UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

Form 10-K/A

(Amendment No. 2)

 

 

Commission File Number 1-33403

 

 

 

 

SIPEX CORPORATION

(Exact name of registrant as specified in its charter)

 

 

Registrant’s telephone number, including area code:

(408) 934-7500

 

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

None

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

Common Stock, par value $0.01 per share

 

Name of exchange on which registered:

The Nasdaq Capital Market

 

 

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

 

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

 

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

 

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

 

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

 

Large accelerated filer o  Accelerated filer o  Non-accelerated filer þ

 

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

 

The aggregate market value of the voting and non-voting common stock held by non-affiliates of the issuer as of the last business day of the registrant’s most recently completed second fiscal quarter (July 1, 2006) was approximately $57,570,000 based upon the last reported price on the Pink Sheets of $5.98 per share. The number of shares outstanding reflects a 1-for-2 reverse stock split effected by the Registrant on February 23, 2007.

 

The number of shares of the registrant’s common stock outstanding on June 18, 2007 was 18,899,680 shares.

TABLE OF CONTENTS

 

EXPLANATORY NOTE

 

We are filing this Amendment (“Amendment No. 2”) to our Form 10-K for the year ended December 30, 2006, as originally filed with the Securities and Exchange Commission (the “SEC”) on March 30, 2007 (the “Original Filing”) and as previously amended by the Form 10-K/A (“Amendment No. 1”) filed with the SEC on April 19, 2007 (the Original Filing, as so amended, the “2006 Form 10-K”) to amend the following:

 

 

As a result of this amendment, we are also filing the certifications pursuant to Section 302 and Section 906 of the Sarbanes-Oxley Act of 2002 as exhibits to this Amendment No. 2.

 

Except as otherwise expressly stated for the items amended in this Amendment No. 2, this Amendment No. 2 continues to speak as of the date of the Original Filing and we have not updated the disclosure contained herein to reflect events that have occurred since the date of the Original Filing. Accordingly, this Amendment No. 2 should be read in conjunction with our Original Filing and Amendment No. 1 and our other filings made with the SEC subsequent to the date of the Original Filing.

 

The following discussion should be read together with our consolidated financial statements and the related notes contained elsewhere in this annual report on Form 10-K.

 

Significant Developments

 

In December 2006, we announced a workforce reduction plan that was implemented in response to our transitioning to a fabless semiconductor company, de-emphasizing optical products, reducing dependency on commodity products and with the goal of improving our cost structure. As a result, we recorded total restructuring costs of $1.1 million related to employee severance compensation, including $0.1 million for vesting acceleration of stock options in lieu of a severance payment for a senior executive officer. Of the $1.1 million, $0.1 million was paid during December 2006. Our current business plans focus our product development and marketing programs toward a greater emphasis on our power management and interface products as we believe these products align greater development synergies and provide greater opportunities for growth and profitability in contrast to other areas such as our optical products.

 

On September 20, 2006, we announced that we had received a notification from the Staff of the SEC that the investigation into matters related to our historical financial reports and revenue recognition practices had been terminated, and no enforcement had been recommended to the SEC with respect to the Company.

 

On September 8, 2006, we announced the appointment of Pierre Guilbault, Dan Casey, both members of the senior management team of Future, an affiliate of our largest stockholder, and Alan Krock, CFO of PMC Sierra, to our board of directors.

 

Based upon our plans initially announced in the third quarter of 2005, in early October of 2006, we completed the shut down of our Milpitas wafer fabrication operations. The products that we formerly manufactured at the Milpitas fab are now manufactured by our wafer fab partner Silan and a wafer fab operated by Episil. We anticipate the financial impact of this transition will require multiple quarters to be realized in our operating results as we sell through higher cost inventory manufactured at our Milpitas fab. The conversion to a fully fabless manufacturing model along with the use of third-party foundries should enable us to minimize fixed costs and capital expenditures

while providing access to diverse manufacturing technologies without bearing the full risk of the obsolescence of such technologies.

 

In conjunction with our previously announced internal investigation and restatement (as described in our annual reports on Forms 10-K for the year ended December 31, 2005), we were not in compliance with Nasdaq’s Marketplace Rule 4310(c)(14) because we did not timely file the annual report on Form 10-K for the year ended January 1, 2005 and quarterly report on Form 10-Q for the three months ended April 2, 2005. On June 21, 2005, a Nasdaq Listing Qualifications Panel, or the Panel, notified us that the Panel had denied our request for continued inclusion on the Nasdaq Global Market. Our common stock was delisted from the Nasdaq Global Market effective with the beginning of trading on June 23, 2005.

 

On August 17, 2006, we announced the completion of our restatement of our financial statements for the fiscal year 2003 and related fiscal quarters of 2003 as well as completing the restatement of the first three quarters of 2004. In addition, we filed our 2004 Annual Report on Form 10-K and 2005 Annual Report on Form 10-K along with our 2005 Quarterly Reports on Forms 10-Q.

 

On September 21, 2006, we filed our Forms 10-Q Quarterly Reports with the SEC for the first and second quarters of 2006. Together with these reports, along with our Form 10-K/A and Form 10-K for 2005, our Form 10-K for 2004 and our Forms 10-Q for 2005, we became current with our periodic SEC reporting requirements.

 

Business Overview

 

We design, manufacture and market, high performance, analog ICs that are used primarily by OEMs, operating in the computing, consumer, communications and networking infrastructure markets. Some of the end product applications that contain our ICs are cellular phones, base stations, computers, DVD players, and digital cameras. Our products fall into three major product families: power management, interface and optical storage.

 

We focus on several key areas to drive operating and financial performance, including product mix, new product introductions, cost reductions, manufacturing yield improvements and productivity. All of these key areas are interrelated and important in achieving improved gross margin.

 

Product mix between our three product families and the sale of new products within each of our product families can significantly impact overall gross margin. Power management product margins have a wide range depending on the mix of sales within this product family. The very high volume commodity products sold into the Asian market, such as power regulators, typically have lower product margins. By contrast, our advanced power management product offerings, such as white LED (light emitting diode) drivers, and our Power Blox^tm family, are newer products, and contribute typically higher product margins. Many Interface products are commodity products as well, but overall the product family typically has more moderate margins, because of our higher margin multi-protocol interface products and our newer low-voltage interface products. Optical storage product margins are typically within range of our average product margin. The products in this family are typically proprietary, but alternative suppliers have introduced competitive solutions.

 

Capacity utilization of our wafer fabrication facility in Milpitas, California was historically an important factor in driving gross margin improvement. In the past, a large portion of our fabrication cost structure was fixed, such as depreciation and payroll expense for process engineering and manufacturing support, and this structure provided for lower per unit costs as the volume of completed wafers increased. In the third quarter of 2005, we decided to outsource all of our wafer fabrication operations and in October 2006, we completed the shut-down of our Milpitas, California wafer fabrication facility. We believe that this transition to an outsourced or “fabless” manufacturing model will improve the overall margins of our interface and certain of our commodity market power management products which we historically manufactured at the Milpitas facility. However, because of this transition away from a fixed cost structure in a captive wafer fab, we may not recognize the same decrease in per unit manufacturing costs as production volumes increase.

 

Cost reductions and productivity improvements are required in order to remain competitive in our marketplace. Cost reductions are achieved in several ways, such as re-designing the products to “shrink” the size of the “die” providing more individual products per wafer produced. This generates increased output without adding

significant incremental cost. Other cost reductions and productivity improvements come through product assembly and test yield improvements and test time reductions.

 

New product introductions represent a key driver of opportunities to improve our product margins. New products are typically proprietary in nature and therefore command a stronger market position and we typically have higher product margins. In 2006, we introduced 69 new products, 15 of which were proprietary in nature. We continuously strive to improve our product mix toward higher margin products by eliminating older legacy products and by focusing on increasing sales of our newer products introduced in our three core product families. Net sales of our three core product families were $78.7 million, $72.1 million, and $74.7 million in 2006, 2005 and 2004, respectively. Net sales attributed to legacy products were $0.1 million, $0.6 million, and $0.8 million in 2006, 2005 and 2004, respectively.

 

Our wafer fabrication operation in Milpitas produced approximately 45%, 84% and 81% of our wafer requirements in 2006, 2005 and 2004, respectively. Our wafer fabrication utilization in Milpitas was 58%, 56%, and 62% in 2006, 2005 and 2004, respectively. Wafer production declined by 20%, 12% and 10% in 2006, 2005 and 2004, respectively, as compared to each prior year.

 

Critical Accounting Policies and Estimates

 

The discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, we evaluate our estimates, including those significant estimates that are particularly susceptible to change, which include revenue recognition, inventory valuation, restructurings and impairments, and income taxes. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. There can be no assurance that actual results will not differ from those estimates.

 

We have identified the accounting policies below as the policies most critical to our business operations and the understanding of our results of operations. The impact and any associated risks related to these policies on our business operations is discussed throughout Management’s Discussion and Analysis of Financial Condition and Results of Operations where such policies affect our reported and expected financial results.

 

Revenue Recognition.  We recognize revenue in accordance with SEC Staff Accounting Bulletin (“SAB”) 104, “Revenue Recognition.” SAB 104 requires that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services rendered; (3) the fee is fixed or determinable; and (4) collectibility is reasonably assured.

 

Prior to January 1, 2004, we entered into arrangements that were not within the original contractual distributor agreements in that we allowed return rights and other concessions beyond the levels provided in the distributor agreements. As a result, our management concluded it is unable to reasonably estimate sales returns for arrangements with its distributors; accordingly, effective January 1, 2003, sales and related cost of sales on shipments to distributors are deferred until the resale to the end customer.

 

Sales to Future are made under an agreement that provides protection against price reductions of Sipex’s products in Future’s inventory. In addition, Future has stock rotation rights. Pursuant to these stock rotation rights, Future is permitted on a quarterly basis to return for credit up to 5% of its total purchases during the most recent three-month period (reduced from 10%, effective April 1, 2006). In addition, effective April 1, 2006, Future is permitted a quarterly scrap allowance credit against accounts receivable for up to 2% of the most recent three-month purchases when they provide evidence of destruction of inventory of Sipex products up to this quarterly amount. As the price of products sold to Future is not fixed or determinable until resold by Future to the end customer, Sipex is using sell-through revenue accounting and deferring recognition of such sales and related cost of goods sold until the product is sold by Future to its customers.

 

Under sell-through revenue accounting, accounts receivable are recognized and inventory is relieved upon shipment to the distributor as title to the inventory is transferred upon shipment; at which point we have a legally enforceable right to collection under normal terms. The associated sales and cost of sales are deferred by recording “deferred income” (gross profit margin on these sales) as shown on the face of the consolidated balance sheet. When the related product is sold by our distributors to their end customers, we recognize previously deferred income as sales and cost of sales.

 

For non-distributor customers, we recognize revenue when title to the product is transferred to the customers, which occurs upon shipment or delivery, depending upon the terms of the customer order, provided that persuasive evidence of a sales arrangement exists, the price is fixed and determinable, title has transferred, collection of the resulting receivables is reasonably assured, there are no customer acceptance requirements, and there are no remaining significant obligations. Provisions for returns and allowances for non-distributor customers are provided for at the time product sales are recognized. An allowance for sales returns and allowances for customers is recorded based on historical experience or specific identification of an event necessitating an allowance.

