won)137 million in 2003, principally as a result of increases in losses on foreign currency transactions and interest expenses, partially offset by an increase in foreign exchange gains.

 

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Interest Income (Expense), Net

 

We recorded net interest expense of (Won)230 million (US$0.2 million) in 2004 after recording net interest income of (Won)1 million in 2003, primarily due to an increase in short-term borrowing, and, to a lesser degree, a decrease in our bank balances and lower interest rates.

 

Foreign Exchange Gain, Net

 

Our net foreign exchange gain increased 144.2% to (Won)337 million (US$0.3 million) in 2004 from (Won)138 million in 2003, primarily due to favorable currency fluctuations between the U.S. dollar and the Korean Won.

 

Income Tax Expenses

 

Our income tax expenses increased 120.8% to (Won)234 million (US$0.2 million) in 2004 from (Won)106 million in 2003, primarily due to an increase in the valuation allowance on deferred tax assets of (Won)1,087 million, partially offset by a (Won)321 million tax credit.

 

Gain (Loss) from Equity Method Investments

 

We recorded a loss of (Won)272 million (US$0.3 million) from our equity method investments in 2004 due to a loss of (Won)329 million (US$0.3 million) from our 42.9% equity interest in PTI in Taiwan, partially offset by gains of (Won)57 million from our 20.0% equity interest in Tesna in Korea. We did not recognize any gain or loss from equity method investment in 2003.

 

Net Income (Loss)

 

We recognized a net loss from operations of (Won)4,065 million (US$3.9 million) in 2004, compared to net income from operations of (Won)804 million in 2003, as a result of the cumulative effect of the factors described above.

 

Accretion of Preferred Shares

 

We recorded a charge to retained earnings and additional paid-in capital for accretion of preferred shares of (Won)1,569 million (US$1.5 million) in 2004, compared to (Won)1,149 million in 2003, to account for the accretion related to the redemption amounts of our Series A preferred shares issued on March 17, 2003.

 

Net Loss Attributable to Common Shareholders

 

Our net loss attributable to common shareholders increased to (Won)5,634 million (US$5.4 million) in 2004 from a loss of (Won)345 million, due to our recording of a net loss and an increase in accretion of preferred shares in 2004.

 

2003 Compared to 2002

 

Revenues

 

We generated total revenues of (Won)17,806 million in 2003, compared to total revenues of (Won)73 million in 2002. This revenue growth was principally the result of the commercialization of our CMOS image sensors and camera modules in July 2003. We did not recognize revenues from our services in 2002 and 2003.

 

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Cost of Revenues

 

Our cost of revenues increased to (Won)14,562 million in 2003 from (Won)296 million in 2002, primarily due to significant increases in the cost of materials, the cost of manufacturing, testing and assembly related to commercialization of our products, cost of salary and benefits, and cost of transportation and inventory impairment.

 

Gross Profit (Loss)

 

Our gross profit from sales of our products in 2003 increased to (Won)3,244 million in 2003 from a gross loss of (Won)223 million in 2002 as we commenced mass production and sale of our products in July 2003.

 

Operating Expenses

 

Our operating expenses increased to (Won)2,471 million in 2003 from (Won)976 million in 2002, primarily due to increases in our selling, general and administrative and our research and development expenses, net of government grants.

 

Selling, General and Administrative

 

Our selling, general and administrative expenses increased to (Won)1,136 million in 2003 from (Won)310 million in 2002, primarily due to increases in total salary and benefits to our sales, marketing and administration employees, commissions to international sales agents, and sales and marketing travel expenses.

 

Research and Development, Net of Government Grants

 

Our research and development, net of government grants, increased to (Won)1,335 million in 2003 from (Won)666 million in 2002, primarily due to an increase in the number of new masks produced for new products to be manufactured by our wafer foundry, and an increase in the number of engineers to 10 in 2003 from 6 in 2002, in anticipation of new product and system technology development.

 

Other Income (Expense)

 

We recognized net other income of (Won)137 million in 2003, compared to a net other expense of (Won)72 million in 2002. This increase in other income was principally the result of foreign exchange gains from proceeds in U.S. dollars from the sale of our Series A preferred shares and interest income.

 

Income Tax Expenses

 

We recorded a tax expense of (Won)106 million in 2003, primarily due to recognition of income from operations in 2003. We did not recognize any tax benefit or expense in 2002.

 

Net Income (Loss)

 

We recognized net income from operations of (Won)804 million in 2003, after suffering a net loss of (Won)1,271 million in 2002, as a result of the cumulative effect of the factors described above.

 

Accretion of Preferred Shares

 

We recorded a charge to retained earnings and additional paid-in capital for accretion of preferred shares of (Won)1,149 million in 2003 to account for the accretion related to the redemption amounts of our Series A preferred shares issued on March 17, 2003.

 

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Net Loss Attributable to Common Shareholders

 

Our net loss attributable to common shareholders decreased to (Won)345 million in 2003 from a net loss of (Won)1,271 million in 2002, due to our recognition of a net income in 2003, partially offset by accretion of preferred shares.

 

Liquidity and Capital Resources

 

Our primary source of liquidity has been the net proceeds from our sales of preferred shares and funds from our short-term and long-term borrowings. The following table sets forth a summary of our cash flows for the periods indicated:

 

     For the Years Ended December 31,

    For the Nine Months Ended
September 30,


 
     2002

    2003

    2004

    2004

    2004

    2005

    2005

 
     (in millions of Korean Won and thousands of U.S. dollars)  

Net cash provided by / (used in) operating activities

   (Won) (766 )   (Won) (4,568 )   (Won) (5,364 )   $ (5,148 )   (Won) (4,477 )   (Won) (1,196 )   $ (1,147 )

Net cash provided by / (used in) investing activities

     100       (858 )     (1,499 )     (1,438 )     (1,203 )     (1,244 )     (1,194 )

Net cash provided by / (used in) financing activities

     114       5,649       7,718       7,404       6,027       1,987       1,906  

Effect of exchange rate changes on cash and cash equivalents

           (18 )     53       51       (5 )     (26 )     (24 )

Net increase / (decrease) in cash and cash equivalents

     (552 )     205       908       869       342       (479 )     (459 )

Cash and cash equivalents, beginning of year

     633       81       286       275       286       1,194       1,145  

Cash and cash equivalents, end of year/period

     81       286       1,194       1,144       628       715       686  

 

Cash Flows from Operating Activities

 

Our net cash used in operating activities decreased to (Won)1,196 million (US$1.1 million) in the first nine months of 2005 from (Won)4,477 million in the first nine months of 2004. The decrease in our net cash used in operating activities was primarily the result of our recognition of net income of (Won)1,257 million (US$1.2 million) in the first nine months of 2005, compared to a net loss of (Won)4,378 million in the first nine months of 2004, a net cash inflow from an increase in our trade accounts payable of (Won)3,444 million (US$3.3 million) in the first nine months of 2005, compared to a net cash outflow of (Won)911 million in the first nine months of 2004, and a net cash inflow from our inventories of (Won)731 million (US$0.7 million) in the first nine months of 2005, compared to a net cash outflow of (Won)9,238 million in the first nine months of 2004. The decrease in our net cash used in operating activities was partially offset by a net cash outflow from our accounts receivable of (Won)8,567 million (US$8.2 million) in the first nine months of 2005, compared to a net cash inflow of (Won)807 million in the first nine months of 2004, and by a decrease in our net cash outflow from adjustments for losses on valuation of inventory to (Won)2,244 million (US$2.2 million) in the first nine months of 2005 from (Won)6,836 million in the first nine months of 2004 and a decrease in our adjustments for provision for allowance for doubtful accounts to (Won)67 million in the first nine months of 2005 from (Won)1,574 million in the first nine months of 2004.

 

Our net cash used in operating activities increased to (Won)5,364 million (US$5.1 million) in 2004 from (Won)4,568 million in 2003 and (Won)766 million in 2002. This increase in our net cash used in operating activities was primarily as a result of our recording a net loss in 2004, coupled with a decrease in our gross margin from 18.2%

 

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in 2003 to 9.8% in 2004, and our cash outflow from inventories of (Won)7,792 million (US$7.5 million) and (Won)8,382 million in 2004 and 2003, respectively, from account receivables of (Won)1,363 million (US$1.3 million) and (Won)5,729 million in 2004 and 2003, respectively, and from trade accounts payables of (Won)1,450 million (US$1.4 million) in 2004. The net cash outflow from our operating activities was partially offset by net cash inflow as a result of trade accounts payable of (Won)7,715 million in 2003, adjustments for losses on valuation of inventory of (Won)7,349 million (US$7.1 million) and (Won)2,009 million in 2004 and 2003, respectively, and adjustments for the allowance for doubtful accounts of (Won)1,447 million (US$1.4 million) and (Won)71 million in 2004 and 2003, respectively. Our net cash outflow from our operating activities of (Won)766 million in 2002 was primarily due to our recording a net loss in 2002.

 

Cash Flows from Investing Activities

 

Our net cash used in investing activities remained relatively stable in the first nine months of 2005, increasing slightly to (Won)1,244 million (US$1.2 million) during that period, compared to (Won)1,203 million in the first nine months of 2004. Our net cash used in investing activities in the first nine months of 2005 primarily consisted of cash outflows from our acquisition of property, plant and equipment in the amount of (Won)609 million (US$0.6 million), acquisition of investments in the amount of (Won)488 million (US$0.5 million), which reflected our additional investment in PTI, and payments on loans to affiliates and employees in the amount of (Won)90 million. Our net cash used in investing activities in the first nine months of 2004 primarily consisted of cash outflows from our acquisition of investments in the amount of (Won)653 million, our acquisition of intangible assets related to design tools in the amount of (Won)359 million and acquisition of property, plant and equipment in the amount of (Won)168 million.

 

Our net cash used in investing activities increased from (Won)858 million in 2003 to (Won)1,499 million (US$1.4 million) in 2004, primarily due to acquisitions of:

 

    an equity interest in Pixelplus Technology Inc. for cash in the amount of (Won)510 million;

 

    an equity interest in Tesna for cash and debt forgiveness in the aggregate amount of (Won)580 million; and

 

    property, plant and equipment in the aggregate amount of (Won)295 million.

 

We had a net cash inflow of (Won)100 million in 2002, primarily due to the sale of our investment securities of (Won)150 million, partially offset by acquisitions of intangible assets.

 

Cash Flows from Financing Activities

 

Our net cash provided by financing activities decreased to (Won)1,987 million (US$1.9 million) in the first nine months of 2005 from (Won)6,027 million in the first nine months of 2004. The decrease in our net cash provided by financing activities was primarily due to a decrease in our proceeds from borrowings to (Won)7,812 million (US$7.5 million) in the first nine months of 2005 from (Won)12,003 million in the first nine months of 2004, partially offset by a slight decrease in our repayments of borrowings to (Won)5,825 million (US$5.6 million) in the first nine months of 2005 from (Won)5,976 million in the first nine months of 2004.

