UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

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

For the quarterly period ended September 30, 2004

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

For the Transition Period from            to           

Commission File Number 000-50553

STAKTEK HOLDINGS, INC.

8900 Shoal Creek Blvd, Austin, TX 78757
(Address of principal executive offices) (Zip Code)

Registrant’s telephone number, including area code:
(512) 454-9531

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

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).      YES o           NO x

     The number of shares of the registrant’s common stock, $0.001 par value, outstanding as of September 30, 2004, was 50,932,481.

STAKTEK HOLDINGS, INC.
FORM 10-Q QUARTERLY REPORT
QUARTERLY PERIOD ENDED SEPTEMBER 30, 2004

TABLE OF CONTENTS

Table of Contents

CAUTIONARY STATEMENT

     EXCEPT FOR THE HISTORICAL FINANCIAL INFORMATION CONTAINED HEREIN, THE MATTERS DISCUSSED IN THIS REPORT ON FORM 10-Q (AS WELL AS DOCUMENTS INCORPORATED HEREIN BY REFERENCE) MAY BE CONSIDERED “FORWARD-LOOKING” STATEMENTS WITHIN THE MEANING OF SECTION 27A OF THE SECURITIES ACT OF 1933, AS AMENDED, AND SECTION 21E OF THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED. THESE FORWARD-LOOKING STATEMENTS INCLUDE DECLARATIONS REGARDING THE INTENT, BELIEF OR CURRENT EXPECTATIONS OF STAKTEK HOLDINGS, INC. AND ITS MANAGEMENT, AND MAY BE EVIDENCED BY WORDS SUCH AS “WE EXPECT,” “ANTICIPATE,” “TARGET,” “PROJECT,” “BELIEVE,” “GOALS,” “ESTIMATE,” “POTENTIAL,” “PREDICT,” “MAY,” “MIGHT,” “COULD,” “INTEND,” VARIATIONS OF THESE TYPES OF WORDS AND SIMILAR EXPRESSIONS. YOU ARE CAUTIONED THAT ANY FORWARD-LOOKING STATEMENTS ARE NOT GUARANTIES OF FUTURE PERFORMANCE AND INVOLVE A NUMBER OF RISKS AND UNCERTAINTIES. ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THOSE INDICATED BY THESE FORWARD-LOOKING STATEMENTS. FACTORS THAT COULD CAUSE OR CONTRIBUTE TO THESE DIFFERENCES INCLUDE THOSE DISCUSSED UNDER “RISKS THAT MAY AFFECT FUTURE RESULTS” AND ELSEWHERE IN THIS REPORT. STAKTEK DISCLAIMS ANY INTENTION OR OBLIGATION TO UPDATE OR REVISE ANY FORWARD-LOOKING STATEMENTS, WHETHER AS A RESULT OF NEW INFORMATION, FUTURE EVENTS OR OTHERWISE.

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STAKTEK HOLDINGS, INC.
CONSOLIDATED CONDENSED BALANCE SHEETS
(in thousands, except share and per share data)

The accompanying notes are an integral part of these consolidated condensed financial statements.

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STAKTEK HOLDINGS, INC.
CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS
(in thousands, except per share data)

The accompanying notes are an integral part of these consolidated condensed financial statements.

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STAKTEK HOLDINGS, INC.
CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS
(in thousands, except per share data)

The accompanying notes are an integral part of these consolidated condensed financial statements.

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STAKTEK HOLDINGS, INC.
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
(in thousands)

The accompanying notes are an integral part of these consolidated condensed
financial statements.

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STAKTEK HOLDINGS, INC.
NOTES TO THE CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(unaudited)

1. Basis of Presentation

     Two investment funds affiliated with Austin Ventures (“Austin Ventures”) formed Staktek Holdings, Inc. (“we,” “us,” “our,” or the “Company”) in May 2003 for the purpose of acquiring Staktek Corporation. Staktek Corporation (the “Predecessor Company”) was incorporated in Texas in June 1990. In August 2003, Austin Ventures acquired Staktek Corporation through a merger of a wholly owned subsidiary of our Company with and into Staktek Corporation (the “Staktek acquisition”). As a result of this merger, Staktek Corporation became our wholly owned subsidiary. We did not have any operations prior to August 21, 2003, other than in connection with the Staktek acquisition.

     The accompanying consolidated condensed statements of operations and cash flows for the periods ended August 20, 2003 represent the results of operations and cash flows of the Predecessor Company and its wholly owned subsidiaries. The accompanying consolidated condensed balance sheets as of September 30, 2004 and December 31, 2003 and the accompanying consolidated condensed statements of operations and cash flows for the periods ended September 30, 2004 and September 30, 2003 represent the financial position, results of operations and cash flows of the Company and its wholly owned subsidiaries.