 

From time to time, we develop custom products for various customers under engineering service contracts culminating in delivery of known functional development samples. We recognize revenue under these agreements upon delivery of known functional development samples as delivery of such represents the culmination of utility of the contract to the customer and agreed to milestones. We recognize the costs as incurred associated with these contracts and present such costs as research and development expenses due to the uncertain nature of the development efforts until delivery of the known functional development samples. Certain of these engineering service contracts include payments in advance of delivery of known functional development samples. These payments are recorded in deferred income, other, until the time of delivery of the functional samples.

 

Valuation of Inventories.  Sipex writes down the value of its inventories for estimated excess quantities, obsolescence, and/or marketability deficiencies. In addition, we write down inventory costs to the lower of cost or market which becomes the new cost basis. Excess and obsolete inventories are determined by comparing current inventory quantities to current backlog, anticipated future demand and shipment history. We also evaluate the net realizable value of inventories to be acquired under purchase commitments with our wafer foundries. If such inventories are also considered to be excess when compared to future demand, we record reserves and charges to cost of sales for these purchase commitments. Lower of cost or market adjustments are determined by reviewing shipments during the quarter as well as quarter beginning backlog and comparing standard cost to anticipated market pricing. In estimating anticipated market pricing, we also consider current market conditions, industry performance, distributor inventory levels and sales to end-users and other relevant factors. If actual market conditions become less favorable than those anticipated by management, additional write-downs of inventories may be required in the future. Inventories, which had previously been written down to zero, with an original cost of $1.4 million, $1.0 million and $0.9 million, were sold in 2006, 2005 and 2004, respectively. The Company recorded inventory write-downs for excess and obsolete inventories of $5.0 million, $5.0 million and $8.6 million, during 2006, 2005 and 2004, respectively. In addition, during 2006, the Company recorded $1.4 million of charges to cost of sales for purchase commitments for excess inventories.

 

Restructuring and Fixed Asset Impairment.  The determination of the estimated restructuring accrual and impairment requires significant management judgment. To estimate the restructuring accrual, we prepare a plan that includes the number of employees to be terminated and the related severance cost, the amount of impairment for certain fixed assets, the termination costs of certain leases and the related actions required to execute the plan. It is possible that future events such as voluntary employee terminations, sublease agreements or a shift in the timing of the execution of the plan could result in significant changes to the original estimate.

 

We account for restructuring charges in accordance with SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” which requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of commitment to an exit or disposal plan. The restructuring reserve represents the present value of future lease payments subsequent to abandonment less any estimated sublease income net of associated costs. However, due to the uncertainty of collectibility, our sublease income is recorded on a cash basis.

 

In December 2006, our board of directors approved a plan to reduce the workforce by approximately 75 positions. This reduction was part of a strategic restructuring plan implemented in response to our transition to a fabless semiconductor company and in an effort to de-emphasize optical products, reduce dependency on our commodity products and with a goal to improve cost structure. As a result, we recognized restructuring charges of approximately $1.1 million in the fourth quarter of 2006 related to this plan representing severance costs for the reduction in our workforce.

 

We review long-lived assets and certain identifiable intangibles for impairment in accordance with the guidelines of SFAS No. 144 “Accounting for Impairment of Disposal of Long Lived Assets” whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net undiscounted cash flows expected to be generated by the asset. If impairment is indicated, the impairment to be recognized is measured by the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of are reported at the lower of the carrying amount or fair value less cost to sell. In estimating future net cash flows, management makes certain assumptions including future sales levels, gross profit margins and expense levels and proceeds from disposition. The future net cash flows can vary from original management estimates due to unforeseen circumstances that may result in additional impairment charges required to be recognized in the income statement.

 

In the second quarter of 2005, we tested our wafer fabrication asset grouping, for which cash flows from the wafer fabrication operations provide the lowest level of cash flows that are largely independent of the cash flows of our other assets and liabilities, for recoverability in accordance with SFAS No. 144 given that we believed that there was a significant decline in the market price of the asset grouping. An impairment loss of $9.4 million was recognized, representing the difference between the carrying value and the fair value of the wafer fabrication asset grouping.

 

In August 2005, our board of directors approved terminating the wafer fabrication operations and the sale of the related assets. Also in August 2005, we identified a potential buyer, Silan, who would purchase, take title to and be trained to use a substantial portion of our wafer fabrication asset grouping by the end of the third quarter of 2006. Accordingly, we continued to use the wafer fabrication assets until September 2006 and recorded depreciation expense based on the estimated remaining useful life at the time of impairment.

 

In September 2005, we tested our Milpitas corporate headquarters facility given that we believed that there was a significant decline in the market price of the facility and determined that the carrying amount might not be recoverable. Our headquarters facility housed the wafer fabrication operations as well as the sales and marketing department, the research and development department and the corporate administration functions. Our Milpitas corporate headquarters facility does not have identifiable cash flows that are largely independent of our cash flows of other assets and liabilities. Accordingly, our Milpitas corporate headquarters facility, which includes all assets located at the Milpitas facility except for the wafer fabrication asset grouping, is included in the asset grouping which includes all of our assets and liabilities. No impairment loss was recognized given the carrying value of all of our assets and liabilities was less than the fair value, determined based on the quoted market value of Sipex.

 

Income Taxes.  Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using statutory tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in earnings in the period that includes the enactment date.

 

In assessing the net realizable value of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become taxable. Management considers the scheduled reversals of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Based upon the level of historical taxable income and projections for future taxable income over the periods in which the deferred tax assets were deductible, management assessed that it is more likely than not that the deferred tax assets at December 30, 2006

will not be realized in the future. Therefore, we maintained a full valuation allowance against our deferred tax assets.

 

Results of Operations

 

For the periods indicated, the following table sets forth the percentages of net sales represented by the respective line items in our consolidated statements of operations.

 

 

Fiscal Year Ended December 30, 2006 compared to Fiscal Year Ended December 31, 2005

 

Net Sales.  The table in Note 16 to our consolidated financial statements shows details of our net sales by product family and geographic location for 2006, 2005 and 2004.

 

Net sales increased by 8.4% to $78.8 million for the year ended December 30, 2006, as compared to $72.7 million for the year ended December 31, 2005. The increase in net sales was due to a $6.1 million increase in net sales for the interface product family, and a $3.8 million increase in net sales for the power management product family, partially offset by a $3.3 million decline in net sales for the optical storage product family. The increase in net sales for the interface product family was driven by an increase in unit volume shipments, partially offset by a decline in average selling prices for this product family. The decline in average selling prices was driven by pricing pressures in the commodity related interface products. The increase in unit volume shipments was driven by gains in market share in this product category. The increase in net sales for the power management product family was driven by an increase in average selling prices as our mix of product sales shifted toward higher value proprietary products away from commodity power management products. The decline in net sales of our optical product family was driven by a reduction in unit volume shipments as certain product programs approached the end of their product life cycles.

 

Geographically during 2006, international net sales were $62.7 million or 80% of total net sales, as compared to $58.0 million or 80% in 2005. In 2006, sales in Japan declined by $4.7 million or 28%. This decline was principally driven by a decline in the optical storage product family. In Asia, other than Japan, net sales increased by $9.0 million or 35% related to growth in the interface and power management product families. Net sales in Europe and the rest of the world increased by $0.4 million or 2%, in 2006. Domestic net sales increased by $1.4 million or 9% in 2006.

 

Gross Profit (Loss).  Gross profit decreased to $9.4 million in 2006 or 12% of net sales, as compared to $13.7 million or 19% in 2005. The reduction in gross profit was partially driven by a decline in standard gross profit due to a mix shift toward higher volumes of lower margin commodity products resulting in approximately $1.5 million of gross profit reduction. The gross profit was further reduced by approximately $2.9 million of added manufacturing yield and price variances as well as additional inventory write-downs, purchase commitments on

excess inventories and warranty reserves of $1.4 million. These additional costs were partially offset by $1.0 million of lower manufacturing overhead spending variances and a $0.5 million recovery of previously paid royalty costs.

 

Research and Development.  Research and development expenses in 2006 were $17.3 million compared to $17.2 million in 2005. The increase of $0.1 million was primarily due to increased stock-based compensation expenses of $1.2 million (due to the adoption of SFAS 123R, effective January 1, 2006) along with higher salaries, benefits and employee travel costs of approximately $283,000 and higher spending on design automation software licenses of approximately $262,000. These higher costs were partially offset by reduced spending on prototype wafers and product development costs of approximately $650,000, an approximately $494,000 reduction in facilities costs, an approximately $324,000 reduction in outside design services costs and an approximately $200,000 reduction in depreciation expenses. As a percentage of net sales, research and development costs were 22.0% in 2006 compared to 23.7% in the prior year. This percentage reduction was due to the increase in net sales in 2006. We anticipate that research and development spending will decline in 2007, as we focus our research and development efforts in the power management and interface product families.

 

Marketing and Selling.  Marketing and selling expenses were $15.5 million in 2006 compared to $10.6 million in 2005. The increase of $4.9 million was primarily due to increased headcount resulting in higher salary and benefits costs of approximately $2,960,000, along with approximately $816,000 for stock-based compensation expenses (due to the adoption of SFAS 123R, effective January 1, 2006). In addition, the increased sales and marketing headcount resulted in an approximately $501,000 increase in travel costs. Finally, the increase in net sales drove an approximately $385,000 increase in sales commissions paid to independent sales representatives. These increases were primarily due to increased sales and marketing efforts to grow our net sales. Marketing and selling expenses were 19.7% of net sales in 2006 compared to 14.6% of net sales in 2005. This percentage increase was primarily driven by marketing and selling expenses increasing at a higher percentage rate than the increase in the net sales growth rate in 2006 along with the increase in expenses. We anticipate that marketing and selling expenses will decline in 2007, as we focus our efforts in the power management and interface product families.

 

General and Administrative.  General and administrative expenses were $13.5 million in 2006 compared to $14.4 million in 2005 or a decrease of $0.9 million. This decrease was principally due to a reduction in legal fees of approximately $1,706,000 associated with the completion of the internal investigation and resolution of related litigation, a reduction in audit and consulting fees of approximately $994,000 related to the completion of the financial restatement process filing our financial reports with the SEC, and a reduction in bad debt expense of approximately $340,000 associated with the collection of amounts previously reserved as bad debts. These expense reductions were partially offset by the inclusion of stock-based compensation expense of approximately $1,266,000 (due to the adoption of SFAS 123R, effective January 1, 2006) and higher salary and benefits costs of approximately $1.0 million. General and administrative expenses were 17.1% of net sales in 2006 compared to 19.8% of net sales in 2005. This percentage decrease was primarily driven by the reduction in these expenses along with an increase in net sales in 2006. We anticipate that general and administrative expenses will decline in 2007.

 

Restructuring and Fixed Asset Impairment.  During the year ended December 30, 2006, we incurred additional restructuring costs of $677,000 that related to employee retention payments for the closure of the wafer fabrication operations located in Milpitas, California, announced in August 2005. For employee costs, we utilized $1.4 million and recognized an accrual expense adjustment of $54,000. We recognized approximately $200,000 in expense for contract termination in the fourth quarter of 2006 associated with gas usage and service agreements with a vendor. For facility costs related to the Milpitas wafer fabrication closure, restructuring charges utilized during 2006 totaling $91,000 was for facility decontamination. Additionally, the Company incurred $116,000 of facility costs related to the unused fabrication portion of the Company’s corporate headquarters facility in Milpitas, California, due to the transfer of wafer fabrication to Silan.