 

Our net cash provided by financing activities increased from (Won)114 million in 2002 to (Won)5,649 million in 2003 and to (Won)7,718 million (US$7.4 million) in 2004, primarily due to our net borrowings of (Won)7,718 million in 2004 and (Won)730 million in 2003 and our Series A preferred shares financing, which resulted in net proceeds of (Won)4,919 million from the sale of 1,441,600 Series A preferred shares at (Won)3,421 per share.

 

We had total borrowings of (Won)16,411 million (US$15.7 million) in 2004, compared to total borrowings of (Won)2,084 million and (Won)479 million in 2003 and 2002, respectively. These borrowings were partially offset by repayments of borrowings of (Won)8,693 million (US$8.3 million) in 2004, compared to repayments of borrowings of (Won)1,354 million and (Won)365 million in 2003 and 2002, respectively. The weighted average interest rates under

 

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the terms of our borrowings were 3.86%, 6.03% and 5.55% as of December 31, 2003 and 2004 and September 30, 2005, respectively. All of our borrowings are loans from local banks extended to us under various secured and unsecured credit facilities.

 

One of our credit facilities contains certain financial covenants, including requirements to maintain annual operating income of more than (Won)3,000 million and net cash after operating activity of more than (Won)0. As we were unable to maintain these financial ratios through December 31, 2004, borrowings under the facility, totaling (Won)500 million, became due and payable on June 20, 2005. On June 27, 2005, the Company renegotiated the terms of this facility, and on June 30, 2005, repaid (Won)100 million of the outstanding balance and extended the repayment date for the remaining (Won)400 million to December 31, 2005.

 

The following table sets forth our total borrowings as of the dates indicated:

 

Short-Term Borrowings

 

     As of December 31,

   As of September 30,

     2003

   2004

   2004

   2005

     (in millions of Korean Won)

Loans, principally from banks:

                           

Won denominated loans with weighted-average interest rates of 6.3%, 6.1% and 6.0% as of December 31, 2004 and September 30, 2004 and 2005

   (Won)    (Won) 6,468    (Won) 4,500    (Won) 8,200

U.S. Dollar denominated loans with weighted-average interest rates of 5.0%, 5.0% and 5.0% as of December 31, 2004 and September 30, 2004 and 2005

          673      749      678

Loans against receivables with weighted-average interest rates of 2.9%, 10.7%(1) and 3.5% and 4.8% as of December 31, 2003 and 2004 and September 30, 2004, and 2005, respectively

     284      517      728      1,133

Current portion of long-term borrowings

     208      427      427      596
    

  

  

  

Total

   (Won) 492    (Won) 8,085    (Won) 6,404    (Won) 10,607
    

  

  

  


 

(1) Consists of a single one-month term loan.

 

Long-Term Borrowings

 

     As of December 31,

   As of September 30,

     2003

   2004

   2004

   2005

     (in millions of Korean Won)

Unsecured loans, representing obligations principally to banks:

                           

Due 2005 to 2008 with interest rates ranging from 3.5% to 5.3% per annum

   (Won) 1,425    (Won) 1,686    (Won) 1,753    (Won) 1,326

Less: current portion

     (208)      (427)      (427)      (596)
    

  

  

  

Total

   (Won) 1,217    (Won) 1,259    (Won) 1,326    (Won) 730
    

  

  

  

 

Capital Resources

 

Our primary source of liquidity has been the net proceeds from our sale of preferred shares and funds from our short-term and long-term borrowings. As of September 30, 2005, our cash and cash equivalents primarily consist of cash on hand and bank deposits. As of September 30, 2005, we had (Won)715 million

 

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(US$0.7 million) in cash and cash equivalents. We have entered into Korean Won denominated borrowing arrangements with certain Korean domestic banks, with an aggregate maximum facility of (Won)8,200 million and a collateralized borrowing facility of (Won)5,600 million, of which (Won)8,200 million and (Won)17 million were outstanding, respectively, at September 30, 2005. In addition, we have entered into one foreign currency denominated debt facility of US$650,000 as of September 30, 2005, the full amount of which was outstanding at such date.

 

We believe that our net proceeds from this offering, together with our current cash, cash equivalents, net cash provided by operating activities and proceeds from borrowings, will be sufficient to meet our capital needs, including anticipated capital expenditures, for at least the next 12 months. We expect to repay a significant portion of our outstanding borrowings with our net proceeds. Our capital requirements and liquidity will depend on many factors, including the level at which we maintain inventory and accounts receivables, market acceptance of our products, technological advances, costs of securing access to adequate manufacturing capacity, increases in our operating expenses and our relationship with our outsourcing contractors. In addition, we may require an increase in the level of our working capital to accommodate planned growth, hiring and other infrastructure needs. To the extent that funds generated by this offering, together with existing resources and cash from operations, are insufficient to fund our future activities, we may need to raise additional funds through public or private equity or debt financing or from borrowings. Additional funds may not be available, or if available, we may not be able to obtain them on terms favorable to us or to our shareholders. In the event that we do raise additional cash through equity financings, investors in this offering could be further diluted.

 

As of September 30, 2005, we did not have any bank commitment available under our credit facilities with foreign and domestic banks. We have not entered into any material financial guarantee or similar commitment to guarantee the payment obligation of a third party.

 

Capital Expenditures

 

Our capital expenditures for 2002, 2003, 2004 and the nine months ended September 30, 2005, which totaled (Won)5 million, (Won)344 million, (Won)295 million (US$0.3 million) and (Won)609 million (US$0.6 million), respectively, were primarily for the acquisition of property, plant and equipment. We anticipate that we will incur capital expenditures in the next 12 months of approximately (Won)500 million (US$0.5 million), primarily for upgrade of our technology and expansion of our international operation. In addition, we plan to purchase land in a government-subsidized technology park and build our new headquarters for approximately (Won)15,000 million (US$14.4 million) to (Won)16,000 million (US$15.3 million), payable in installments over a four-year period, from 2006 to 2009.

 

Off-Balance Sheet Arrangements

 

We have no outstanding derivative financial instruments, off-balance sheet guarantees, interest rate swap transactions or foreign currency forward contracts. We do not engage in trading activities involving non-exchange traded contracts.

 

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Contractual Obligations

 

The following table sets forth our contractual obligations as of September 30, 2005:

 

          Payment Due by Period

     Total

   Less than
1 year


   1-3 years

   3-5
years


   More than
5 years


     (in millions of Korean Won)

Contractual Obligations

                                  

Long-term debt obligations(1)

   (Won) 1,326    (Won) 596    (Won) 688    (Won) 42    (Won)

Operating lease obligations(2)

     693      251      442          

Purchase obligations(3)

     5,088      5,088               
    

  

  

  

  

Total

   (Won) 7,107    (Won) 5,935    (Won) 1,130    (Won) 42    (Won)
    

  

  

  

  


 

(1) Excludes short-term borrowings.
(2) Operating lease obligations consist of operating leases for our office space.
(3) Purchase obligations consist of purchase orders outstanding for purchase of wafers from our suppliers and are net of VAT.

 

Other than our borrowings and contractual obligations set forth above, we do not have any long-term commitments.

 

Quantitative and Qualitative Disclosures about Market Risks

 

Market risk is the risk of loss related to adverse changes in market prices, including interest rates and foreign exchange rates, of financial instruments. In the normal course of our business, we are subject to market risk associated with currency movements on non-Won denominated assets and liabilities and interest rate movements.

 

Foreign Currency Risk

 

In the first nine months of 2005, 97.0% of our revenues from domestic and overseas customers were denominated in U.S. dollars. In most of the countries in which our products are sold, including Korea, the revenues generated by our customers are denominated in U.S. dollars. While we received most of our revenues in U.S. dollars, 93.2% of our selling, general and administrative expenses and 44.8% of our cost of revenues in the first nine months of 2005 were denominated in Korean Won. Our financial statements are also prepared and presented in Korean Won. Appreciation or depreciation of the Korean Won against the U.S. dollar during any given period will result in foreign currency losses or gains and affect our gross profits and net income during that period, because our revenues and our cost of revenues may be recorded in different currencies. In 2004, we estimate that a hypothetical 10.0% appreciation of the Korean Won against the U.S. dollar would have reduced our net income by approximately 11.2%.

 

To date, we have not engaged in any foreign currency hedging activity to reduce our exposure to exchange rate fluctuations. If necessary, we plan to enter into hedging transactions in the future to reduce our exposure to foreign currency exchange risks.

 

Interest Rate Risk

 

Our risk exposure from changes in interest rates relates primarily to the interest expense due to our short-term and long-term borrowings and the interest income generated by excess cash invested in short term

 

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bank deposits. Interest-earning instruments carry a degree of interest rate risk. As substantially all of our cash and cash equivalents consist of bank deposits, we do not expect any material change with respect to our net income as a result of a 10% hypothetical interest rate change.

 

We may be exposed to interest rate risks on additional debt financing that we may periodically undertake to fund capital expenditures, as well as for working capital and other general corporate purposes. Upward fluctuations in interest rates increase the cost of new debt. The interest rate that we will be able to obtain in a new debt financing will depend on market conditions at that time and may differ from the rates we have secured on our current debt.

 

To date, we have not entered into any hedging or derivative transaction with regard to interest rates to manage our exposure to changes in interest rates. We currently do not have any plan to enter into such hedging or derivative transactions.

 

Inflation

 

Inflation in Korea and our other principal markets has not had a material impact on our results of operations. Inflation in Korea was 2.7% in 2002, 3.6% in 2003, 3.6% in 2004 and 2.8% in the first nine months of 2005.

 

Recent Accounting Pronouncements

 

In November and December 2004, the Financial Accounting Standards Board, FASB, issued and amended SFAS No. 151, Inventory Costs—an amendment of ARB No. 43, Chapter 4 to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). This statement requires that those items be recognized as current-period charges regardless of whether they meet the criterion of “so abnormal.” Paragraph 5 of Accounting Research Bulletin, ARB, No. 43, Chapter 4, previously stated that “. . . under some circumstances, items such as idle facility expense, excessive spoilage, double freight, and rehandling costs may be so abnormal as to require treatment as current period charges. . . ” This statement requires that those items be recognized as current-period charges regardless of whether they meet the criterion of “so abnormal.” In addition, this statement requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The provisions of this statement are effective for inventory costs incurred during the first fiscal year beginning after June 15, 2005. We do not expect a significant impact on our results of operations and disclosures.