     The accompanying unaudited consolidated condensed financial statements of the Company and the Predecessor Company have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission (the “SEC”). These financial statements do not include all of the information and footnotes required by generally accepted accounting principles for annual financial statements. In our opinion, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires us to make estimates and assumptions that affect reported assets, liabilities, revenues and expenses, as well as disclosure of contingent assets and liabilities. Actual results could differ from those estimates. In addition, operating results for the three- and nine-month periods ended September 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004, or for any other period.

     These financial statements and notes should be read with the financial statements and notes for the period ended December 31, 2003 included in the Company’s final prospectus for its initial public offering filed with the SEC on February 6, 2004.

2. Initial Public Offering

     The Securities and Exchange Commission declared our first registration statement effective on February 6, 2004, which we filed on Form S-1 (Registration No. 333-110806) under the Securities Act of 1933 in connection with the initial public offering of our common stock. Under this registration statement, we registered 11.5 million shares of our common stock, including 1.5 million shares subject to the underwriters’ over-allotment option.

     On February 11, 2004, we completed our initial public offering in which we sold 10 million shares of our common stock at $13 per share, for an aggregate public offering price of $130 million. On March 5, 2004, we sold an additional 1.19 million shares in connection with the underwriters’ over-allotment option, for an aggregate public offering price of approximately $15.5 million. Our sale of shares of common stock, including the underwriters’ exercise of their over-allotment option, resulted in aggregate gross proceeds of approximately $145.5 million. Of this total, we applied approximately $10.2 million to underwriting discounts and commissions; $1.9 million to related costs; $78.8 million to pay in full our senior, short-term and subordinated debt (including accrued interest and fees); and $30.6 million to redeem our outstanding preferred stock. As a result, we retained approximately $24.0 million of the offering proceeds, which we may use for working capital and general corporate purposes.

3. Recent Accounting Pronouncement

     In January 2003, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 46, or FIN 46, Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51. FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the

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entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective immediately for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period ending after March 15, 2004. The adoption of FIN 46 had no impact on our financial position, results of operations or cash flows.

4. Inventories

     Inventories consist of the following at the respective dates (in thousands):

5. Other Intangibles, Net

     In June 2004, we acquired from DPAC Technologies Corp. (“DPAC”) its stacking patents and patent applications as well as certain customer information and in exchange for which we paid DPAC $600,000. In the third quarter of 2004, we made other payments, including payments for related transaction costs, which totaled approximately $134,000. As a result, we have recorded $536,000 in purchased patents, included in “Acquired technology and patents” below, which is being amortized over 12 years, and $198,000 for the customer list intangible included in “Other intangible assets” below. We are amortizing the customer list over two years. Amortization for both the purchased patents and the customer list intangible began in the third quarter of 2004.

     The following information details the gross carrying amount and accumulated amortization of our acquired intangibles and patents (in thousands):

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     Amortization expense for all intangibles in the third quarter and the first nine months of 2004 was $4.4 million and $13.3 million, respectively. Amortization expense for all intangibles for the period from inception to September 30, 2003 was $1.7 million. Amortization expense for all intangibles for the periods from July 1, 2003 to August 20, 2003 and January 1, 2003 to August 20, 2003 was $11,000 and $53,000, respectively. The following table details the estimated aggregate annual amortization expense (in thousands) for 2004 and for each of the five succeeding fiscal years for all of the intangibles we owned, which are subject to amortization:

6. Debt

     During January 2004, we paid a quarterly principal installment of approximately $1.9 million on our senior term loans. In February 2004, we used a portion of the net proceeds from our initial public offering to repay all of our remaining outstanding debt plus accrued interest and fees as follows (dollars in thousands):

7. Commitments and Contingencies

     From time to time, we may be subject to legal proceedings and claims in the ordinary course of business. As of September 30, 2004, we were not involved in any material legal proceedings.

8. Redeemable Preferred Stock

     During February 2004, we used $30.6 million of the net proceeds from our initial public offering to redeem all of the outstanding shares of our redeemable preferred stock and to pay all accrued but unpaid dividends.

9. Common Stock

     In January 2004, the Company’s Board of Directors authorized a 2.15-for-1 forward stock split of the common stock of the Company. All common stock and per share information has been adjusted to reflect the stock split as if this stock split had taken place at the inception of the Company.

     Of the 51,579,455 shares and 40,377,396 shares of common stock issued and outstanding as of September 30, 2004 and December 31, 2003, respectively, 2,030,747 shares and 3,391,517 shares were unvested and subject to rights of repurchase, at a price per share equal to the original exercise price, which repurchase rights lapse according to a time-based vesting schedule. The proceeds received from the exercise of these unvested options are recorded as a liability, allocated between long term and short term.