 

In the fourth quarter of 2006, we announced a workforce reduction plan that was implemented in response to our transitioning to a fabless semiconductor company, de-emphasizing optical products, reducing dependency on our commodity products and with a goal of improving cost structure. As a result, we recorded total restructuring costs of $1.1 million related to employee severance compensation, including $0.1 million for vesting acceleration of stock options in lieu of a severance payment to a senior executive officer. Of the $1.0 million (excluding the stock-based compensation charge), $0.1 million was paid during December 2006.

 

In 2006, we utilized restructuring accruals of $726,000 for the unused portion of the Billerica facility. The adjustment to the accrual for the Billerica facility primarily related to sub-lease income of $565,000 being received.

 

As of December 30, 2006, the balance of the restructuring accrual principally consisted of employee severance costs, contract termination costs and facility lease costs, which are anticipated to be paid over the next 15 months. The balance of the accrual as of December 30, 2006 was $1.8 million, of which $1.7 million was the short-term portion and $0.1 million was the long-term portion.

 

The following is a summary of the activities related to accrued restructuring costs and fixed asset impairment for fiscal years 2006 and 2005 (in thousands):

 

 

Other Income (Expense), Net.  Other income (expense), net was $2.2 million of net other expense in 2006 compared to $0.6 million of net other income in the prior year. The increase in other expense, was primarily due to a $3.0 million increase in interest expense, $1.9 million of which related to the convertible senior notes issued in May 2006 and $0.9 million of which related to the lease financing obligation executed in March 2006. The interest expense was partially offset by a $0.5 million increase in interest income attributable to higher balances of interest bearing cash equivalents and short-term investments from the proceeds of the convertible senior notes.

 

Income Tax Expense.  Our income tax expense primarily relates to our foreign operations as we continue to incur losses from domestic operations. In 2006, we recorded an income tax provision of $125,000, compared to a provision of $192,000 in 2005. Notwithstanding our net operating losses, we did not record a tax benefit as we believed that it was more likely than not, considering the level of historical taxable income and expectations for future taxable income, that the operating loss would not be utilized in the future.

 

Fiscal Year Ended December 31, 2005 compared to Fiscal Year Ended January 1, 2005

 

Net Sales.  Net sales decreased by 3.7% to $72.7 million for the year ended December 31, 2005, as compared to $75.5 million for the year ended January 1, 2005. The decrease in net sales was due to a $2.2 million decline in net sales for the power management product line and a $1.1 million decline in the interface product line, partially offset by a $0.8 million increase in the optical storage product line. The decrease in net sales of the power product line was driven by an overall softness in demand that led to a unit volume decline as well as a decline in average selling prices. The decline in demand for the commodity products was only partially offset by increasing demand for our proprietary power management products. The decline in net sales of the interface product line was driven by a decline in average selling prices while unit volume increased. The increase in net sales for the optical storage product line was primarily driven by an increase in unit volume as demand for these products was strong.

 

Geographically during 2005, international net sales were $58.0 million or 80% of total net sales, as compared to $60.3 million or 80% in 2004. In 2005, sales in Japan declined by $1.7 million or 9%. This decline was driven by

declines in power management and interface products off-set by increases in optical storage products. In Asia, other than Japan, net sales decreased by $1.3 million or 5% related to the declines in power management and interface. Net sales in Europe and the rest of the world increased by $0.7 million or 5%, in 2005. Domestic net sales declined by $0.5 million or 3% in 2005.

 

Gross Profit (Loss).  Gross profit increased to $13.7 million in 2005 or 19% of net sales, as compared to $11.8 million or approximately 16% in 2004. The improvement in gross profit was comprised of improvements in manufacturing yields lowering overall product costs as well as reductions in inventory write-downs for excess and obsolete products. These cost reductions were offset by recognition of $4.3 million of increased depreciation on the Milpitas, California facility after determination that the facility had a shorter economic useful life to Sipex recorded in the fourth quarter of 2005. The improvement in gross profit was comprised of the following: product mix, higher margins at standard cost due to manufacturing yield and process improvements.

 

Research and Development.  Research and development expenses in 2005 were $17.2 million compared to $14.7 million in 2004. The increase of $2.5 million was primarily due to increased product development costs for outside design services costs of approximately $893,000 and prototype wafers costs of approximately $665,000. In addition, approximately $1.1 million of increased depreciation for the reduction in the economic life of the Milpitas, California facility was recorded in 2005. As a percentage of net sales, research and development costs were 23.7% in 2005 compared to 19.5% in the prior year. This was primarily due to the increase in research and development expenses along with the lower net sales in 2005.

 

Marketing and Selling.  Marketing and selling expenses were $10.6 million in 2005 compared to $8.6 million in 2004. The increase of $2.0 million was primarily due to increased headcount resulting in higher salary and benefits costs of approximately $1,147,000, marketing activities and travel costs of approximately $440,000. In addition, approximately $313,000 of increased depreciation for the reduction in the economic life of the Milpitas, California facility was recorded in 2005. These increases were primarily due to increased sales and marketing efforts for our core product families. Marketing and selling expenses were 14.6% of net sales in 2005 compared to 11.4% of net sales in 2004. This was primarily due to the decline in net sales in 2005 as well as the increase in expenses.

 

General and Administrative.  General and administrative expenses were $14.4 million in 2005 compared to $9.8 million in 2004 or an increase of $4.6 million. This increase was principally due to increase of approximately $2,320,000 of legal fees associated with the internal investigation and related litigation, approximately $707,000 of consulting and audit fees related to the financial restatement process and approximately $400,000 of higher salary and benefits costs as well as bad debt expense of approximately $256,000. In addition, approximately $707,000 of increased depreciation for the reduction in the economic life of the Milpitas, California facility was recorded in 2005.

 

Restructuring and Fixed Asset Impairment.  During the year ended January 1, 2005, we incurred restructuring expenses reflecting the continuation of our plans initiated in 2003 to move our manufacturing operations from Billerica, Massachusetts to Milpitas, California. These restructuring expenses consisted of $1.4 million for future lease payments, $447,000 write-off of leasehold improvements and $32,000 for severance payments. For the same period, we utilized $1.0 million of restructuring reserves, which was primarily the $447,000 write-off of leasehold improvements, and $463,000 of lease costs associated with the unused portion of our Billerica facility. We made additional adjustments to the restructuring for changes to the lease obligation totaling $60,000. For the year ended January 1, 2005, the balance of the restructuring accrual principally consisted of facility lease costs, and was expected to be paid over the next three years. The balance as of the year ended January 1, 2005 was $1.8 million, of which $566,000 was the short-term portion and $1.3 million was long term portion.

 

In the second quarter of 2005, Sipex recognized a $9.4 million impairment charge for its long-lived assets. Based on changes in the planned use for its wafer fabrication assets and as we believed that there was a significant decline in the market price of the asset grouping, we performed an impairment evaluation in accordance with SFAS No. 144. Sipex determined that the appropriate grouping for this impairment evaluation was the wafer fabrication assets taken together and the associated cash flows for these assets. These assets were evaluated on a held-for-use basis as we were required to operate our wafer fabrication facility until new wafer fabrication partner processes were qualified. As the carrying value exceeded the undiscounted cash flows of the wafer fabrication assets for the period of planned use by us, an impairment charge was recorded for the difference between the carrying value and the fair value of the wafer fabrication assets. While we subsequently agreed to sell a substantial

portion of its wafer fabrication machinery and equipment to Silan by the end of the third quarter of 2006, the wafer fabrication assets remain in use and Sipex will continue to record depreciation expense based on the estimated remaining useful life at the time of impairment.

 

In August 2005, our board of directors approved a plan to close our wafer fabrication operations located in Milpitas, California and transfer the fabrication to Silan in China, Episil in Taiwan and other vendors to reduce costs and improve operating efficiencies. As a result, we recognized total restructuring charges of approximately $871,000 in the second half of 2005 including severance and retention benefits totaling $766,000 for approximately 70 employees and other exit costs of $105,000. In addition, during the third quarter of 2005, Sipex decided not to transfer the remaining operations in Billerica to Milpitas that was originally anticipated to be completed by the end of 2005. The adjustment to the restructuring accrual of $294,000 during 2005 primarily included exiting costs of $213,000, offset by sublease income of $293,000 and $195,000 recorded in the third quarter of 2005 as a reduction to future lease payment obligation for not transferring such remaining operations in Billerica. Sublease income is recorded on a cash basis due to the uncertainty of collectibility. The restructuring accrual balance as of December 31, 2005 consisted of a short-term portion of $1.4 million and a long-term portion of $584,000. The $2.0 million restructuring accrual balance included $1.2 million of facility lease costs to be paid out over the next two years and the remaining portion to be paid out in less than a year.

 

In November 2005, based on the previous decision to close our wafer fabrication operation located at the Milpitas, California headquarters facility, we decided to sell this facility. As a result of a decision, we reduced the remaining estimated depreciation life for our headquarters building and related improvements from 25 years to approximately four months. This change resulted in an increase in depreciation expense recorded in the fourth quarter of 2005 of $6.5 million (including $4.3 million included in cost of sales).

 

The following is a summary of the activity related to accrued restructuring costs and fixed asset impairment for fiscal years 2004 and 2005 (in thousands):

 

 

Other Income (Expense), Net.  Other income (expense), net was $0.6 million in 2005 compared to $185,000 in the prior year. The increase in other income (expense), net was attributable to higher interest income on short-term investments, other income and lower interest expense associated with the two convertible notes with Future (See Note 2 to our consolidated financial statements for Related Parties). Both convertible notes were extinguished and converted into 2.3 million of our common shares as of February 18, 2004.

 

Income Tax Expense.  Our income tax expense primarily relates to our foreign operations as we continue to incur losses from domestic operations. In 2005, we recorded an income tax provision of $192,000 in contrast to an income tax benefit of $133,000 in 2004 due to a reversal of the previously established expected tax liability from our off-shore operations, primarily Belgium. Notwithstanding our net operating losses, we did not record a tax benefit as we believed that it was more likely than not, considering the level of historical taxable income and expectations for future taxable income, that the operating loss would not be utilized in the future to offset taxable income.

 

Financial Condition, Liquidity and Capital Resources

 

As of December 30, 2006, cash, cash equivalents and short-term investments, were $15.4 million as compared to $2.0 million at December 31, 2005. The increase of $13.5 million was principally due to our net cash inflows from financing activities during 2006 of $43.5 million along with a reduction in restricted cash of $0.6 million, partially offset by our net cash outflows from operations of $27.9 million along with our cash payments for capital expenditures of $3.8 million. The two most significant sources of cash from financing activities were the net proceeds from our convertible debt offering completed in May 2006 of $28.7 million and the $12.6 million net proceeds from our lease financing obligation completed in March 2006.

 

Operating Activities

 

Net cash used in operating activities was $27.9 million, $17.4 million, and $8.9 million in 2006, 2005, and 2004, respectively. We will continue to depend upon our cash and cash equivalents to fund our operations until such time that we generate cash from operating activities.