 

In December 2004, the FASB issued SFAS No. 123(R), Share-based Payment, which requires that the cost resulting from all share-based payment transactions be recognized in the financial statements using a fair-value-based method. The statement replaces SFAS 123, supersedes Accounting Principles Board, APB, Opinion No 25, Accounting for Stock Issued to Employees, and amends SFAS No. 95, Statement of Cash Flows. The new statement will be effective for public entities in the first fiscal year beginning after June 15, 2005. We do not expect a significant impact on our results of operations and disclosures.

 

In December 2004, the FASB issued SFAS No. 153, Exchanges of Non-Monetary Assets, an Amendment of APB Opinion No. 29. This statement amends APB Opinion 29 to eliminate the exception for non-monetary exchanges of similar productive assets and replaces it with a general exception for exchanges of non-monetary assets that do not have commercial substance. The statement is effective for non-monetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. We do not expect a significant impact on our results of operations and disclosures.

 

In May 2005, the FASB issued SFAS 154, Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20 and FASB Statement No. 3. This statement replaces APB Opinion No. 20, Accounting

 

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Changes, and FASB Statement No. 3, Reporting Accounting Changes in Interim Financial Statements, and changes the requirements for the accounting for and reporting of a change in accounting principle. This statement requires retrospective application to prior periods’ financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. This standard is effective for accounting changes and corrections of errors made in fiscal periods beginning after December 15, 2005. We do not expect a significant impact on our results of operations and disclosures.

 

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BUSINESS

 

Overview

 

We design, develop and market high-performance, high-resolution and cost-effective CMOS image sensors for use in mobile camera phones and other applications such as PC cameras and security and surveillance systems. Our image sensors are used to capture and convert images into digital signals for display or transmission. As a fabless semiconductor company, we are focused on creating proprietary design technologies to develop and market image sensors with sharp, colorful, enhanced image quality, size efficiency and low power consumption, while outsourcing our manufacturing, testing and assembly requirements to independent companies.

 

Our product family consists of CMOS image sensors of various specifications, which are sold as stand-alone products or incorporated into camera modules. Our customers include some of the leading designers and manufacturers of mobile phones and camera modules, such as BYD Co., Ltd., China TechFaith, DART Express Incorporated, DK Semicon, Ningbo Bird Co., Ltd., Pantech Co., Ltd., ROHM Co., Ltd., Seiko Precision Inc. and Sharp. We market and sell our products primarily through our domestic direct sales force and through a network of authorized international sales agents and distributors.

 

Since we first began producing our image sensors in September 2002, our revenues have increased from (Won)73 million in 2002 to (Won)17,806 million in 2003 and to (Won)35,796 million (US$34.3 million) in 2004. For the first nine months of 2005, we recognized revenues of (Won)30,418 million (US$29.2 million). In 2004, we shipped approximately 10.8 million image sensors worldwide, of which 7.7 million CMOS image sensors were sold through DongbuAnam to Sharp under our arrangements with DongbuAnam, and during the first nine months of 2005, we shipped approximately 14.8 million CMOS image sensors and camera modules, of which approximately 5.6 million CMOS image sensors were sold through DongbuAnam to Sharp.

 

We intend to expand our market position in the image sensor industry by penetrating new geographic markets, such as North America and Western Europe. We recently began providing our CMOS image sensors for PC cameras and security and surveillance systems and also intend to develop and market our products for integration into emerging applications requiring high-resolution image sensors, such as automobiles, biometrics, pattern recognition, medical devices and toys. We believe that our expertise in design and process technologies, our strong ability to integrate multiple functions into a single-chip solution and our close relationships with customers will allow us to grow our business.

 

Industry Background

 

Image sensors are semiconductor devices that transform analog light and color into digital information for processing, storage or display without the need for photographic film. Such devices either employ CMOS or CCD technology. Recent demand for image sensors has been spurred by the growing market for digital cameras and more recently, mobile camera phones. Other applications for image sensors include automobiles, biometrics, pattern recognition, medical devices, PC cameras, security and surveillance systems and toys.

 

According to a November 2005 report issued by Gartner, the image sensor market generated US$1.7 billion in revenues in 2002 and is expected to grow to US$5.5 billion by 2005 and US$8.3 billion by 2010. CMOS image sensors are expected to replace CCD image sensors in many applications by 2006. The following table shows the expected total demand for CMOS image sensors and CCD image sensors from 2005 to 2010.

 

Worldwide Image Sensor Revenue by Technology, 2005—2010(1)

 

     2005

   2006

   2007

   2008

   2009

   2010

     (in millions of US$)

CMOS

   2,697    3,143    3,857    4,374    5,108    5,699

CCD

   2,838    2,843    2,758    2,754    2,668    2,649
    
  
  
  
  
  

Total

   5,535    5,986    6,615    7,128    7,776    8,348
    
  
  
  
  
  

 


 

(1) Gartner, “Forecast: Semiconductor Consumption by Device, Worldwide, 2002-2010,” November 18, 2005.

 

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Image Sensor Demand Driven by Technological Advances, Increasingly Smaller End Applications and Decreasing Costs

 

The proliferation in end applications for image sensors has been driven by a number of factors including:

 

Shift from Analog to Digital Technology. The migration from analog to digital technology has revolutionized how people record and store audio and visual information. Digital technology is convenient, has no quality degradation upon successive reproduction, and can be reproduced in multiple formats, such as on film or on a liquid crystal display, or LCD, screen. Digital cameras demonstrate the shift from analog to digital as photographic film has been replaced in such cameras by the use of an image sensor to transform an image into electronic format for recordation, storage and transmission.

 

Increasingly Smaller Application and Component Sizes. Technological advancement in the image sensor industry has resulted in progressively streamlined, converged and smaller applications that offer a combination of mobility, connectivity, entertainment, storage and security. This has been facilitated by the continued reduction in the size of, and integration of multiple functions in, component parts. For example, technological advances in smaller component parts have enabled manufacturers to combine multimedia, image capture, storage and transmission functions to mobile phones which were previously used only for voice communication.

 

Decreasing Costs. Technological advances coupled with market competition, improved manufacturing processes and economies of scale have resulted in decreasing prices of end-applications as well as component parts. As a result, image sensors are now used in or being developed for many innovative applications. For example, image sensors are used in biometric applications to create personal identity information unique to each individual, such as fingerprints, for identity authentication and fraud prevention. Another developing application is in medical devices such as x-ray scanning and ingestible scanning pills. Additionally, image sensors can be used in automobiles to assist a driver through lane change warning systems, automatic cruise control, airbag development and headlight adjustments.

 

Emergence of CMOS as a Cost-Effective Replacement Technology

 

The demand for image sensors has been accelerated by improvements in CMOS technology. CMOS technology permits compact structures for image sensor chips and is a low cost alternative to CCD technology. CMOS technology was first used in image sensors in 1998, almost 40 years after the advent of CCD technology. When it was first introduced, CMOS technology was not used in commercial products due to lower light sensitivity, greater susceptibility to noise, and lower image quality at higher resolutions when compared to CCD technology. Recent improvements in CMOS technology, including a reduction in size, improvement in current control, and a more stable fabrication process, enable it to produce higher quality images at lower costs.

 

CMOS has many advantages compared to CCD technology, including:

 

    Easier Integration with Companion Chips. CMOS image sensors require only one voltage, either the standard three or five volts used for modern integrated CMOS circuits. In contrast, CCD image sensors require three different and non-standard voltages. Thus, CMOS image sensors are easier and less costly to integrate into companion chips.

 

    Less Complex Manufacturing Processes. CMOS image sensors use traditional manufacturing processes which are commonly used for the manufacture of a variety of semiconductor chips. CMOS image sensors are less costly than CCD image sensors that require more complex manufacturing processes and equipment.

 

    Lower Power Consumption. CMOS image sensors are more energy efficient than CCD image sensors, which can be a critical factor when used in battery-dependent portable device applications.

 

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    Integrated Single Chip Solutions. CMOS image sensors offer mobile communication device manufacturers a compact and integrated single chip solution that incorporates multiple functions including digital signal processing, or DSP, and image signal processing, or ISP, for conversion of images, panning, and moving pictures experts group, or MPEG, audio. In contrast, CCD image sensors generally require three chips: a CCD image sensor for image capture, a power and timing generator for signal control and a DSP for image processing.

 

Camera Mobile Phones to Dominate the Imaging Market

 

The camera mobile phone market is a major growth market for images sensors. According to an October 2004 report issued by Gartner, camera mobile phones will have penetrated 95% of the Japanese and Korean mobile phone markets by 2008. Other mobile phone markets are also expected to follow this trend in which cameras will become a standard feature of mobile phones. According to a December 2003 report issued by IDC, as consumers are increasingly drawn to multiple functions in a mobile phone in addition to voice services, wireless operators will cater to consumer preferences and demand through bundled pricing plans, which include image sharing, while mobile phone manufacturers will continue to upgrade, enhance and produce new mobile phone models. The adoption of third-generation mobile networks by wireless carriers will enable faster data transfer rates, which will further drive the mass-market adoption of mobile camera phones in the next several years.

 

According to a November 2005 report issued by IDC, worldwide camera mobile phone shipments are expected to grow from 270.1 million units in 2004 to 765.9 million units in 2009. By 2007, a majority of camera mobile phones are expected to have 1.0 or 2.0 megapixel resolution.

 

Worldwide Camera Phone Unit Shipments by Camera Resolution, 2004—2009(1)(2)

 

Megapixel


   2004

   2005

   2006

   2007

   2008

   2009

     (in millions of units)

<1MP

   219.0    231.7    226.7    176.3    121.3    78.2

1MP

   44.8    107.8    186.6    254.3    282.8    282.5

2MP

   4.9    25.4    49.5    113.8    198.2    252.4

3MP+

   1.4    7.7    22.7    48.2    86.3    152.8
    
  
  
  
  
  

Total

   270.1    372.6    485.5    592.6    688.6    765.9
    
  
  
  
  
  

 


 

 

(1) IDC, “Worldwide Camera Phone and Videophone 2005-2009 Forecast,” November 2005 (IDC #34338).
(2) For certain types of mobile camera phones, such as dual-camera phones, which have two image sensors, the data provided in the above table only counts one image sensor with higher resolution.

 

 

In its November 2005 report, Gartner estimates that revenues from image sensors in wireless communications electronics application will grow from US$2,136 million in 2005 to US$3,205 million in 2010.

 

Our Strengths

 

We provide high-performance and cost-effective image sensor solutions, based on single-chip CMOS technology, for mobile camera phone and other consumer electronics applications. Our image sensors, which are based on our proprietary technologies, integrate multiple functions such as image capturing, auto focus, mechanical shutter, image processing, image correction, color processing, conversion and output. We believe our image sensors are well suited for high-volume, space-constrained and portable applications such as the mobile handset, as our CMOS image sensor chips are lower in cost, smaller in size, lighter in weight and consume less power.

 

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We believe the following strengths allow us to offer cost-effective and superior quality products and solutions to our customers:

 

    Our Design and Engineering Expertise. Our key management and technical team members have had an average of over 15 years of experience working with CCD image sensors and applied CCD design ideas and techniques to develop our technology, including our proprietary 3-transistor pixel structure. As a result, we have successfully reduced noise levels and improved light sensitivity of our CMOS image sensors, resulting in superior-quality images with realistic color, sharpness, brightness and high contrast ratios.

 

    Our Process Engineering Know-How. Based on our process engineering know-how and CCD image sensor experience, we have modified standard CMOS process technologies to increase our manufacturing yields that we believe are higher than the yields achieved by many of our competitors using the conventional pixel structure. As a result of our high manufacturing yields, we have realized higher number of image sensor chips per wafer, thereby reducing our product costs.

 

    Our Integration of Multiple Functions. Through our proprietary design technology, we are able to integrate various different features into a single-chip-based image sensor, which allow our customers to build their end-products using a single chip instead of multiple chips offered by some of our competitors. Our image sensors use an embedded ISP engine based on a compact algorithm and many advanced features required for a camera system, including image capturing, auto focus, mechanical shutter, image processing, image correction, color processing, conversion and output. This complete solution is referred to as a camera System on a Chip, or SoC. Our integrated design solutions allow for smaller, lighter and more power-efficient end-products.

 

    Our Close Relationships with Customers. Our close relationships with our customers provide us with valuable knowledge and industry insights into trends in the image sensor industry, creating opportunities to establish a market position as an early entrant by providing products that feature enhanced design and functionalities for incorporation into new products and applications. For example, our close relationships with Japanese mobile manufacturer vendors such as Sharp and Seiko Precision led us to be one of the first movers in developing very small, highly customized common intermediate format, or CIF, image sensors, which are in high demand for use in dual-camera third generation, or 3G, handsets. We are also working with China Techfaith, a mobile handset design company in China, to incorporate our image sensors into their designs.

 

Our Strategy

 

Our objective is to be a leading global supplier of image sensor-related semiconductor products for a broad range of applications. In order to achieve our objective, we intend to pursue the following strategies:

 

    Pursue Customer Diversification and International Expansion. We are implementing a customer acquisition strategy across all levels of our organization with the objective of enhancing our brand image, retaining our existing customer base and acquiring new customers. To execute our plan, we are creating a new marketing department, engaging additional sales agents with valuable local networks in the United States and Europe and realigning our sales organization. We have recently qualified two of our CMOS image sensor product lines with LG Electronics Inc., and we expect to begin delivering our products to LG Electronics Inc. in the first half of 2006. By the first quarter of 2006, we expect to add two employees specifically for marketing activities, in addition to increasing our sales team from 14 to 20, with many of them focused exclusively on international customers. We will also establish a sales office in Western Europe to augment our international sales efforts currently conducted from Korea and our offices in San Jose, California.

 

   

Diversify Our Product Offerings for Use in New Applications. We are leveraging our core competency in CMOS image sensor technology, and our strong market position in the mobile camera phone market,

 

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to extend our product offerings to other applications. We believe that by providing high quality and competitively-priced image sensors, we will continue to find new market opportunities in automobiles, biometrics, pattern recognition, medical devices, security and surveillance systems, digital still cameras, toys and PC cameras. For example, we provide CMOS image sensors for the home security and surveillance system application to Vimicro International Corp. and we recently received a purchase order for our CMOS image sensors for the PC camera application from one of the largest PC camera manufacturers worldwide. We also plan to partner with leading companies in each of these emerging image sensor markets to combine their industry experience with our image sensor expertise and to co-develop competitive, high quality image sensors. We believe that our expansion into new product markets will allow us to continue to grow our business while achieving greater stability through a broader product base in non-mobile phone applications.

 

    Maintain Technological Competitiveness to Better Serve Our Customers. We believe the combination of our core technologies and our experience in device engineering, circuit engineering and process engineering are our key competitive advantage. Since maintaining our technological competitiveness will be critical in attracting and retaining customers, we plan to continue to increase our investment in research and development, grow our internal engineering team from 27 as of September 30, 2005 to 45 by the first quarter of 2006, strengthen our expertise by conducting fundamental and advanced research in the image sensing and image processing fields and introduce new products in a timely manner.

 

    Continue to Focus Our Design Efforts on Integrated Multi-Functional Chip Design. In line with the miniaturization trends in the consumer electronics industry, we will continue to focus on developing chips with integrated multiple functions, such as advanced digital signal processing and image signal processing, JPEG image compression and motor controller capabilities, on a single chip. We are also seeking to develop a separate chip to complement our CMOS image sensor chip to meet the feature- and system-intensive design requirements of new emerging applications, such as in biometrics and medical devices. Through a combination of our system engineering and chip design engineering expertise, our research and development department will focus on configuring and testing an optimal chip layout and designing new and complementary functions to enhance our customers’ end-products.

 

    Further Develop Third Party Cooperative Relationships. While we continue to seek joint development of CMOS image sensor process technology with DongbuAnam, we are exploring additional opportunities to establish cooperative relationships with other leading foundries to expand our dedicated manufacturing capacity and improve manufacturing yield and image quality. For example, we have recently entered into a manufacturing outsource agreement with UMC and expect to establish an on-going cooperative relationship with UMC. We also intend to partner with leading mobile phone designers, such as China Techfaith, and module makers to deliver superior solutions to our customers as we continue to focus on the development of image sensors. In addition, we plan to develop cross marketing and product development relationships with leading mobile communications companies.

 

Products

 

We design, develop and market some of the world’s most advanced CMOS image sensors, featuring high quality resolution, a high level of system integration and low power consumption. Our product portfolio consists of CMOS image sensors and camera modules incorporating our CMOS image sensors of various specifications, used predominantly in mobile phone applications. We provide CMOS image sensors for the PC camera and security and surveillance system applications and also intend to develop and market our products for integration into emerging applications requiring high-resolution image sensors, such as automobiles, biometrics, pattern recognition, medical devices and toys.

 

We combine our image sensor engineering and system engineering expertise to offer our customers innovative and advanced products. Our product offerings ranges from our 0.1 megapixel CIF and 0.3 megapixel

 

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VGA products to our higher-end 1.3 megapixel super extended graphics array, or SXGA, and 2.0 megapixel ultra extended graphics array, or UXGA, products. All of our CMOS image sensors incorporate on a single chip many high performance digital camera functions, including an integrated ISP, noise reduction circuits, color gain controller, internal timing generator and analog-to-digital converter, or ADC.

 

We developed our first 1.3 megapixel CMOS image sensor for commercial production in September 2003, and our first 2.0 megapixel single chip product with auto-focus capabilities for commercial production in April 2005. In April 2005, we also integrated a four-channel motor controller into our commercially available 2.0 megapixel products to control mechanical shutter, aperture and auto focus functions as part of our camera SoC strategy.

 

Our CMOS image sensors incorporate our proprietary single-chip design and 3-transistor architecture to achieve high quality, multiple functionality and size efficiency, while our leading process technology facilitates high manufacturing yields. Our single-chip design enables our CMOS image sensors to combine image capturing with ISP, color processing and image output functions. We offer a broad product portfolio, including image sensors with resolutions ranging from 0.1 to 2.0 megapixels, from which our customers can choose CMOS image sensors best suited for their application needs.

 

Pixelplus CMOS Image Sensors

 

We derived 4.5%, 17.6% and 41.4% of our total revenues from the sale of our CMOS image sensors in 2003, 2004 and the first nine months of 2005, respectively. The trend in the mobile camera phone industry is toward smaller image sensors with higher image quality. To achieve size efficiency, we are continuing to develop products with smaller optical size, such as our CIF image sensor with 1/7 inch optical size. We are also seeking to provide products with better image quality and multiple functionality, such as our 1.3 megapixel SXGA and 2.0 megapixel UXGA products with multiple features and high system integration. In addition, we are also working with our independent foundry to improve the manufacturing process of our CMOS image sensors, such as upgrading to a back-end over layer, or BEOL, process technology to reduce the noise and image distortion. Our current CMOS image sensor portfolio consists of the following:

 

Product Group

(Resolution)


  

Product

Name


  

Technology

(µm)


  

Optical Size

(Inch)


    

                Key                

            Features            


CIF (0.1 megapixel)

   PO2010D    0.25    1/7      On-chip ISP
     PO3010K    0.18    1/11      On-chip ISP,
CIF shrink version

VGA (0.3 megapixel)

   PO2030N    0.25    1/4.5      On-chip ISP
     PO3030K    0.18    1/6.2      VGA shrink version,
upgraded BEOL process

SXGA (1.3 megapixel)

   PO2130D    0.25    1/2      On-chip ISP
     PO3130D    0.18    1/3.3      SXGA shrink version
     PO3130R    0.18    1/3.3     

SXGA shrink version,

upgraded BEOL process

     PO4130K    0.15    1/3.9      On-chip ISP,
SXGA shrink version

UXGA (2.0 megapixel)

   PO1200N    0.18    1/2.7      On-chip ISP
     PO1200D    0.18    1/2.7      On-chip ISP,
upgraded BEOL process
     PA1200N    0.18    1/2.7      Auto-focus, on-chip ISP
     PA1200D    0.18    1/2.7     

Auto-focus, on-chip ISP,

upgraded BEOL process

NTSC/PAL (0.2 megapixel)

   PC1025N    0.25    1/4      Analog TV signal output

 

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CIF. We commercialized our first 0.1 megapixel CIF image sensors in June 2004. Our CIF image sensors are our smallest product with optical sizes from 1/7 inch to 1/11 inch. Our CIF image sensors are used mainly in dual camera mobile phones which utilize two image sensors, a smaller CIF image sensor for taking digital photos and a much larger CCD image sensor for video conferencing. Our CIF image sensors are sold primarily to our customers in Japan, such as Sharp and Seiko Precision Inc., due to the popularity of dual camera mobile phones in Japan.

 

VGA. We developed our first 0.3 megapixel VGA image sensors using 0.25 µm technology for commercial production in September 2003 and using 0.18 µm BEOL process technology in May 2005. Our VGA image sensors and our camera modules incorporating VGA image sensors have accounted for more than 95% and 80% of our revenues in 2003 and 2004, respectively. During the same two-year period, VGA image sensors have been the most widely used CMOS image sensor in the mobile camera phone industry during 2003 and 2004, primarily due to their size, image quality and price. Our VGA image sensors range in optical size from 1/4.5 inch to 1/6.2 inch.

 

SXGA. We developed our first 1.3 megapixel SXGA image sensors for the mobile camera phone application using 0.25 µm technology for commercial production in December 2003, using 0.18 µm BEOL process technology in May 2005 and using 0.15 µm process technology in November 2005. Our SXGA image sensors are used primarily in higher-end, higher resolution mobile camera phones. Our SXGA image sensors and camera modules incorporating SXGA image sensors accounted for approximately 4% of our revenues in 2003, which increased to more than 15% of our revenues in 2004. Our SXGA image sensors currently include image sensors with 1/2 inch, 1/3.3 inch and 1/3.9 inch optical sizes.