 

Net cash used in operating activities of $27.9 million in 2006 resulted primarily from a $41.2 million net loss and the unfavorable impact of a $9.3 million net change in assets and liabilities, partially offset by $22.6 million of non-cash adjustments to net loss. The changes in assets and liabilities primarily included an increase in inventory of $7.0 million, an increase in accounts receivable of $1.3 million, decreases in accrued restructuring costs of $1.9 million and accrued expenses of $1.5 million, partially offset by an increase in accounts payable of $2.8 million, respectively. Non-cash adjustments primarily comprised depreciation and amortization of $9.4 million, a $5.0 million provision for inventories and $1.4 million purchase commitments on excess inventories, $3.8 million of stock-based compensation expense as a result of adopting SFAS No. 123R, effective January 1, 2006, a $1.6 million net provision for restructuring costs, a provision for uncollectible receivables and sales returns and allowances of $0.9 million, and $0.5 million for amortization of the notes payable discount and issuance costs.

 

Net cash used in operating activities of $17.4 million in 2005 resulted primarily from a $38.1 million net loss and the unfavorable impact of a $6.9 million net change in assets and liabilities, partially offset by $27.5 million of non-cash adjustments to net loss. The changes in assets and liabilities included an increase in inventory of $5.3 million, a decrease in accounts payable of $3.4 million, a decrease in deferred income of $1.2 million and a decrease in accrued restructuring costs of $433,000, partially offset by a decrease in accounts receivable of $1.7 million and an increase in accrued expenses of $1.4 million, respectively. The $1.2 million decrease in deferred income comprises of a decrease of $0.2 million from Future and a decrease of $1.0 million from other distributors. Non-cash adjustments primarily comprised depreciation and amortization of $11.0 million, $9.4 million of fixed asset impairment charges, and a $5.0 million provision for inventories, a provision for uncollectible receivables and sales returns and allowances of $1.5 million, and a $577,000 net provision for restructuring costs.

 

Net cash used in operating activities of $8.9 million in 2004 resulted primarily from a $22.7 million net loss and increase of $4.6 million in net assets and liabilities, partially offset by $18.5 million of non-cash adjustments to net loss. The changes in assets and liabilities included an increase in inventory of $5.4 million, an increase in accounts receivable of $0.9 million, a decreases in accrued restructuring costs of $608,000, partially offset by an increase in accrued expenses of $1.4 million, an increase of deferred income of $620,000 and an increase in accounts payable of $391,000. The $620,000 increase in deferred income comprises of an increase of $1.1 million from Future offset by a decrease of $449,000 from other distributors. Non-cash adjustments primarily comprised $8.6 million provision for inventories, depreciation and amortization of $6.6 million, provision for uncollectible receivables and sales returns and allowances of $1.3 million, and a $1.8 million net provision for restructuring costs.

 

Accounts receivable, net of allowances, was $7.2 million and $6.7 million as of December 30, 2006 and December 31, 2005, respectively. The allowances for accounts receivable decreased to $0.9 million for 2006 from $1.3 million for 2005 primarily due to lower sales allowances for product returns.

 

In 2006, we recorded inventory write-downs for excess and obsolete inventories of $5.0 million. Similarly, we recorded write-downs of $5.0 million and $8.6 million, in 2005 and 2004, respectively. In addition, during 2006, we recorded $1.4 million of charges to cost of sales for purchase commitments for excess inventories. Inventories

previously written off with an original cost of $1.4 million, $1.0 million and $0.9 million, were sold in 2006, 2005 and 2004, respectively.

 

In 2005, we began the transfer of our manufacturing processes to foundries operated by Silan in China and Episil in Taiwan in conjunction with the planned closure of our Milpitas, California wafer fabrication facility in 2006. The transfer has been a complicated and time-consuming process that has been met with significant unforeseen complications that delayed the integration transfer and required additional allocation of our resources. In 2006, we incurred approximately $1.6 million of manufacturing process transfer and qualification costs, as reflected in cost of sales. We anticipate that we will continue to incur similar costs in the future. There can be no guarantees that additional unforeseen integration issues will not arise in the future related to the integration that could cause additional delays which could materially adversely affect our ability to timely produce our products.

 

In addition, we may be unable to achieve all or any of the expected benefits of the relationship within the anticipated time-frames. The anticipated synergies between Sipex and Silan or Episil may not be as significant as originally expected. We may be unable to qualify the manufacturing processes and wafer testing following the transfer from Sipex to Silan or Episil or the qualification process may take significantly longer than currently expected. This could result in additional operating costs, loss of customers, and business disruption.

 

Investing Activities

 

Net cash used in investing activities in 2006 was $4.4 million, consisting of $8.0 million of purchases of short-term investment securities and $3.8 million of capital expenditures, partially offset by $5.6 million from the proceeds of maturities of short-term securities, $1.1 million for the sale of machinery and equipment and $593,000 from reductions in restricted cash.

 

Net cash provided by investing activities in 2005 was $209,000, consisting of $850,000 proceeds from maturities of short-term securities, $838,000 from reductions in restricted cash, offset by $878,000 of capital expenditures and $601,000 of purchases of short-term investment securities.

 

Net cash used in investing activities in 2004 was $1.0 million, consisting of $6.3 million purchases of short-term securities, purchase of property, plant and equipment of $1.9 million and $1.8 million of deposit to restricted cash to meet a contractual obligation with a vendor, mostly offset by the $9.0 million proceeds from maturity of short-term securities.

 

Financing Activities

 

Net cash provided by financing activities in 2006 was $43.5 million, resulting primarily from $28.7 million of net proceeds from the issuance of convertible senior notes and warrants, $12.6 million of net proceeds from lease financing obligation, $7.0 million of proceeds from related party borrowings, $3.4 million from the issuance of common stock upon the exercise of warrants relating to the 2006 convertible notes and employee stock option plans, and $2.0 million from the proceeds from bank borrowings. These cash inflows were partially offset by $7.0 million of repayments of related party borrowings, $3.0 million of repayments of bank borrowing in 2005 under our bank line of credit and $0.2 million of payments against our lease financing obligation.

 

Net cash provided by financing activities in 2005 was $3.7 million, resulting primarily from $3.0 million of borrowings under our bank line of credit and $0.7 million of net proceeds from issuance of common stock under employee stock option plans. As of December 31, 2005, we violated the tangible net worth covenant under our bank line of credit. However, the borrowings of $3.0 million were subsequently repaid in January 2006.

 

Net cash provided by financing activities in 2004 was $7.1 million, resulting primarily from $2.7 million of net proceeds from the exercise of warrants relating to the 2002 convertible notes and $4.4 million of net proceeds from issuance of common stock under employee stock option plans.

 

On July 21, 2005, we entered into a Loan and Security Agreement, with Silicon Valley Bank, and this agreement was subsequently amended on October 7, 2005, November 10, 2005, January 19, 2006, May 18, 2006, August 1, 2006 and September 28, 2006. The agreement currently provides for a secured revolving line of credit with an aggregate principal amount of up to $5,000,000, which may be used to borrow revolving loans or to issue

lines of credit on our behalf. We have granted to Silicon Valley Bank a security interest in all presently existing and later acquired collateral, including but not limited to goods, equipment, inventory, contract rights, and financial assets, in order to secure the obligations and duties under such loan and security agreement. Advances accrue interest on the outstanding principal balance at an annual rate, decided by us, either equal to Silicon Valley Bank’s prime rate or LIBOR rate (depending upon the interest period of one, two or three months selected by us) plus 2.75%. In addition to the $5,000,000 secured revolving line of credit, we can borrow under term loans in an aggregate amount not to exceed $2,000,000. Each term loan shall be in an amount not less than $500,000. The number of term loans shall not exceed two (2). Interest accrues from the date of each term loan at a rate of 9.25%. Each term loan shall be payable in thirty-six (36) equal monthly installments of principal plus accrued interest. When repaid or prepaid, the term loan may not be re-borrowed. As of December 30, 2006, the unused portion of our line of credit was $3,735,000, and a $2,000,000 term loan was outstanding.

 

The agreement with Silicon Valley Bank has been extended to September 29, 2007 at which time all outstanding advances must be repaid, and all outstanding letters of credit must be cash collateralized. The agreement requires us to comply with a minimum liquidity ratio of 2.50:1.00 at each fiscal quarter end. It also requires us to retain a minimum tangible net worth as of the last day of each fiscal quarter. The liquidity ratio is calculated as the sum of (i) Sipex’s unrestricted cash and cash equivalents, short-term marketable securities and 50% of consolidated Accounts divided by (ii) the Obligations. Sipex must maintain, as of the last day of each fiscal quarter set forth below, a tangible net worth of at least the amount set forth below for each fiscal quarter ending date. For purposes of this calculation, up to $5,000,000 in an aggregate amount of non-cash charges relating to inventory write-downs and/or restructuring charges may be added to tangible net worth. Fiscal quarter ending date: September 30, 2006, minimum tangible net worth: $600,000; fiscal quarter ending date: December 30, 2006, minimum tangible net worth (deficit): (-$5,500,000); fiscal quarter ending date: March 31, 2007, minimum tangible net worth (deficit): (-$10,000,000); fiscal quarter ending date: June 30, 2007, minimum tangible net worth (deficit): (-$13,000,000); Each fiscal quarter thereafter, minimum tangible net worth (deficit): (-$13,000,000) plus 50% of any positive net income (with no adjustment for losses) and 50% of any new equity raised. The agreement contains additional affirmative covenants, including, among others, covenants regarding the payment of taxes and other obligations, maintenance of insurance, reporting requirements and compliance with applicable laws and regulations. In addition, the agreement contains negative covenants limiting our ability to dispose of assets, change our business plans, be acquired or beneficially owned, merge or consolidate, incur indebtedness, grant liens, make investments, pay dividends, repurchase stock, and pay subordinated debt. The agreement contains events of default that include, among others, non-payment of principal, interest or fees, inaccuracy of representations and warranties, violations of covenants, bankruptcy and insolvency events, any material adverse change, material judgments, cross defaults to certain other indebtedness and seizure of assets. The occurrence of an event of default will increase the applicable rate of interest by 5.0% and would, unless waived by Silicon Valley Bank, result in the immediate payment of all of our obligations under the agreement. As of December 30, 2006, total borrowing with Silicon Valley Bank was $2.0 million, of which $667,000 was the short-term portion and $1.3 million was the long-term portion. If we are unable to satisfy the financial covenant requirements and to obtain a waiver from the bank, we may be required to repay the outstanding borrowing amounts and/or classify such amounts as short-term bank borrowing.

 

On January 19, 2006, we announced the completion of a $7.0 million private loan financing in which we issued a 9% secured note with convertible interest due January 19, 2008 to Rodfre, an affiliate of Future. The note was secured by a deed of trust on our headquarters property located in Milpitas, California. The holder of the note could require repayment of the loan in the event of, among other things, the sale of the property subject to the deed of trust.

 

On March 9, 2006, we entered into an Agreement for Purchase and Sale of Real Property with Mission West Properties, L.P. The agreement provides for the sale of Sipex’s Hillview facility to Mission West Properties, L.P. for a price of $13.4 million in cash (net proceeds of $12.6 million). We used the proceeds from the sale of our Hillview facility to pay off and terminate the $7.0 million loan with Future. The remaining balance of $6.4 million from the sale of the property was used for operating activities.

 

Simultaneously with the sale of the Hillview property in March 2006, we entered into a Standard Form Lease agreement to lease back the facility from Mission West Properties, L.P. The lease term is 60 months. In addition, we provided a security deposit of $1,265,000 in the form of an irrevocable standby letter of credit issued to Mission

West Properties, L.P. under our line of credit with Silicon Valley Bank. The security deposit is held as security for our faithful performance of the terms, covenants, and conditions prescribed under the lease agreement.