 

UXGA. Our 2.0 megapixel UXGA image sensors with 1/2.7 inch optical size are currently our highest-end product. We began offering our first UXGA products with auto focus in January 2005. We have also integrated mechanical shutter motor control mechanisms into this product.

 

NTSC/PAL. Our 0.2 megapixel NTSC/PAL image sensors are our only product not used in mobile camera phone applications and are instead used in security and surveillance cameras and toys. We commercialized our first NTSC/PAL image sensors in October 2004. Our NTSC/PAL image sensors are highly integrated products combining on a single chip CMOS image sensors, ISP, a television encoder, which is used to convert the digital video generated from the sensors to a composite 10 bit signal, and a video discretionary access control mechanism that converts composite 10 bit signal to an analog signal for television viewing. In 2004, our NTSC/PAL image sensors accounted for less than 1% of our revenues.

 

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Products to be Released

 

The mobile camera phone market continues to demand smaller chip size, higher image quality and greater functionality, all at a competitive price. We are currently developing a new line of image sensors that will provide higher resolution and smaller optical size than our existing products. We are also developing separate chips to complement our CMOS image sensors to meet the feature- and system-intensive design requirements of new emerging applications, such as in biometrics and medical devices. Our products currently under development or testing consist of the following:

 

Product Group

(Resolution)


   Product
Name


  

Technology

(µm)


  

Optical Size

(Inch)


  

Key

Features


   Expected
Time of
Completion


UXGA (2.0 megapixel)

   PO2200K    0.13    1/3.5    Auto focus, mechanical shutter, on-chip ISP, on-chip regulator, motor controller    First half of
2006
     PO3200K    0.13    1/4    Auto focus, mechanical shutter, on-chip ISP, on-chip regulator, motor controller    First half of
2006

QXGA (3.2 megapixel)

   PX1320K    0.13    1/3    Advanced analog processing, on-chip regulator, fast serial interface    First half of
2006

NTSC/PAL (0.4 megapixel)

   PC1044K    0.18    1/4    Analog TV signal output, auto focus, motor controller    First half of
2006

Pattern Recognition Processor SoC

   PM1001K    0.18    _    Direct sensor interface, real-time pattern extraction, ARM-embedded    Second half
of 2006

Capsule Endoscope Image Sensor SoC

   PD1010K    0.18    _    0.1 megapixel, low power consumption, low illumination exposure, direct LED control, embedded general purpose ADC, channel modulation    Second half
of 2006

 

1/3.5 Inch UXGA. We expect to offer UXGA image sensors using our most advanced 0.13 µm technology with 1/3.5 inch optical size by the first half of 2006. This product will incorporate auto focus and mechanical shutter functions, in addition to the on-chip ISP, on-chip regulator and on-chip motor controller functions. This product is currently undergoing engineering sample fabrication by our independent foundry.

 

1/4 Inch UXGA. We expect to offer UXGA image sensors using our most advanced 0.13 µm technology with 1/4 inch optical size by the first half of 2006. This product will incorporate auto focus, mechanical shutter, on-chip ISP, on-chip regulator and on-chip motor controller. This product is currently undergoing engineering sample fabrication by our independent foundry.

 

QXGA. We expect to offer 3.2 megapixel quantum extended graphics array, or QXGA, image sensors using our most advanced 0.13 µm technology with 1/3 inch optical size by the end of the first half of 2006. We have integrated various camera SoC functions and fast serial interface to reduce noise and simplify the interface with multimedia chip. This product, which we expect to be our most advanced, is now undergoing engineering sample fabrication by our independent foundry.

 

 

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0.4 Megapixel NTSC/PAL. We expect to offer 0.4 megapixel NTSC/PAL image sensors using 0.18 µm technology with ¼ inch optical size by the end of the first half of 2006. We expect this product, which is undergoing the final phase of design by our research and development team, will be used in security and surveillance system application.

 

Pattern Recognition Processor SoC. We expect to offer Pattern Recognition Processor SoC, an application-specific SoC processor, by the second half of 2006. This product will be used mainly in biometric security applications for mobile phones, personal digital assistants and PC peripherals. This product accelerates real-time pattern recognition by integrating application-specific design with a processor to aid biometric applications. Along with the chipset which consists of this product and CMOS image sensors, we also expect to provide total mobile security solutions, including firmware or software. This product is now undergoing the final phase of design by our research and development team.

 

Capsule Endoscope Image Sensor SoC. We expect to offer Capsule Endoscope Image Sensor SoC, an application-specific image sensor SoC for capsule endoscope applications, by the second half of 2006. This product offers size efficiency for ease of use and has special features, such as low power consumption, low illumination imaging capability, direct light emitting diode, or LED, light source control, embedded general purpose ADC and direct channel modulation, for cost-effective medical usage. This product is now undergoing the final phase of design by our research and development team.

 

Pixelplus Camera Modules

 

We derived 92.6%, 68.9% and 50.3% of our total revenues from sales of our camera modules in 2003, 2004 and the first nine months of 2005, respectively. We offer a variety of custom-made camera modules incorporating our CMOS image sensors. Our camera modules, which consist mainly of an optical lens, a lens holder, a printed circuit board, a socket that attaches the image sensor to the end-product, and our CMOS image sensor chip, allow our customers to incorporate a complete camera system into their mobile phones. We outsource the assembly of our camera modules to third party contractors.

 

We began offering camera modules in June 2003 at the request of our mobile phone manufacturing customers. For 2003, 2004 and the first nine months of 2005, we recognized revenues of (Won)16,491 million, (Won)24,663 million (US$23.7 million) and (Won)15,302 million (US$14.7 million), respectively, from sales of camera modules. Although revenues from sales of our camera modules accounted for 50.3% of our total revenues in the first nine months of 2005, we expect revenues from sales of our camera modules to decrease significantly in the first half of 2006 as we focus sales and marketing activities on our higher margin CMOS image sensors. In order to continue to meet the demands of those customers continuing to require camera modules, we are currently undergoing a transition to form a new arrangement under which we sell our CMOS image sensors to camera module assembly companies who will then assemble the camera modules and sell directly to such customers.

 

Services

 

We derived 12.4% and 7.5% of our total revenues from our engineering and technology services provided to DongbuAnam, our sole customer for such services, in 2004 and the first nine months of 2005, respectively. Under our arrangement with DongbuAnam, which is also our independent foundry, we provide engineering, technology and other services, including CMOS image sensor design, product customization services, manufacturing process consulting to achieve high yield, product probe testing, customer support and technical services, to DongbuAnam. Our service fee is based on the number of CMOS image sensors successfully passing the product probe test conducted by Tesna. DongbuAnam manufactures and sells these CMOS image sensors directly to Sharp. CMOS image sensors sold pursuant to this arrangement accounted for 71.3% and 38.0% of our CMOS image sensor unit volume in 2004 and the first nine months of 2005, respectively, and consisted mostly of CIF image sensors.

 

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Sales and Marketing

 

We generally market and sell our products through our domestic direct sales force and through a network of authorized international sales agents and distributors. During the first nine months of 2005, we derived 35.1% of revenues from our direct sales force, 29.8% of revenues from our sales agents, and 35.1% of revenues from our distributors.

 

We rely predominantly on our direct sales force for domestic sales. As of September 30, 2005, our sales and marketing organization had a total of 14 employees, 11 of whom were located at our Korean headquarters. Our sales employees, like all of our other employees, participate in our corporate profit sharing or year-end bonus system and do not receive any commission on sales.

 

We have an international network of six independent distributors, with two located in Korea, two in Japan, one in China and one in Hong Kong. We also have three independent sales agents, with two located in Europe and one in Korea.

 

We established a wholly-owned sales subsidiary in Shanghai, China, in September 2004. In March 2004, we established a sales joint venture in Taiwan with Taiwanese partners that have significant local customer and supply chain relationships. We also established a wholly-owned sales and research and development subsidiary in San Jose, California, in January 2005. We plan to establish a sales office in Western Europe in the first half of 2006.

 

Sales Cycle

 

CMOS Image Sensors. We sell most of our CMOS image sensors to mobile phone manufacturers or module assembly companies that sell camera modules under their own brand names. All of our CMOS image sensors are standardized products. The sale process begins by us qualifying with a customer to supply a specific product. After the successful completion of the qualification process, we may receive a purchase order eight to 10 weeks prior to the desired date of delivery. For high volume orders, our customers generally provide us with three-months forecasts, which, together with our own forecasts, allow us to plan our production requirements with our independent foundry.

 

Camera Modules. Our camera modules are sold directly to mobile phone manufacturers, and most of our camera modules are custom-made. The sales process begins when a mobile phone manufacturer delivers a mobile camera phone design to us and to other CMOS image sensor or camera module companies. Based on the customer’s design, we work with our camera module assembly contractors to design a camera module prototype, which takes approximately one month. The prototype is then sent to the customer for review and testing, which generally takes one or two months. If the customer finds our prototype acceptable, the customer will ask us, as well as other camera module makers, to submit a pricing proposal. If we are selected based on our pricing proposal, the customer will issue a purchase order approximately 10 to 12 weeks prior to the first delivery date.

 

Sales and Marketing Efforts

 

Our sales and marketing efforts focus on the following strategies:

 

Establish and Strengthen Relationships with Large Customers. We plan to implement a customer acquisition strategy across all levels of our organization with the objective of enhancing our brand image and identifying new customer acquisition opportunities. To execute our plan, we are creating a new strategy and marketing organization and realigning our sales organization to better address the rapidly evolving image sensor market opportunity and our growing customer base. We have reorganized our marketing department to focus on defining our strategic vision, creating our marketing programs and building corporate alliances. In our early

 

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stages, we effectively mixed the functions of sales and marketing but as we plan to grow and as competition is expected to become more concentrated, we plan to devote dedicated efforts solely toward defining, articulating and executing our strategic vision. By the first quarter of 2006, we expect to add two employees specifically for marketing strategy and planning.

 

Maintain and Reinforce Our Relationships with Existing Customers. Our realigned marketing and sales department will also devote significant time and resources to marketing to, and maintaining close relationships with, existing customers. Through our close relationship with our third party contractors, such as DongbuAnam and Tesna, we strive to lower the cost of development, manufacturing and testing. We believe that our ability to exercise significant cost control and work closely with our customers in the design and development stages of new products serves to strengthen our relationships with customers. We also believe that providing strong technical support to customers is extremely important in developing long term relationships with key customers. Accordingly, we provide our customers with reference designs, engineering design reviews, engineering product evaluation testing and product debugging services.