 

On May 16, 2006, we placed $30.0 million of 5.5% Redeemable Convertible Senior Notes due 2026, or the 2006 Notes, in a private placement. The 2006 Notes bear interest of 5.5% per year, payable semi-annually on May 15 and November 15 of each year, commencing on November 15, 2006, and mature on May 16, 2026. The 2006 Notes are convertible into common stock at any time at a fixed conversion price of $5.36 per share. If fully converted, the principal amount of the 2006 Notes would convert into approximately 5,597,015 shares of our common stock. At any time following the effectiveness of a registration statement related to the resale of the common stock issuable upon the conversion of the 2006 Notes, we may, subject to certain conditions, elect to automatically convert the 2006 Notes into common stock if the average price of our common stock exceeds 150% of the conversion price for at least 20 trading days during any consecutive 30 trading-day period, ending within 5 days of the notice of automatic conversion. We have the right to redeem the 2006 Notes at par plus accrued interest at anytime after May 15, 2009 and the purchasers have the right to require us to repurchase the 2006 Notes at par plus accrued interest on May 15 in 2011, 2016 and 2021.

 

The 2006 Notes are convertible into Sipex’s common stock at any time prior to maturity, initially at a conversion price of $5.36 per share, subject to adjustment upon certain events, including, among other things, dividends, stock splits and recapitalizations. If fully converted, the principal amount of the 2006 Notes would convert into 5,597,015 shares of the Company’s common stock.

 

The 2006 Notes contains certain covenants including a covenant restricting the amount of indebtedness that we can incur that is senior or pari passu with the 2006 Notes to an aggregate principal amount of $7.5 million, unless such restriction is waived by holders of over 662/3% of the principal amount of the 2006 Notes then outstanding. Additionally, an event of default would occur under the 2006 Notes for a number of reasons, including our failure to pay when due any principal, interest or late charges on the 2006 Notes, the default and acceleration of indebtedness with our bank and other lenders in amounts greater than $2.5 million, certain events of bankruptcy and our breach or failure to perform certain representations and obligations under the 2006 Notes. Upon the occurrence of an event of default, our obligations under the 2006 Notes may become due and payable in accordance with the terms thereof.

 

The 2006 Notes provide that since we were not current in our SEC filings by August 15, 2006, we incurred additional interest on the 2006 Notes at an annual rate of 1.5% for the period beginning August 16, 2006 through the date that our filings became current. The Company filed all its late Forms 10-K and 10-Q to the SEC by September 21, 2006. In addition, as our common stock is not listed on the Nasdaq Global Market, the New York Stock Exchange or another national exchange or automated quotation system by December 31, 2006, we will pay additional interest on the 2006 Notes at an annual rate of 1.5% for the period beginning January 1, 2007 through the date that our common stock becomes listed for trading on one of the national exchanges. Likewise, the Registration Rights Agreement entered into in connection with the 2006 Notes provides that since we have not filed a registration statement for the shares of our common stock issuable upon conversion of the 2006 Notes or exercise of the warrants issued in connection with the 2006 Notes as of August 15, 2006, we must pay additional payments to the noteholders equal to a per annum rate of 0.8% times the principal amount of the 2006 Notes for the period beginning on August 16, 2006 through the date that the registration statement is filed. However, we have to pay increased interest payments at an annual rate of 1.2% as the filing of the registration statement was delayed by over 60 days, and the registration statement was not declared effective by December 31, 2006. We have not filed a registration statement as contemplated in the Registration Rights Agreement. Our common stock is not listed on any one of the national exchanges. As a result of our failure to meet these conditions, we are effectively obligated to pay up to an additional 2.7% of interest on the notes and our current effective interest rate is 8.2% per annum. A more detailed description of the terms of the 2006 Notes is presented in Note 12 to our consolidated financial statements included in this 10-K filing.

 

On March 29, 2007, we entered into a Securities Purchase Agreement with Rodfre, an affiliate of Future, our largest distributor worldwide and an affiliate of our largest stockholder (Alonim Investment Inc.), to provide an unsecured promissory note facility of up to $10.0 million. This facility expires, and the borrowings and accrued interest under any notes issued under this facility are due and payable, on June 30, 2008, or upon certain other events such as a change of control. Borrowings under this promissory note facility bear interest of 9% per annum subject to

an increased interest rate of up to 20% in case of default or after maturity. This promissory note facility is subordinate to our Loan and Security Agreement with Silicon Valley Bank and to our 5.5% Redeemable Convertible Senior Notes due 2026.

 

Based on our current plans and business conditions, we believe that our existing cash, cash equivalents and short-term investments together with available borrowings under our bank line of credit and unsecured promissory note facility will be sufficient to meet our liquidity and capital spending requirements for at least the next twelve months. In addition, if desirable or necessary, we may seek to raise additional capital through the sale of debt or equity. There can be no assurances, however, that future borrowings and capital resources will be available on favorable terms or at all. Our cash flows are highly dependent on demand for our products, timing of orders and shipments with key customers and our ability to manage our working capital, especially inventory and accounts receivable, as well as controlling our production and operating costs in line with our revenue.

 

Off-Balance Sheet Arrangement

 

As of December 30, 2006, we had no off-balance sheet arrangements as defined in Item 303(a) (4) of the SEC’s Regulation S-K except for the $1,265,000 security deposit in the form of irrevocable standby letter of credit issued to Mission West Properties, L.P. as described under “Interest Rate Risk.”

 

Contractual Obligations

 

Our contractual obligations as of December 30, 2006 were as follows (in thousands):

 

 

 

 

Effect of Recent Accounting Pronouncements

 

See Note 2 to our consolidated financial statements for the discussion on effect of recent accounting pronouncements.

 

Sipex’s consolidated financial statements and related Report of Independent Registered Public Accounting Firm are presented in the following pages.

 

 

Schedules not listed above have been omitted since they are not applicable or are not required, or the information required to be set forth therein is included in the consolidated financial statements or notes thereto.

 

To the Board of Directors and Stockholders of Sipex Corporation:

 

We have audited the accompanying consolidated balance sheets of Sipex Corporation and subsidiaries (the “Company”) as of December 30, 2006 and December 31, 2005, and the related consolidated statements of operations, stockholders’ equity (deficit) and comprehensive loss, and cash flows for each of the three years in the period ended December 30, 2006. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. As of December 30, 2006, the Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting as of December 30, 2006. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Sipex Corporation and subsidiaries as of December 30, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 30, 2006, in conformity with accounting principles generally accepted in the United States of America.

 

As described in Note 2 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment”, effective January 1, 2006.

 

 

San Jose, California

March 30, 2007

 

 

See accompanying notes to consolidated financial statements

 

 

See accompanying notes to consolidated financial statements

 

 

See accompanying notes to consolidated financial statements

 

 

See accompanying notes to consolidated financial statements

SIPEX CORPORATION

 

 

Sipex Corporation (“Sipex” or the “Company”) is a semiconductor company that designs, manufactures and markets high performance, value-added analog ICs that are used primarily by original equipment manufacturers (“OEMs”) operating in the computing, communications and networking infrastructure markets.

 

While advances in digital technology have fueled the demand for digital ICs, they have also created a rapidly growing demand for more precise, faster and more power efficient analog ICs. Sipex possesses a broad portfolio of analog ICs, organized into three product families: power management, interface and optical storage. Sipex’s products are sold either directly to customers or through a global network of manufacturers’ representatives and distributors.

 

The Company’s wafer fabrication facility in Milpitas, California along with a number of third-party contractors fabricate, package and test its ICs. In an effort to achieve significant cost savings, in the third quarter of 2005 Sipex decided to close down the Milpitas wafer fabrication facility and transfer the IC manufacturing processes from there to a wafer fabrication facility operated by Hangzhou Silan Integrated Circuit Co., Ltd. (“Silan”) in China and a wafer fabrication facility operated by Episil Technologies, Inc. in Taiwan. The closure of the Milpitas wafer fabrication facility was fully completed in early October 2006.

 

 

Basis of Presentation

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates that are particularly susceptible to changes include those related to revenues, sales returns and allowances, deferred income, inventory valuation, restructuring reserves, asset impairments and income taxes.

 

The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, Sipex GmbH and Sipex Nippon. All significant intercompany accounts and transactions have been eliminated in consolidation.

 

Effective January 1, 2004, the Company’s fiscal year was changed from a calendar year end to a 52 or 53-week fiscal year, which ends on the Saturday closest to December 31. The first quarter of fiscal year 2006 covered 91 days from January 1, 2006 to April 1, 2006, the second quarter covered 91 days from April 2, 2006 to July 1, 2006, the third quarter covered 91 days from July 2, 2006 to September 30, 2006, and the fourth quarter covered 91 days from October 1, 2006 to December 30, 2006. Hereinafter, the years ended December 30, 2006, December 31, 2005 and January 1, 2005 are also referred to as “2006,” “2005,” and “2004.”

 

Reverse Stock Split

 

On January 30, 2007, Sipex’s stockholders at a special meeting of stockholders approved a 1-for-2 reverse stock split. The reverse split became effective at 1:31 p.m. Pacific Standard Time on February 23, 2007. The par value of the common stock was not affected by the reverse stock split and remains at $0.01 per share. Consequently, the aggregate par value of the issued common stock was reduced by reclassifying the par value amount of the eliminated shares of common stock to additional paid-in capital in the Company’s consolidated balance sheets. The Company has paid cash in lieu of any fractional shares to which a holder of common stock would otherwise be entitled as a result of the reverse stock split. The number of authorized shares of common stock remains unchanged. All shares and per share amounts, including all common stock equivalents (stock options, warrants and convertible

 

SIPEX CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

notes) have been restated in the consolidated financial statements and in the notes to consolidated financial statements for all periods presented to reflect the reverse stock split.

 

Revenue Recognition

 

The Company recognizes revenue in accordance with Securities Exchange Commission (“SEC”) Staff Accounting Bulletin (“SAB”) 104, “Revenue Recognition.” SAB 104 requires that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services rendered; (3) the fee is fixed or determinable; and (4) collectibility is reasonably assured.

 

Prior to January 1, 2004, the Company entered into arrangements that were not within the original contractual distributor agreements in that the Company allowed return rights and other concessions beyond the levels provided in the distributor agreements. Company management concluded it is unable to reasonably estimate sales returns for arrangements with its distributor; accordingly, effective January 1, 2003, sales and related cost of sales on shipments to distributors are deferred until the resale to the end customer.

 

Sales to Future Electronics Inc. (“Future”), and a related party, are made under an agreement that provides protection against price reductions of Sipex’s products in Future’s inventory. In addition, Future has stock rotation rights. Pursuant to these stock rotation rights, Future is permitted on a quarterly basis to return for credit up to 10% of its total purchases during the most recent three-month period. This credit will be reduced to 5% applicable to all purchases made by Future from Sipex starting April 1, 2006.

 

Additionally, the Company provides Future with a 2% scrap allowance also effective April 1, 2006. As the price of products sold to Future is not fixed or determinable until resold by Future to the end customer, Sipex is using sell-through revenue accounting and deferring recognition of such sales and related cost of goods sold until the product is sold by Future to its customers.

 

Under sell-through revenue accounting, accounts receivable are recognized and inventory is relieved upon shipment to the distributor as title to the inventory is transferred upon shipment, at which point the Company has a legally enforceable right to collection under normal terms. The associated sales and cost of sales are deferred by recording “deferred income” (gross profit margin on these sales) as shown on the face of the consolidated balance sheet. When the related product is sold by the Company’s distributors to their end customers, Sipex recognizes previously deferred income as sales and cost of sales.

 

For non-distributor customers, the Company recognizes revenue when title to the product is transferred to the customers, which occurs upon shipment or delivery, depending upon the terms of the customer order, provided that persuasive evidence of a sales arrangement exists, the price is fixed and determinable, title has transferred, collection of the resulting receivables is reasonably assured, there are no customer acceptance requirements, and there are no remaining significant obligations. Provisions for returns and allowances for non-distributor customers are provided for at the time product sales are recognized. An allowance for sales returns and allowances for customers is recorded based on historical experience or specific identification of an event necessitating an allowance.

 

From time to time, Sipex develops custom products for various customers under engineering service contracts culminating in delivery of known functional development samples. The Company recognizes revenue under these agreements upon delivery of known functional development samples as delivery of such represents the culmination of utility of the contract to the customer and agreed to milestones. Sipex recognizes the costs as incurred associated with these contracts and presents such costs as research and development expenses due to the uncertain nature of the development efforts until delivery of the known functional development samples. Certain of these engineering service contracts include payments in advance of delivery of known functional development samples. These payments are recorded in deferred income, other, until the time of delivery of the functional samples.

 

SIPEX CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Research and Development

 

Research and development costs are expensed as incurred.

 

Net Loss Per Share

 

Basic net loss per share is based upon the weighted average number of common shares outstanding. Diluted net loss per share is based upon the weighted average number of common and common equivalent shares outstanding assuming dilution. Common equivalent shares, consisting of outstanding stock options, convertible debt and warrants, are included in the per share calculations where the effect of their inclusion would be dilutive. As the Company had a net loss in 2006, 2005 and 2004, stock options, warrants, and shares issuable in conversion of debt were excluded from the calculation of diluted net loss per share because the effect of such assumed conversion would be anti-dilutive.

 

A reconciliation of basic weighted average common shares with diluted weighted average shares is as follows (in thousands):

 

 

Antidilutive potential common shares excluded from the weighted average common shares outstanding for net loss per share calculation are as follows (in thousands, except per-share information):

 

 

Concentration of Credit Risk

 

Financial instruments that potentially subject Sipex to concentrations of credit risk consist primarily of cash equivalents, short-term investments (see below) and accounts receivable. Cash equivalents consist of deposits with, or guaranteed by, major commercial banks, the maturities of which are three months or less on the date of purchase. With respect to accounts receivable, Sipex performs periodic credit evaluations of the financial condition of its customers and typically does not require collateral from them. Management assesses the need for allowances for potential credit losses by considering the credit risk of specific customers, historical trends and other information. In addition, management reviews other inherent risks in the portfolio based on current market conditions, the economic environment and the Company’s concentration of credit risk.

 

Concentration of Other Risks

 

The semiconductor industry is characterized by rapid technological change, competitive pricing pressures and cyclical market patterns. The Company’s financial results are affected by a wide variety of factors, including general economic conditions worldwide, economic conditions specific to the semiconductor industry, the timely

 

SIPEX CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

implementation of new manufacturing technologies, the ability to safeguard patents and intellectual property in a rapidly evolving market and reliance on assembly and test subcontractors, third-party wafer fabricators and independent distributors. In addition, the semiconductor market has historically been cyclical and subject to significant economic downturns at various times. The Company is exposed to the risk of obsolescence of its inventory depending on the mix of future business. Additionally, the Company utilizes third-party wafer fabricators as sole-source suppliers, primarily Polar, Episil and Silan. As a result, the Company may experience significant period-to-period fluctuations in future operating results because of the factors mentioned above or other factors.

 

Fair Values of Financial Assets and Financial Liabilities

 

The carrying values of cash and cash equivalents, short-term investments, accounts receivable, accounts payable and accrued liabilities approximate their fair values due to the relatively short periods to maturity of the instruments. The carrying value of bank borrowings approximates fair value as the fixed interest rate was set at the time of borrowing in December 2006. The carrying value of the Company’s convertible senior notes was $25.8 million, and the fair value was approximately $62.4 million as of December 30, 2006. The assumptions used for the fair value calculation included the Company’s stock price movements, interest rate changes, credit rating changes, timing on re-listing with Nasdaq Global Market, effectiveness on its Form S-1 filing with the SEC and other economic variables (See Note 12).

 

Short-term Investments

 

Short-term investments, which primarily consist of highly rated commercial paper with original maturities greater than 90 days, are accounted for under Statement of Financial Accounting Standards (SFAS) No. 115, “Accounting for Certain Investments in Debt and Equity Securities” issued by the Financial Accounting Standards Board (FASB). Pursuant to the provisions of SFAS No. 115, the Company has classified its short-term investments as “held to maturity” which represent investments that the Company intends to hold to maturity and are recorded at amortized cost.

 

Inventories

 

Inventories are stated at the lower of cost or market. Costs are determined using the first-in, first-out method.

 

Valuation of Inventories

 

Sipex writes down the value of its inventories for estimated excess quantities, obsolescence, and/or marketability deficiencies. In addition, the Company writes down inventory costs to the lower of cost or market which becomes the new cost basis. Excess and obsolete inventories are determined by comparing current inventory quantities to current backlog, anticipated future demand and shipment history. The Company also evaluates the net realizable value of inventories to be acquired under purchase commitments with our wafer foundries. If such inventories are also considered to be excess when compared to future demand, we record reserves and charges to cost of sales for these purchase commitments. Lower of cost or market adjustments are determined by reviewing shipments during the quarter as well as quarter beginning backlog and comparing standard cost to anticipated market pricing. In estimating anticipated market pricing, the Company also considers current market conditions, industry performance, distributor inventory levels and sales to end-users and other relevant factors. If actual market conditions become less favorable than those anticipated by management, additional write-downs of inventories may be required in the future. Inventories, which had previously been written down to zero, with an original cost of $1.4 million, $1.0 million and $0.9 million, were sold in 2006, 2005 and 2004, respectively. The Company recorded inventory write-downs for excess and obsolete inventories of $5.0 million, $5.0 million and $8.6 million, during 2006, 2005 and 2004, respectively. In addition, during 2006, the Company recorded $1.4 million of charges to cost of sales for purchase commitments for excess inventories.

 

SIPEX CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Related Parties

 

Future is a related party and its affiliates own approximately 8.6 million shares or 47% of Sipex’s outstanding common stock as of December 30, 2006. Sipex has a distribution agreement that provides for Future to act as the Company’s sole distributor for certain products within North America and Europe. Sales to Future are made under an agreement that provides protection against price reduction for its inventory of Sipex’s products. The Company recognizes revenue on sales to Future under the distribution agreement when Future sells the products to end customers. Future has historically accounted for a significant portion of the Company’s revenues. It is the Company’s largest distributor worldwide and accounted for 43%, 44% and 39% of its total net sales for the years ended December 30, 2006, December 31, 2005 and January 1, 2005 respectively.

 

From time to time, Future provides services and/or incurs expenses on behalf of the Company. The fair value of the unreimbursed expenses and uncompensated services rendered by Future has been recorded in the Company’s consolidated financial statements as capital contributions totaling $5,000, $17,000 and $100,000 for the years ended December 30, 2006, December 31, 2005 and January 1, 2005 respectively.

 

In addition, Sipex incurred expense to Future totaling approximately $23,000 for marketing promotional materials, temporary accounting services and used furniture sold to the Company for the year ended December 30, 2006. Sipex recorded $44,000 of reimbursement expense for marketing promotional materials charged by Future for the year ended December 31, 2005. For the year ended January 1, 2005, no such expenses were recorded.

 

During February 2004, the affiliates of Future exercised the conversion rights to convert their existing notes into Sipex common stock for an additional 2.3 million shares. On August 5, 2004, the affiliates of Future exercised a warrant to purchase 450,000 shares of Sipex common stock at $5.8916 per share. The warrant was issued to the affiliates of Future in conjunction with the $12 million convertible note issued in 2002, which was converted into Sipex common stock in February 2004. In connection with the warrant exercise, Sipex agreed to modify the standstill restrictions on the affiliates of Future to enable them to hold the lesser of (i) 49% of the Company’s issued and outstanding voting capital stock and (ii) 42.5% of the Company’s issued and outstanding voting capital stock, measured on a “Fully Diluted Basis,” as defined using the following equation: The numerator includes all voting capital stock and securities convertible into or exercisable for voting capital stock held by the affiliates of Future and the denominator is the greater of (i) all shares of the Company’s voting capital stock outstanding or issuable upon the exercise or conversion of vested securities convertible into or exercisable for voting capital stock and (ii) 20,000,000 (as adjusted for stock dividends, splits or like transactions). On August 9, 2004, the affiliates purchased 1.25 million shares of Sipex common stock in the open market.

 

On January 19, 2006, Sipex announced the completion of a $7.0 million private loan financing in which the Company issued a 9% secured note with convertible interest due January 19, 2008 to the affiliates of Future, which could provide these affiliates with the opportunity to obtain additional shares of Sipex common stock. The loan was repaid in March 2006. Sipex incurred interest expense totaling $86,000 related to the $7.0 million note with Future for the year ended December 30, 2006.

 

As discussed in Note 12, on May 16, 2006, Sipex placed $30.0 million of its 5.5% Redeemable Convertible Senior Notes (“2006 Notes”) due 2026 and related warrants in a private placement transaction to accredited investors in reliance on Regulation D under the Securities Act of 1933, as amended (the “Securities Act”). Rodfre Holdings LLC (“Rodfre”), an affiliate of Alonim Investments Inc., Sipex’s largest stockholder, and an affiliate of Future, purchased 50% of the 2006 Notes or $15.0 million aggregate principal amount being placed in this offering. The 2006 Notes will mature on May 18, 2026 and bear interest at an annual rate of 5.5% payable semi-annually on May 15 and November 15 of each year, beginning on November 15, 2006. On December 21, 2006, Rodfre paid $2.7 million to exercise its warrant for 419,776 shares of Sipex common stock at $6.432 per share. As of December 30, 2006, the affiliates of Future held 8.6 million shares, or 47% of the Company’s outstanding common stock.

 

SIPEX CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Interest expense incurred by Sipex relating to the $15.0 million portion of 2006 Notes sold to Rodfre totaled $936,000 for the year ended December 30, 2006. No interest expense was recorded for the year ended December 31, 2005 as both convertible notes, issued in 2002 and 2003, were extinguished and converted into 2.3 million of the Company’s common shares as of February 18, 2004. Sipex recorded interest expense related to the debt with Future totaling $90,000 for the year ended January 1, 2005.

 

On September 8, 2006, Sipex appointed two executive vice presidents working for Future to its Board of Directors. The Board has determined that both new directors are not independent within the meaning of Rule 4200(a) (15) of the NASDAQ Manual by virtue of their relationships with Future. Accordingly, the Board does not expect to appoint them to any standing committees of the Board. In connection with their appointment as directors, both new directors have agreed to excuse themselves from any Board discussions that relate to transactions between Sipex and Future.