 

Enhance Our Brand Recognition Through Cooperative Relationships with Leading Companies. We will continue to seek cooperative relationships with mobile phone designers, chip designers and other leading companies in the mobile communication and chip design sectors to enhance our brand recognition and further improve market penetration opportunities. For example, in June 2005, we entered into a non-exclusive joint development agreement with China TechFaith, a mobile phone design company, to incorporate our CMOS image sensors into their mobile phone designs. In July 2005, we also entered into a non-exclusive cross-marketing and development agreement with Qualcomm to produce CMOS image sensors that incorporate fast serial interface specifications using Qualcomm’s proprietary technology, which we are implementing for our next generation high-resolution CMOS image sensors.

 

Penetrate New Geographic Markets and New Industries. We are also focused on entering new overseas markets, such as North America and Western Europe, as well as new emerging applications for CMOS image sensors, such as automobiles, biometrics, medical devices, pattern recognition, medical devices, security and surveillance systems and toys. We established a sales and research and development office in San Jose, California, in January 2005 and plan to establish a sales office in Western Europe in the first half of 2006.

 

Warranties

 

In accordance with industry standards, we generally provide a limited warranty to our end-customers. We have not incurred significant costs related to our warranty obligations. Our products are technically and visually tested by our customers prior to their issuance of purchase orders and undergo multiple testing processes by Tesna after each stage of the wafer fabrication and chip scale packaging, or CSP, process. We believe these testing processes allow us to minimize the number of warranty claims from our customers. We also receive from our independent foundry a 90-day warranty from the date of the delivery of the wafers used in our products.

 

Customers

 

We have a diverse customer base throughout Asia, consisting of leading OEMs which include major branded customers and contract manufacturers. During the first nine months of 2005, Asia accounted for 99.0% of our total revenues, with 51.2% from China, 26.5% from Korea and 21.3% from other Asian countries, such as Japan and Taiwan.

 

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A relatively small number of customers have accounted for a significant portion of our past revenues. In 2004, our top five customers accounted for approximately 79% of our revenues, compared to approximately 97% of our 2003 revenues. The following table provides a list of our top ten customers, their location and the category of products purchased in the first nine months of 2005 attributable to each listed customer:

 

Customer


    

Country


    

Product Categories


BYD Co., Ltd.      China      VGA
China TechFaith      China      SXGA, UXGA
DART Express Incorporated      Taiwan      VGA
DK Semicon      Korea      VGA
Ningbo Bird Co., Ltd.      China      VGA
Pantech Co., Ltd.      Korea      VGA
ROHM Co., Ltd.      Japan      VGA
Seiko Precision Inc.      Japan      CIF/VGA
Sharp(1)      Japan      CIF/VGA
VK Corporation      Korea      VGA

 


 

(1) Indirect customer under our services arrangements with DongbuAnam.

 

None of our distributor customers accounted for more than 10% of our revenues in 2004. In the first nine months of 2005, two of our distributors, Shenghe Technology Limited and YEL Electronics Limited, accounted for 13.2% and 10.3%, respectively, of our revenues in the first nine months of 2005 and no other distributor accounted for more than 10% of our revenues for that period. We believe our customer base will become larger and more diversified in 2006 as we increase sales to leading domestic and international OEMs. For example, we have recently qualified two of our CMOS image sensor product lines with LG Electronics Inc., and we expect to begin delivering our products to LG Electronics Inc. in the first half of 2006.

 

Technology

 

We use proprietary technologies and advanced design methodologies to design and develop CMOS image sensors that provide our customers with high levels of resolution, flexibility and image quality. The engineers who developed our proprietary pixel technologies have had experience with CCD image sensor technology since 1989. We produce low-cost and high-quality CMOS image sensors by combining high- resolution CCD image sensor technology with scalable CMOS image sensor technology.

 

Pixelplus 3-Transistor Technology

 

We have optimized the architecture of the analog signal path to minimize the chip size while maintaining superior image quality. Most of our competitors have moved to a 4-transistor pixel structure or are still using a conventional 3-transistor pixel structure for their CMOS image sensors. Unlike our competitors’ 4-transistor pixel structures, our proprietary 3-transistor pixel structure optimizes the area that the photo diode occupies on a pixel, also known as the fill factor. Unlike conventional 3-transistor structures, our pixel structure allows light, or photons, to be converted into greater amounts of electrical signal, which is known as conversion gain and noise to be kept low. Combined with our optimal in-pixel amplifier design, our 3-transistor pixel structure produces high fill factor and high conversion gain and results in low noise in the darker light spectrum to provide high image quality.

 

Pixelplus Process Know-How

 

We leverage our CCD image sensor technology experience and process engineering know-how to continue to improve our CMOS process technologies and advanced pixel design methodologies. We also share

 

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our process technology and methodology know-how with our independent foundry to achieve high manufacturing yields and the shortest design and production cycles in the industry. As CMOS technology evolves from 0.18 µm to 0.13 µm and 90 nanometers, we believe our proprietary 3-transistor pixel structure, SoC architecture and efficient device engineering will provide us with a competitive advantage and enable us to deliver high quality products with high manufacturing yields.

 

Pixelplus Camera SoC Technology

 

After photons are converted and digitized by an image sensor, our on-chip ISP engine integrates the major ISP functions such as gamma correction, color correction, color interpolation, edge enhancement, white balance, exposure control and back light compensation. Our camera SoC architecture further integrates additional functions such as auto focus, JPEG image compression and motor driver capabilities on a single chip and enables the ISP circuits to occupy less space on a chip, reducing the overall chip size.

 

Research and Development

 

We believe that our future success depends on our ability to maintain our technological competitiveness by continuing to enhance our existing products and developing new products that comply with new standards in a rapidly evolving consumer oriented mobile communications market. We attempt to use our CMOS image sensor design and embedded system design expertise to gain additional market share in the mobile phone market and enter into new emerging applications.

 

Our research and development engineers are organized into three separate groups that focus on application specific integrated circuit, or ASIC, sensors and system applications. Our sensors team focuses on pixel design and architecture and analog circuitry design, our ASIC team concentrates on ISP algorithm and other SoC design and integration, and our system applications team focuses on product customization, camera module design and customers’ system applications. We expect to hire additional engineers for peripheral circuit and system design to achieve higher functional integration on our CMOS image sensor chips.

 

Research and development expenses, net of government grants, for 2002, 2003, 2004 and the first nine months of 2005 were approximately (Won)666 million, (Won)1,335 million, (Won)3,211 million (US$3.1 million) and (Won)2,498 million (US$2.4 million), respectively. As of September 30, 2005, we had a total of 27 research and development personnel. We intend to increase the number of our research engineers to 45 by the first quarter of 2006, approximately five of whom will be based in our new research and development facility in San Jose, California.

 

Intellectual Property

 

Our success and future revenue growth will depend, in part, on our ability to protect our intellectual property. We rely on a combination of patents and trade secrets, as well as nondisclosure agreements and other methods, to protect various aspects of our products and related propriety technology and know-how. As of September 30, 2005, we had been issued six patents in Korea, two patents in Taiwan and two patents in the United States, and we had 12 patent applications pending in Korea, two pending in China and one pending in Japan. Our patents have terms expiring from 2022 to 2025. These patents and patent applications are intended to protect our unique 3-transistor single chip design, noise reduction and cancellation circuits, and image enhancement and color processing technologies of our image sensors.

 

We also enter into nondisclosure agreements with our employees and strategic partners, and we control access to and distribution of our documentation and other proprietary information. We do not license intellectual property from third parties other than licensed specialty software for design work, such as Cadence and Synopsys.

 

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Manufacturing

 

We outsource our wafer fabrication, testing, packaging and module assembly to third party contractors. This outsourcing allows us to focus on our design strengths and minimize our fixed costs and capital expenditures while gaining access to advanced manufacturing, testing and assembly facilities. Our engineers work closely with our contractors to increase yields, lower manufacturing costs and improve quality.

 

Our average production cycle for our products ranges between 11 to 13 weeks. The following chart shows the basic manufacturing process and approximate time required for each step, from design to product assembly and delivery to our customers.

 

LOGO

 

Wafer Fabrication

 

DongbuAnam has manufactured all of our integrated circuits since our first production model in 2002. DongbuAnam utilizes two CMOS wafer fabrication facilities in Korea and has the capacity to produce approximately 50,000 wafers per month. In the first nine months of 2005, our wafer production requirements ranged from approximately 3,000 to 5,000 wafers per month. We have recently qualified UMC as an alternative manufacturing resource and have entered into a manufacturing outsource agreement with UMC. We believe UMC will begin providing wafer manufacturing services for us in the second half of 2006. We believe our independent foundries will be able to satisfy our wafer production requirements in 2006.

 

Wafer fabrication occurs in a highly controlled, clean environment to minimize dust and other contaminants affecting yield and quality. Despite stringent manufacturing controls, dust particles, equipment errors, minute impurities in materials, defects in circuit design or other problems may cause wafers to be defective or individual circuits to fail. We rely on our wafer manufacturer’s ability to minimize such defects to maximize the yield of high-quality CMOS image sensor chips. As part of our manufacturing outsource agreement with DongbuAnam, DongbuAnam provides us with a warranty in the form of a cash credit in the event they fail to produce a minimum number of acceptable image sensors per wafer. In addition, DongbuAnam provides us with a 90-day warranty from the date of the delivery for any defective wafers used in our products.

 

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We are also required to make penalty payments to DongbuAnam if we do not meet certain minimum wafer orders requirements which are based on a rolling six-month forecast of our wafer needs. To date, we have not had to make any penalty payment. Under the terms of our manufacturing outsource agreement with UMC, UMC is required to provide us with a limited warranty for a period of one year from the date of delivery for any failure to meet a specified criteria.

 

Wafer and CSP Testing

 

High volume product testing is a critical element in the production of CMOS image sensors. After fabrication, wafers are tested for any design or manufacturing defect, which takes approximately two to three days. Following the completion of the wafer probe tests, our CMOS image sensor chips that will be packaged by the CSP process are tested again for integrity, a process which takes another two to three days.

 

Our wafer testing and CSP testing are primarily conducted by Tesna. Tesna’s facilities are located in Ichon, Korea, and have the capacity to test 5,000 wafers per month. We hold a 13.9% equity interest in Tesna. See “Related Party Transactions—Relationship with Tesna” for a discussion of our relationship with Tesna.

 

On May 31, 2004, we entered into a testing agreement with Tesna, which is valid until either Tesna or we give a written termination notice to the other party. Pursuant to this agreement, we provide order forecasts to Tesna on a monthly basis. Tesna is deemed to have agreed to meet the number of orders forecasted unless it notifies us otherwise in writing within seven days of receipt of such forecast. We believe that Tesna has the intellectual property rights to the test programs it uses and develops in addition to any related probe cards.