 

On March 29, 2007, the Company entered into a Securities Purchase Agreement with Rodfre, an affiliate of Future, Sipex’s largest distributor worldwide and an affiliate of its largest stockholder (Alonim Investment Inc.), to provide an unsecured promissory note facility of up to $10.0 million. This facility expires, and the borrowings and accrued interest under any notes issued under this facility are due and payable, on June 30, 2008, or upon certain other events such as a change of control. Borrowings under this promissory note facility bear interest of 9% per annum subject to an increased interest rate of up to 20% in case of default or after maturity. This promissory note facility is subordinate to the Company’s Loan and Security Agreement with Silicon Valley Bank and to its 5.5% Redeemable Convertible Senior Notes due 2026.

 

Employee Advances

 

Included in other current assets is approximately $58,000 and $39,000 due from employees at December 30, 2006 and December 31, 2005, respectively, which consist mainly of amounts due to Sipex related to hiring and relocation costs. These amounts are normally forgiven over employee’s service periods as agreed upon between each employee and Sipex.

 

Property, Plant and Equipment

 

Property, plant and equipment are stated at cost. Depreciation is provided by using the straight-line method over their expected useful lives:

 

 

Restricted Cash

 

As of December 30, 2006, restricted cash totaled $407,000 consisting of $350,000 held in a certificate of deposit as a guarantee payment to fulfill the terms of a software license agreement and $57,000 as a rental deposit related to the Company’s Belgium facility.

 

Impairment of Long-Lived Assets and Long-Lived Assets to be Disposed of

 

Sipex reviews long-lived assets and certain identifiable intangibles for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net undiscounted cash flows expected to be generated by the asset. If such asset is considered to be impaired, the impairment to be recognized is

 

SIPEX CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

measured by the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of are reported at the lower of the carrying amount or fair value less cost to sell (See Note 3).

 

Foreign Currency Translation

 

Prior to the third quarter of 2004, the functional currencies of the Company’s foreign subsidiaries are the local currencies. Effective beginning the third quarter of 2004, based on the Company’s reassessment of economic facts and circumstances of its foreign subsidiaries, the functional currencies of the Company’s foreign subsidiaries were changed to the U.S. dollar. Gains and losses from transactions denominated in currencies other than the functional currencies of the Company and its subsidiaries are included in operating expenses in the consolidated statements of operations.

 

Income Taxes

 

Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using statutory tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in earnings in the period that includes the enactment date.

 

Stock-Based Compensation

 

Adoption of SFAS No. 123R

 

Effective January 1, 2006, the Company adopted SFAS No. 123 (revised 2004), “Share-Based Payment,” (“SFAS No. 123R”), using the modified-prospective transition method. Under this transition method, stock compensation cost recognized beginning January 1, 2006 includes: (a) compensation cost for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123, and (b) compensation cost for all share-based payments granted or modified on or subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123R. In addition, compensation cost to be recognized under SFAS No. 123R considers an estimate of options which will be forfeited prior to vesting.

 

The Company has elected to adopt the alternative transition method provided in the FASB Staff Position (“FSP”) No. FAS 123R-3 “Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards” (FSP 123R-3) for calculating the tax effects of stock-based compensation pursuant to SFAS No. 123R. The alternative transition method provides a simplified method to establish the beginning balance of the additional paid-in capital pool (“APIC Pool”) related to the tax effects of employee stock-based compensation, and to determine the subsequent impact on the APIC Pool and consolidated statements of cash flows of the tax effects of employee stock-based compensation awards that are outstanding upon adoption of SFAS No. 123R. SFAS No. 123R prohibits the recognition of a deferred tax asset for an excess tax benefit that has not yet been realized. As a result, the Company only recognizes a benefit from stock-based compensation in paid-in-capital if an incremental tax benefit is realized after all other tax attributes currently available to the Company have been utilized. In addition, the Company has elected to account for the indirect benefits of stock-based compensation on the research tax credit through the consolidated statement of operations rather than through paid-in-capital.

 

Prior to adopting SFAS No. 123R, the Company accounted for stock option grants under the recognition and measurement provisions of Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees and related interpretations.” No compensation expense was recognized when the exercise price of the Company’s employee stock options equaled the market price of the underlying stock on the date of the grant. Compensation expense associated with the option repricing in 2005 was recorded up to the date of adoption of

 

SIPEX CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

SFAS No. 123R until the options were exercised, cancelled, or otherwise expired, and the expense or benefit for the increase or decrease, respectively, in the fair market value of the Company’s common stock in excess of the option’s exercise price was recognized immediately for vested options and was recognized over the vesting period using an accelerated method for unvested employee options.

 

As the Company was not current with its filing with the SEC, employees who terminated from the Company during this period had been unable to exercise their stock options during the contractual 90 days of post-termination exercise period. The Company made a decision effective February 1, 2006 to extend the post-termination exercise period for former employees with approximately 96,000 vested stock options for the year ended December 30, 2006, until the earlier of 1) such date that was ninety (90) days after the date that the former employees were able to freely exercise the options pursuant to a registration statement on Form S-8 filed by the Company or 2) December 31, 2006. As a result, the Company recorded stock-based compensation relating to such extension totaling $177,000 for the year ended December 30, 2006.

 

In the fourth quarter of 2006, the Company accelerated the vesting of 220,000 stock options for three former directors of its board upon their departures. As a result, the Company recorded additional $138,000 stock-based compensation expense for the year ended December 30, 2006. During the same period, Sipex recorded additional employee stock-based compensation of $137,000 as restructuring expense for accelerating the vesting of 125,000 stock options in lieu of a severance payment made to a senior executive officer.

 

A summary of the Company’s stock option plan activities for the year ended December 30, 2006 is as follows:

 

 

Under SFAS No. 123R, stock-based compensation expenses for stock option grants are based on the fair value calculated from a stock option pricing model on the date of grant. The Company has utilized the Black-Scholes single option pricing model to determine the fair value for stock option grants. The fair value of stock option grants issued is recognized as compensation expense on a straight-line basis over the requisite service period, which is the vesting period of the grants. Compensation expense recognized is shown in the operating activities section of the consolidated statements of cash flows. In addition, SFAS No. 123R requires the cash flows resulting from the tax benefits from tax deductions in exercise of the compensation cost recognized (excess tax benefits) to be classified as financing cash flows.

 

As part of the requirements of SFAS No. 123R, the Company is required to estimate potential forfeitures of stock grants and adjust compensation cost recorded accordingly. The estimate of forfeitures will be adjusted over the requisite service period to the extent that actual forfeitures differ, or are expected to differ, from such estimates. Changes in estimated forfeitures will be recognized in the period of change and will also impact the amount of stock compensation expenses to be recognized in future periods.

 

SIPEX CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

The following table shows total employee and non-employee stock-based compensation expense recognized in the condensed consolidated statements of operations pursuant to SFAS No. 123R (in thousands):

 

 

At December 30, 2006, there was $167,000 of total compensation cost capitalized in inventory.

 

As a result of adopting SFAS No. 123R on January 1, 2006, the Company’s loss before income taxes and net loss for the year ended December 30, 2006 included 3.7 million of employee stock-based compensation expense. At December 30, 2006, there was a total of $5.2 million unrecognized compensation cost, net of estimated forfeitures, related to non-vested stock option awards which is expected to be recognized over a weighted-average period of approximately 32 months.

 

During the year ended December 30, 2006, the aggregate intrinsic value of options exercised under the Company’s stock option plans was $849,000, determined as of the date of option exercise.

 

Prior to the Adoption of SFAS No. 123R

 

Prior to 2006, the Company’s stock-based employee compensation plans were accounted for under the recognition and measurement provisions of APB 25. The Company also provided the required pro forma disclosures as required by SFAS No. 123. The ESPP qualified as a non-compensatory plan under APB 25; therefore, no compensation cost was recorded in relation to the discount offered to employees for purchases made under the ESPP.

 

Pro forma information under SFAS No. 123 for periods prior to the adoption of SFAS No. 123R has not been restated to reflect the effects of implementing SFAS No. 123R. For purposes of this pro forma disclosure, the value of stock options was estimated using the Black-Scholes single option pricing valuation approach with forfeitures recognized as they occur. The following table illustrates the effect on net loss and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock options granted under the Company’s

 

SIPEX CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

stock option plans and shares issued under the employee stock purchase plan (in thousands, except per-share amounts):

 

 

On September 6, 2005, the Company informed the employees that certain options would be repriced to the then current market price of the Company’s stock which was $3.80 per share. The repricing applied to all options with an exercise price that was over $3.80 per share but excluded options granted to the Company’s CEO and board of directors. The repricing affected 1,227,983 stock options shares for 235 employees. The incremental employee compensation cost of the repricing was approximately $1.1 million calculated using the Black-Scholes stock option pricing model. The incremental employee compensation costs are included in the pro forma amounts above to the extent of vested options and the remaining cost will be recognized over the remaining vesting periods of the related options.

 

Valuation Assumptions

 

The fair value of the Company’s stock options granted was estimated at the date of grant using the Black-Scholes single option pricing model with the following weighted-averaged assumptions:

 

 

Effective January 1, 2006, the Company has elected to use the “Simplified Method” outlined in SAB 107 to determine the expected term of its stock option grants. The calculation of expected term for previous SFAS No. 123 disclosure fair value estimates was based solely on an analysis of historical exercises of stock options. The Company believes that using the “Simplified Method” provides a better estimate of future exercise patterns. Stock volatility is based upon the Company’s historical stock price volatility. The Company considered historical volatility of a period generally commensurate with the expected or contractual term, as applicable, of the share option. The Company continues to use the risk-free rate based on the U.S. Treasury yield curve in effect at the time of grant for the expected term of the option to be valued. The Company does not currently intend to pay cash dividends. Therefore, the Company has assumed a dividend yield of zero.

 

SIPEX CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

No shares were issued under the Company’s Employee Stock Option Plan (ESPP) during 2005 and 2006. The fair value of each ESPP share issued during 2004 was estimated on the date of grant using the Black-Scholes option-pricing model based on the following assumptions:

 

 

Effect of Recent Accounting Pronouncements

 

In March 2004, the FASB issued EITF Issue No. 03-1, or EITF 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” which provides new guidance for assessing impairment losses on investments. Additionally, EITF 03-1 includes new disclosure requirements for investments that are deemed to be temporarily impaired. The disclosure requirements are effective for annual periods ending after June 15, 2004. The adoption of EITF 03-1 did not have a material impact on the Company’s consolidated financial statements.

 

In October 2004, the FASB approved EITF Issue 04-10 “Determining Whether to Aggregate Operating Segments That Do Not Meet the Quantitative Thresholds” which addresses an issue in the application of paragraph 19 of SFAS No. 131, Disclosures about Segments of an Enterprise and related information. EITF 04-10 is effective for fiscal years ending after September 15, 2005. The adoption of this issue did not have a material impact to the disclosures relating to the Company’s consolidated financial statements.

 

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs, an Amendment of ARB No. 43, Chapter 4.” The amendments made by SFAS No. 151 are intended to improve financial reporting by clarifying that abnormal amount of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges and by requiring the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. The guidance is effective for inventory costs incurred beginning on January 1, 2006. The adoption of SFAS No. 151 did not have a material impact on Sipex’s consolidated financial statements.