 

In July 2004, we qualified King Yuan Electronics Co., Ltd. in Taiwan to provide us with an alternative source for our wafer and CSP testing services. King Yuan Electronics Co., Ltd. currently has the capacity to test approximately 10,000 wafers per month.

 

CSP and COB Packaging

 

After wafer fabrication and wafer testing, wafers are diced into individual die. Functional die are sorted, connected to external leads and encapsulated in plastic packages. Our chip on board, or COB, type of CMOS image sensor chips are sent directly to our customers or camera module assembly partners without separate packaging or further testing. For our CSP type of CMOS image sensor chips which are designed for smaller-sized applications, we rely on XinTec Inc., a Taiwanese company, and Shellcase Ltd., an Israeli company, for packaging. The CSP packaging process takes approximately three weeks, including shipping time. After CSP packaging, our CMOS image sensors are tested once again by our testing contractor, Tesna, before being shipped to our customers or camera module assembly partners.

 

Camera Module Assembly

 

Our packaged CMOS image sensor chips are sent to independent contractors for camera module assembly. Our camera modules are currently being assembled in Korea by two independent contractors, Cresyn Co., Ltd. and DDMT Co., Ltd. Other contractors, such as Terra-Sem Co., Ltd., provide us with assembly services for our COB image sensors. Our suppliers, such as Sekonix Co., Ltd. and Kyocera Corp., provide us with optical lenses, lens holders, sockets and other camera module parts that are used by our camera assembly contractors to assemble the modules. Camera module assembly for CSP-packaged products takes two to three days. For COB products, the assembly takes approximately seven days. The finished camera modules are shipped to our customers after assembly is completed.

 

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Competition

 

We compete in an industry characterized by intense competition, rapid technological change, evolving industry standards, declining average selling prices and rapid product obsolescence.

 

We believe the principal factors affecting competition in our markets are:

 

    pricing;

 

    product quality (including image quality, pixel and chip size and special features);

 

    cost control;

 

    new product development and time to market;

 

    relationships with key OEMs that incorporate image sensors into mass market applications; and

 

    relationships with semiconductor foundries and other participants in the manufacturing chain.

 

Our main competition comes from other CMOS image sensor design companies and manufacturers, which include a number of well-established companies such as MagnaChip, Micron, Omnivision STMicroelectronics and Toshiba Corporation. In addition, Samsung Electronics, one of the largest corporations in Asia and one of the world’s leading mobile phone manufacturers, has recently commenced the production of CMOS image sensors for the mobile phone application. Samsung Electronics also has a long history of working with CCD image sensors, a competing technology. Also, certain companies, like Matsushita, are in the process of developing hybrid technology by mixing CMOS and CCD image sensor technologies, to compete in the same markets with our CMOS-based image sensors. For our higher-end image sensors, such as our planned 3.2 megapixel products, we also expect to compete with CCD image sensor manufacturers, such as Sony Corporation.

 

Our competitors include many large domestic and international companies that have greater presence in key markets, greater access to advanced wafer foundry capacity, substantially greater financial, technical, marketing, manufacturing, distribution and other resources, broader product lines, better access to large customer bases, greater name recognition, longer operating histories and more established strategic and financial relationships than we do. As a result, they may be able to adapt more quickly to new or emerging technologies, customer requirements and pricing wars or devote greater resources to the promotion and sale of their products. Although we believe that we are competitively positioned in the CMOS image sensor industry based on our design and engineering expertise and our research and development capability, we cannot assure you that we will be able to compete successfully against our current or future competitors.

 

Backlog

 

Sales are made pursuant to standard and customized purchase orders. For standard sales, our backlog includes only those customer orders for which we have accepted purchase orders and assigned shipment dates within the upcoming 12 months. As of December 31, 2003 and 2004 and September 30, 2005, our backlog was approximately (Won)623 million, (Won)1,859 million (US$1.8 million) and (Won)1,643 million (US$1.7 million), respectively. Although our backlog is typically filled within two to three months, our current backlog is subject to changes in delivery schedules and may not be an indication of future revenue.

 

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Employees

 

As of September 30, 2005, we had a total of 86 full-time employees, 66 located at our headquarters in Korea and 20 located in our foreign offices in China and the United States. 14 of our employees were staffed in sales and marketing, 27 in research and development and 45 in administration and management. Our future success will depend, in part, on our ability to continue to attract, retain and motivate highly qualified technical and management personnel.

 

We do not have a labor union and none of our employees are covered by collective bargaining agreements, except for an agreement with us and our employees, as required under Korean law, to set up procedures to formally hear complaints from our employees. We believe that we maintain a good working relationship with our employees and we have not experienced any significant labor disputes.

 

Under the Korean Labor Standard Act, employees with more than one year of service with us are entitled to receive a severance payment upon voluntary or involuntary termination of their employment. The amount of the benefit equals the employee’s monthly salary, calculated by averaging the employee’s daily salary for the three months prior to the date of the employee’s departure, multiplied by the number of continuous years of employment. As allowed under Korean law, we pay all of the accrued amounts under this requirement to each employee, other than our officers, at the end of each fiscal year.

 

Pursuant to the Korean National Pension Law, our employees are entitled to receive an annuity in the event they lose, in whole or in part, their wage earning capability. In order to fund the annuity, we are required to pay 4.5% of each employee’s annual wages to the National Pension Corporation. Our employees are also required to pay 4.5% of their annual wages to the National Pension Corporation. The total amount of our payments to the National Pension Corporation in 2003 and 2004 was (Won)20 million and (Won)48 million, respectively.

 

Facilities and Subsidiaries

 

Korea. Our principal executive and administrative offices are located at 5th Floor, Intellige I, KINS Tower, 25-1 Jeongja-dong, Bundang-gu, Seongnam-si, Gyeonggi-do 463-811, Korea, which is just outside of Seoul. We occupy approximately 21,858 square feet of office space and pay a monthly rent of (Won)16.6 million pursuant to a lease that expires in July 2008.

 

We believe that our existing facilities are adequate for our current requirements. To meet our future growth, we plan to purchase land in Pankyo Technology Park, a new technology park just south of Seoul, in 2006 in order to build our permanent headquarters. We expect to move into this new headquarters by 2009. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Capital Expenditures” for additional information about our planned new headquarters.

 

China. Established in September 2004, Pixelplus Shanghai Ltd. is wholly-owned by Pixelplus Asia Co., Limited, our wholly-owned Hong Kong subsidiary, and serves as our sales and marketing headquarters for China, including Hong Kong. The offices of Pixelplus Shanghai Ltd., our Shanghai sales and marketing subsidiary, are located at Room 2311, Huarong Building, No. 1289 Pudongnan Road, Shanghai 200122, China. Pixelplus Shanghai Ltd. occupies approximately 3,600 square feet of office space and pays a monthly rent of approximately (Won)5.5 million pursuant to a lease that expires in September 2006. We believe that the existing facilities of Pixelplus Shanghai Ltd. are adequate for its current requirements and that additional space can be obtained on commercially reasonable terms to meet its future requirements.

 

United States. Established in January 2005, Pixelplus Semiconductor, Inc. is our wholly-owned U.S. subsidiary. Pixelplus Semiconductor, Inc. serves as our U.S. headquarters for sales and marketing and

 

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research and development. The offices of Pixelplus Semiconductor, Inc. are located at 3003 North First Street, Suite 330, San Jose, California 95134. Pixelplus Semiconductor, Inc. occupies 1,043 square feet of office space, which serves as our U.S. headquarters for sales and marketing and research and development, and we pay a monthly rent of US$1,600 pursuant to a lease that is renewable on a semi-annual basis until November 2008. We believe that the existing facilities of Pixelplus Semiconductor, Inc. are adequate for its current requirements and that additional space can be obtained on commercially reasonable terms to meet its future requirements.

 

Legal Proceedings

 

On June 10, 2005, we received a letter from MagnaChip asserting that one of our 1.3 megapixel CMOS image sensors infringes two of MagnaChip’s Korean patents. We have reviewed these two patents and we do not believe there is a valid claim against us under either of the patents. On July 29, 2005, we sent a response letter to MagnaChip requesting a further elaboration of the claims mentioned in its original letter and a specific identification of the areas of alleged infringement. On August 8, 2005, MagnaChip sent a follow-up letter to us continuing to assert the claims of patent infringement, along with alleged technical support material for its claims. On November 14, 2005, we initiated cancellation proceedings in KIPO to invalidate both of the subject patents of MagnaChip. We plan to vigorously defend ourselves against any claim that may ensue from these allegations.

 

On October 31, 2004, we filed a claim with the Suwon District Court against Maxon, our fourth largest customer in terms of sales in 2004, for unpaid accounts receivables in the amount of (Won)1,392 million (US$1.3 million). On January 14, 2005, the court awarded a judgment in our favor of the full amount of our claim. However, Maxon has not paid the judgment awarded to us due to recent deterioration of its financial condition. In response, we have joined the Council for Commercial Creditors of Maxon, which has been voluntarily formed by the creditors of Maxon, and have designated this Council to negotiate a settlement on our behalf. We have provisioned 100% of the amount awarded by the court after recognition of translation loss, or approximately (Won)1,250 million (US$1.2 million), as an allowance for doubtful accounts.

 

On March 22, 2005, Telson, one of our customers, was declared bankrupt by the Bankruptcy Division of the Seoul Central District Court. As a result, a court administrator was appointed to liquidate Telson, and we have filed our claims in the amount of (Won)191 million (US$0.2 million) with the administrator in April 2005. We have written off the entire amount of (Won)191 million.

 

Except for the legal proceedings described above related to our customers, we are not currently involved in any material litigation and we are not subject to any pending or threatened litigation or similar proceedings which could reasonably be expected, if decided adversely to us, to have a material adverse effect on our financial condition or results of operations.

 

Insurance

 

We maintain medical and accident insurance for our employees to the extent required under Korean law. We also maintain fire insurance for our principal office in Korea. We also maintain a key-man insurance policy for any death or extraordinary disability of six members of our senior management. Under the key-man insurance policy, we may claim an amount between approximately (Won)200 million (US$0.2 million) to (Won)300 million (US$0.3 million) for the death or extraordinary disability of any covered executive officer which causes the termination of such officer’s employment. We also maintain directors and officers insurance for our directors and members of senior management.

 

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MANAGEMENT

 

Directors and Executive Officers

 

Board of Directors

 

Our board of directors has the ultimate responsibility for the administration of our affairs. Our articles of incorporation, as amended and to be effective on the execution date of the underwriting agreement for this offering, provide for a board of directors comprised of not less than five directors. The directors are elected at a shareholders’ meeting by a majority vote of the shareholders present or represented, so long as the quorum is met by a representation of not less than one-third of all issued and outstanding shares with voting rights. Our directors are not required to hold any of our shares to be qualified to serve on our board of directors.