 

In December 2004, the FASB staff issued FSP FAS 109-1, “Application of FASB Statement No. 109, Accounting for Income Taxes, to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004” (the “FSP”) to provide guidance on the application of Statement 109 to the provision within the American Jobs Creation Act of 2004 (the “Act”) that provides tax relief to U.S. domestic manufacturers. The FSP states that the manufacturer’s deduction provided for under the Act should be accounted for as a special deduction in accordance with Statement 109 and not as a tax rate reduction. A special deduction is accounted for by recording the benefit of the deduction in the year in which it can be taken in the Company’s tax return, rather than by adjusting deferred tax assets and liabilities in the period of the Act’s enactment (which would have been done if the deduction on qualified production activities were treated as a change in enacted tax rates). The FSP was effective upon issuance. The adoption of the FSP did not have a material impact on the Company’s consolidated financial position or results of operations.

 

SIPEX CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

In December 2004, the FASB issued SFAS No. 153, “Exchanges of Nonmonetary Assets, an amendment of Accounting Principles Board (APB) No. 29, Accounting for Nonmonetary Transactions.” SFAS No. 153 requires exchanges of productive assets to be accounted for at fair value, rather than at carryover basis, unless (1) neither the asset received nor the asset surrendered has a fair value that is determinable within reasonable limits, or (2) the transactions lack commercial substance. SFAS No. 153 is effective for non-monetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. The adoption of the standard did not have a material effect on the Company’s consolidated financial statements.

 

In May 2005, FASB issued SFAS No. 154, “Accounting Changes and Error Corrections.” SFAS No. 154 establishes new standards on accounting for changes in accounting principles. Pursuant to the new rules, all such changes must be accounted for by retrospective application to the financial statements of prior periods unless it is impracticable to do so. The Statement is effective for accounting changes and error corrections made in fiscal years beginning after December 15, 2005, with early adoption permitted for changes and corrections made in years beginning after May 2005. Adoption of SFAS No. 154 did not have a material impact on the Company’s consolidated financial position, results of operations or cash flows.

 

In November 2005, the FASB issued FASB Staff Position (“FSP”) Nos. FAS 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments (FSP 115-1),” which replaces the measurement and recognition guidance set forth in the Emerging Issues Task Force (“EITF”) Issue No. 03-01, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” and codifies certain existing guidance on investment impairment. FSP 115-1 clarifies that an investor should recognize an impairment loss no later than when the impairment is deemed other-than-temporary, even if a decision to sell the security has not been made, and also provides guidance on the subsequent accounting for an impaired debt security. FSP 115-1 also requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. The guidance in FSP 115-1 amends SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities” and is effective for reporting periods beginning after December 15, 2005. The Company adopted the provisions of FSP 115-1 beginning on January 1, 2006, and the adoption did not have a material impact on the Company’s financial condition or results of operations.

 

In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments,” an amendment of FASB Statements No. 133 and 140. SFAS No. 155 will be effective for the Company beginning in the first quarter of 2007. The Statement permits interests in hybrid financial instruments that contain an embedded derivative that would otherwise require bifurcation, to be accounted for as a single financial instrument at fair value, with changes in fair value recognized in earnings. This election is permitted on an instrument-by-instrument basis for all hybrid financial instruments held, obtained, or issued as of the adoption date. The Company is assessing the impact of the Statement.

 

In July 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”) as an interpretation of FASB Statement No. 109, “Accounting for Income Taxes” (“SFAS 109”). This Interpretation clarifies the accounting for uncertainty in income taxes recognized by prescribing a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This Interpretation also provides guidance on de-recognition of tax benefits previously recognized and additional disclosures for unrecognized tax benefits, interest and penalties. The evaluation of a tax position in accordance with this Interpretation begins with a determination as to whether it is more likely than not that a tax position will be sustained upon examination based on the technical merits of the position. A tax position that meets the more-likely-than-not recognition threshold is then measured at the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement for recognition in the financial statements. FIN 48 is effective no later than fiscal years beginning after December 15, 2006, and is required to be adopted by the Company in the first quarter of its fiscal year 2007. The Company is assessing the impact of the adoption of FIN 48.

 

On September 13, 2006, the Securities and Exchange Commission (the “SEC”) issued Staff Accounting Bulletin No. 108 (“SAB 108”), “Considering the Effects of Prior Year Misstatements when Quantifying

 

SIPEX CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Misstatements in Current Year Financial Statements,” which provides interpretive guidance on the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of a materiality assessment. SAB 108 is effective for companies with fiscal years ending after November 15, 2006 and is required to be adopted by the Company in its fiscal year ended December 30, 2006. The adoption of SAB 108 did not have a material impact on the Company’s financial statements.

 

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. This Statement applies under other accounting pronouncements that require or permit fair value measurements, the FASB having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, this Statement does not require any new fair value measurements. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. This Statement is required to be adopted by the Company in the first quarter of its fiscal year 2008. The Company is currently assessing the impact of the adoption of this Statement.

 

In December 2006, the FASB staff issued FSP EITF Issue No. 00-19-2, “Accounting for Registration Payment Arrangements” which specifies that the contingent obligation to make future payments or otherwise transfer consideration under a registration payment arrangement, whether issued as a separate agreement or included as a provision of a financial instrument or other agreement, should be separately recognized and measured in accordance with FASB Statement No. 5, Accounting for Contingencies. This FSP shall be effective immediately for registration payment arrangements and the financial instruments subject to those arrangements that are entered into or modified subsequent to the date of issuance of this FSP. For registration payment arrangements and financial instruments subject to those arrangements that were entered into prior to the issuance of this FSP, this guidance shall be effective for financial statements issued for fiscal years beginning after December 15, 2006, and interim periods within those fiscal years. The FSP is required to be adopted by the Company in the first quarter of its fiscal year 2007. Sipex is currently assessing the impact of the adoption of this FSP.

 

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities — Including an amendment of FASB Statement No. 115.” SFAS No. 159 permits companies to measure many financial instruments and certain other items at fair value at specified election dates. Unrealized gains and losses on these items will be reported in earnings at each subsequent reporting date. The fair value option may be applied instrument by instrument (with a few exceptions), is irrevocable and is applied only to entire instruments and not to portions of instruments. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. This Statement is required to be adopted by the Company in the first quarter of its fiscal year 2008. The Company is currently assessing the impact of the adoption of this Statement.

 

SIPEX CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

Below is a summary of the activities related to restructuring and impairment of fixed assets (in thousands):

 

 

In addition to the restructuring costs incurred above, in the fourth quarter of 2006, the Company incurred $116,000 of facility costs related to the unused fabrication portion of the Company’s headquarters facility in Milpitas, California, due to the transfer of wafer fabrication to Silan.

 

Restructuring

 

During the third quarter of 2004, Sipex entered into a sublease arrangement for a portion of the facility and decided to relocate the remaining personnel to Milpitas, California. This resulted in Sipex incurring $1.9 million of an additional restructuring accrual which reflected the Company’s plan to move the majority of remaining operations to Milpitas, California and consisted of $1.4 million for future lease payments, $447,000 write-off of leasehold improvements and $32,000 for severance payments to 12 employees.

 

During the year ended January 1, 2005, the Company utilized $1.0 million of restructuring reserves, which primarily included $447,000 of write-off of leasehold improvements, and $463,000 of lease costs associated with the unused portion of its Billerica facility. The Company made additional adjustments to the restructuring for changes to the lease obligation totaling $60,000. For the year ended January 1, 2005, the balance of the restructuring accrual principally consisted of facility lease costs, and is expected to be paid over the next three years. The balance as of the year ended January 1, 2005 is $1.8 million, of which $566,000 was the short-term portion and $1.3 million was long-term portion.

 

On August 29, 2005, the Board of Directors of Sipex approved a plan to close its wafer fabrication operations located in Milpitas, California and transfer the fabrication to Silan in China to reduce costs and improve operating efficiencies. As a result, the Company recognized total restructuring charges of approximately $871,000 in the second half of 2005 including severance and retention benefits totaling $766,000 for approximately 70 employees and other exit costs of $105,000. In addition, during the third quarter of 2005, Sipex decided not to transfer the

 

SIPEX CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

remaining operations in Billerica to Milpitas that was originally anticipated to be completed by the end of 2005. The adjustment to restructuring accrual of $294,000 during 2005 primarily included exiting costs of $213,000, offset by sublease income of $293,000 and $195,000 recorded in the third quarter of 2005 as a reduction to future lease payment obligation for not transferring such remaining operations in Billerica. Sublease income is recorded on a cash basis due to uncertainty of collectibility. The restructuring accrual balance as of December 31, 2005 consisted of short-term portion of $1.4 million and long-term portion of $584,000. The $2.0 million restructuring accrual balance included $1.2 million of facility lease costs to be paid out over the next two years and the remaining portion to be paid out in less than a year.

 

During the year ended December 30, 2006, for the unused portion of Billerica facility initiated in October 2003, the Company utilized the restructuring accrual totaling $726,000 which was primarily consisted of lease costs. Adjustments to the accrual for the Billerica facility primarily related to sub-lease income of $565,000 recorded on a cash basis due to the uncertainty of collectibility.

 

During 2006, Sipex incurred additional restructuring costs of $677,000 that related to employee retention payments for the closure of its wafer fabrication operations located in Milpitas, California, announced in August 2005. For employee costs, the Company utilized $1.4 million and recognized an expense accrual adjustment of $54,000. For facility costs related to Milpitas wafer fabrication closure, the Company recognized approximately $200,000 in expense for contract termination in the fourth quarter of 2006 associated with gas usage and service agreements with a vendor. For facility costs related to the Milpitas wafer fabrication closure, restructuring charges utilized during 2006 totaling $91,000 was for facility decontamination.

 

In the fourth quarter of 2006, the Company introduced a workforce reduction plan involving approximately 75 positions that was implemented in response to its transitioning to a fabless semiconductor company, optical products, reducing dependency on the commodity products and with a goal of improving cost structure. As a result, Sipex recorded total restructuring costs of $1.1 million related to employee severance compensation including $137,000 for accelerating the vesting of stock options in lieu of a severance payment for a senior executive officer. Severance payments of $122,000 were made in December 2006.

 

As of December 30, 2006, the balance of the restructuring accrual primarily consisted of employee severance costs, contract termination costs and facility lease costs. These costs are expected to be paid over the next 15 months. The balance of the accrual as of December 30, 2006 was $1.8 million of which $1.7 million was the short-term portion and $139,000 was the long-term portion.

 

Impairment

 

In the second quarter of 2005, Sipex tested its wafer fabrication asset grouping, for which cash flows from the wafer fabrication operations provide the lowest level of cash flows that are largely independent of the cash flows of other assets and liabilities of the Company, for recoverability in accordance with SFAS No. 144 given that management believed that there was a significant decline in the market price of the asset grouping. An impairment loss of $9.4 million was recognized, representing the difference between the carrying value and the fair value of the wafer fabrication asset grouping.

 

In August 2005, the Board of Directors approved terminating the wafer fabrication operations and the sale of the related assets. Also in August 2005, the Company identified a potential buyer, Silan, who would purchase, take title to and be trained to use a substantial portion of its wafer fabrication asset grouping by the end of the third quarter of 2006. Accordingly, the Company continued to use the wafer fabrication assets until September 2006 and recorded depreciation expense based on the estimated remaining useful life at the time of impairment.

 

The Company recognized an additional impairment loss of $12,000 resulting from the sale of wafer fabrication equipment and machinery in Milpitas, California, in the fourth quarter of 2006. These wafer fabrication assets had been impaired in the second quarter of 2005. Net proceeds from the sale totaled $1.1 million.

 

SIPEX CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

Inventories are as follows (in thousands):

 

 

 

Property, plant and equipment are as follows (in thousands):