 

Each of our directors is elected for a term of three years. However, if a director’s term expires after the end of a fiscal year but prior to the annual general meeting of shareholders convened in respect to such fiscal year, then such director’s term shall be extended until the close of such annual general meeting of shareholders. In addition, directors may serve any number of consecutive terms and may be removed from office at the recommendation of the nomination committee in accordance with corporate governance guidelines by a special resolution adopted at a general meeting of shareholders.

 

The board of directors elects one director from its members to serve as the representative director. The representative director is authorized to represent and oversee the operation of our company. In addition, the representative director is the chairman of the board of directors.

 

Under the Korean Commercial Code and our articles of incorporation, any director with a special interest in an agenda item of any board meeting may not vote on such item at the board meeting.

 

Directors and Executive Officers

 

The following table sets forth the name, age, position and first appointment date of our directors and executive officers:

 

Name


   Age

  

Position


  

Date First Elected

or Appointed


Seo Kyu Lee

   46    President, Chief Executive Officer, and Director (Representative Director)    April 12, 2000

Sang Soo Lee

   46    Chief Technology Officer, Executive Vice President, and Director   

December 1, 2004 (officer);

June 30, 2005 (director)

Moon Sung Kim

   50    Chief Financial Officer, Senior Vice President, and Director   

February 21, 2005 (officer);

June 30, 2005 (director)

Dongwoo Chun

   60    Independent Director    October 14, 2005

Ha Jin Jhun

   47    Independent Director    October 14, 2005

Choong-Ki Kim

   63    Independent Director    October 14, 2005

Taek Jin Nam

   38    Independent Director    October 14, 2005

Euy Hyeon Baek

   41    Vice President    October 23, 2000

Ou Seb Lee

   46    Vice President    December 26, 2001

Chang Hyun Rho

   46    Vice President    March 15, 2004

Jawoong Lee

   47    Technical Director    November 1, 2005

Sung Su Lee

   37    Technical Director    August 21, 2000

 

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Executive Directors

 

Seo Kyu Lee is one of our founders and has served as our chief executive officer, president, representative director and chairman of the board of directors, since April 2000. Mr. Lee received a bachelor’s degree in physics and electronic engineering from Sogang University in 1985, a master’s degree in electrical engineering from Yonsei University in 1993 and a Ph.D. in electronic and electrical engineering from Pohang University of Science & Technology in 1997. He started his career as an engineer at LG Semiconductor Co., Ltd., or LGS, in 1984, and served in its CCD development division as design team leader and CCD research and development team leader and later as CMOS image sensor project leader until 2000.

 

Sang Soo Lee has served as our executive vice president and chief technology officer and as the president of Pixelplus Semiconductor Inc., our U.S. subsidiary, since December 2004, and as our director since June 2005. Mr. Lee received bachelor’s and master’s degrees in electronic engineering from Sogang University in 1982 and in 1984, respectively, and a Ph.D. in electrical and computer engineering from Carnegie Mellon University in 1993. He started his career as a device and process engineer at LGS in 1984 and has worked with Micro Linear Corp. in San Jose, California and DataPath System in San Jose, California. Before joining us, he served as director of engineering at LSI Logic Corp. in Milpitas, California from 2000 to 2004.

 

Moon Sung Kim has served as our chief financial officer and senior vice president since February 2005 and as our director since June 2005. Mr. Kim received a bachelor’s degree in business administration and an MBA from Washington State University in 1981 and 1984, respectively. He started his career at Mitsui Co., Ltd. in Portland, Oregon in 1984 and then worked with Citibank Seoul, Standard Chartered Bank Seoul, and Credit Agricole Indosuez in Seoul and in its regional headquarters in Singapore as head of corporate banking and as the head of the Korea Desk. Before joining us, Mr. Kim served as Group Chief Financial Officer of Kumgang Korea Chemical Co., Ltd., Korea’s largest diversified manufacturer of paint, glass and building materials, from 1998 to 2005.

 

Independent Directors

 

As of the date of this prospectus, we have applied to have our ADSs listed for quotation on the Nasdaq National Market and, upon approval, we expect to be subject to the Nasdaq listing requirements applicable to listed foreign companies. Under the Nasdaq listing requirements, we are required to appoint a minimum of three independent directors, unless we receive an exemption from Nasdaq to appoint a lesser number. The independence standards under the Nasdaq rules exclude, among other things, any person who is a current or former employee of a company, either for the current year or in the past three years, or of any of its affiliates, as well as any immediate family member of an executive officer of a listed company or of any of its affiliates. Dongwoo Chun, Ha Jin Jhun, Choong-Ki Kim and Taek Jin Nam, representing a majority of the members of our board of directors, are our independent directors as required by the Nasdaq Stock Market, Inc. Marketplace Rules.

 

Dongwoo Chun has served as our independent director since October 14, 2005 . Mr. Chun received a bachelor’s degree in 1967, a master’s degree in 1969 and a Ph.D. in electronic engineering in 1976, from Seoul National University, University of California, Berkeley and University of Texas, Austin, respectively. He started his career as a senior engineer at Hewlett-Packard Company in 1975 and served in various senior engineer and management roles with Hyundai Electronics Industries Co., Ltd., LGS, and Silicon Magic Inc. From 2000 to 2001, he served as a vice president of the operations and image processing department at Cirrus Logic, Inc. He then served as a statutory auditor at DongbuAnam from 2002 to 2005. Mr. Chun is currently an independent director of LG-Philips LCD Co., Ltd. and has served in such position since 2005.

 

Ha Jin Jhun has served as our independent director since October 14, 2005. Mr. Jhun received a bachelor’s degree in industrial engineering from Inha University in 1984 and an MBA degree from Yonsei University in 1996. From 1998 to 2001, Mr. Jhun served as the chief executive officer of Haansoft Inc., one of the largest computer software company in Korea. From 2001 to 2003, he served as the chief executive officer of

 

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Netian, Inc., an internet portal company. Mr. Jhun currently serves as the chief executive officer of both INKE Corporation, a globalization consulting firm for Korean venture companies, and BonWave, Inc., a software company, since 2005.

 

Choong-Ki Kim has served as our independent director since October 14, 2005. Mr. Kim received a bachelor’s degree in 1965 from Seoul National University, a master’s degree and a Ph.D. in electrical engineering from Columbia University in 1967 and 1970, respectively. He started his career in 1970 as a member of the research staff and a section head at Fairchild Research and Development Laboratory in Palo Alto, California and has served with Korea Electronics Technology Institute and Microelectronics Center of North Carolina. From 1994 to 2003, he served as a director at the Centre for Electro Optics. Mr. Kim has been a professor of electrical engineering and computer science department at Korea Advanced Institute of Science and Technology since 1975 and served as its vice president from 1995 to 1998.

 

Taek Jin Nam has served as our independent director since October 14, 2005. Mr. Nam previously served as our statutory auditor from April 2003 to October 14, 2005. He received a bachelor’s degree in business administration from Korea University in 1988 and is currently a partner at Mirae Accounting Corp., an independent accounting firm in Korea.

 

Executive Officers

 

Euy Hyeon Baek has served as our vice president since October 2000. From March 2004 to June 2005, Mr. Baek served as our director. Mr. Baek received a bachelor’s degree in computer science from Korea National Open University in 2000 and he is currently enrolled in an MBA program at Ajou University. He started his career as an engineer at LGS’s CCD development team in 1987, and also served as a manager in various CCD development teams at LGS. He served as a manager at Hyundai Micro-Electronic Ltd. from 1999 to 2000.

 

Ou Seb Lee has served as our vice president since March 2004. From March 2004 to June 2005, Mr. Lee served as our director. Mr. Lee received a bachelor’s degree in physics from Sogang University in 1985, a master’s degree in electrical engineering from Manhattan College in 1989, and a Ph.D. in electrical engineering from Polytechnic University in 1994. Before joining us, he served as an associate professor at Hanshin University from 1996 to 2003.

 

Chang Hyun Rho has served as our vice president since March 2004. Mr. Rho received a bachelor’s degree in electrical engineering from Kyungbook National University in 1982. He started his career at Hyundai Electronics in 1984 and served in various senior sales and marketing positions until 2001. From 2001 to 2004, Mr. Rho served as the vice president of marketing and sales at ASE Korea Co., Ltd., which subsequently became Motorola Korea Co., Ltd.

 

Jawoong Lee has served as our technical director since November 2005. Mr. Lee received a bachelor’s degree in electronic engineering and a master’s degree in physics from Seoul National University in 1980 and 1984, respectively, and a Ph.D. in electrical and electronic engineering from Pohang University of Science and Technology in 1993. Before joining us, he was a visiting scientist at NanoStructures Laboratory (Research Laboratory of Electronics) at the Massachusetts Institute of Technology from 1997 to 1998, a professor of electronic engineering at Sunchon National University from 1994 to 2002, and an assistant professor of computational sciences at the Korean Institute for Advanced Study from 2004 to 2005. Mr. Lee also served as the chief technology officer of LeeScope, Inc., an optical imaging company, in 2001.

 

Sung Su Lee is one of our founders and has served as our technical director since January 2004. Mr. Lee has a bachelor’s degree and master’s degree in electronic engineering from Pohang Institute of Science and Technology in 1993 and 1995, respectively. He started his career as multi-media processor designer at LGS in 1995 and also served as CD player photo detector designer and LCD/PDP drive designer at LGS from 1996 to 2000. Mr. Lee first joined us in August 2000, and since then, he has helped design many of our CMOS image sensors including our VGA, CIF, UXGA, NTSC/PAL products and our CIS and JPEG encoder.

 

 

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The business address of each of our directors and executive officers is our principal executive office at 5th Floor, Intellige I, KINS Tower, 25-1 Jeongja-dong, Bundang-gu, Seongnam-si, Gyeonggi-do 463-811, Korea. None of our directors or officers has a family relationship with another.

 

Committees of the Board of Directors and Corporate Governance

 

Under the Korean Commercial Code, a company may establish committees under its board of directors in accordance with its articles of incorporation. The board of directors may delegate its authorities to such committees, except for the authorities to submit the agenda for general meetings of shareholders, to elect and/or remove the representative director and to establish committees and elect and/or remove the members thereof, in addition to other authorities stipulated in the articles of incorporation. The committees are required to notify each director of all resolutions and recommendations adopted by such committees, and any director so notified may demand a meeting of the full board of directors to review the resolution or recommendation adopted by the committees and report on and finally resolve on the matters in questions de novo. Pursuant to the Korean Commercial Code, any committee under the board of directors must consist of two or more directors, while the audit committee must consist of at least three directors.

 

Under our articles of incorporation, we currently have three committees that serve under our board of directors:

 

    the audit committee;

 

    the compensation committee; and