     On July 28, 2004, we announced that our Board of Directors approved a stock repurchase program. Under this program, we can spend up to $15 million to purchase shares of our common stock through open market transactions or privately negotiated transactions. The exact timing and amount of repurchases will depend on market conditions. Austin Ventures has notified us that they will not sell into the buy-back program. During the third quarter of 2004,

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the Company purchased 447,900 shares of its stock on the open market under this program at a total cost of $2.4 million. Additionally, on March 26, 2004, the Company repurchased 199,074 unvested shares for approximately $3,000 from a former executive as a result of his resignation from the Company. At September 30, 2004, these shares are included at cost as treasury stock.

10. Stock-Based Compensation

     The following tables illustrate the effect on income available to common stockholders and earnings per share if the Company and the Predecessor Company had applied the fair value recognition provision of Statement of Financial Accounting Standards 123, Accounting for Stock-Based Compensation, to stock-based compensation (in thousands, except per share data):

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11. Income Taxes

     We accrue a provision for federal, state and foreign income taxes at the applicable statutory rates adjusted for non-deductible expenses. Foreign income tax includes withholding tax on certain royalty income received from foreign customers. For the year ending December 31, 2004, the Company’s effective tax rate is estimated to be 40%. For the nine months ended September 30, 2004, the Company’s effective tax rate was approximately 39% due to the recognition in the first quarter of 2004 of certain deferred tax assets not previously recognized.

12. Earnings Per Share

     Basic earnings per share is computed by dividing income available to common stock stockholders by the weighted-average number of vested common shares outstanding for the period. Diluted earnings per share is computed giving effect to all potential dilutive common stock, including options and common stock subject to repurchase.

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     Reconciliations of the numerator and denominator used in the calculation of basic and diluted earnings (loss) per share follow (in thousands, except per share data):

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Cautionary Statement

     The following discussion should be read along with the unaudited consolidated condensed financial statements and notes included in Item 1 of this Quarterly Report, as well as the audited consolidated financial statements and notes and Management’s Discussion and Analysis of Financial Condition and Results of Operations for the fiscal year ended December 31, 2003, included in the Company’s final prospectus dated February 5, 2004 for its initial public offering filed with the Securities and Exchange Commission. This Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements regarding future events and our future results are based on current expectations, estimates, forecasts, and projections and the beliefs and assumptions of our management including, without limitation, our expectations regarding fourth quarter revenue; selling, general and administrative expenses and research and development expenses in the next few quarters; the impact of current transitions in our industry and their impact on our business; expectations regarding the transition from 256 megabit memory to 512 megabit memory; expectations regarding the future of planar solutions and the impact to our business; our future position in our market; the sufficiency of our cash for operations for the next year; and the extension or renegotiation of our license agreement with Samsung. Words such as “we expect,” “anticipate,” “target,” “project,” “believe,” “goals,” “estimate,” “potential,” “predict,” “may,” “might,” “could,” “intend,” variations of these types of words and similar expressions are intended to identify these forward-looking statements. Readers are cautioned that these forward-looking statements are predictions and are subject to risks, uncertainties, and assumptions that are difficult to predict. Therefore, actual results may differ materially and adversely from those expressed in any forward-looking statements.

     Among the important factors that could cause actual results to differ materially from those indicated by our forward-looking statements are those discussed below under the subheading “Risks That May Affect Future Results” and elsewhere in this report. We undertake no obligation to revise or update publicly any forward-looking statement for any reason. Readers should carefully review the risk factors described in “Risks That May Affect Future Results” below, as well as in the documents filed by us with the Securities and Exchange Commission, specifically our final prospectus dated February 5, 2004, as well as other quarterly reports on Form 10-Q and in our other SEC filings, as they may be amended from time to time.

Overview

     We provide manufacturing services to deliver high-density memory stacking solutions and also offer licenses of our technologies to our customers to enable them to manufacture stacked memory products. In addition, we offer a broad range of services to support our customers’ needs, including design of custom-stacked memory assemblies, electrical modeling assistance and component inventory management.

     Since our inception in 1990, we have been an innovator in the development of technologies to enable the stacking of integrated circuits, with an initial focus on customized stacking solutions. In 1994, we released our original Stakpak® technology, which stacked DRAM chips packaged in industry-standard thin small outline packages, or TSOPs. In 1998, we began shipping our third-generation Stakpak technology, enabling dramatically lower Stakpak pricing through our implementation of automated manufacturing processes. In 2001, we introduced our Value Stakpak® product as a low-cost stacked high-density memory solution for devices and systems with lower thermal management requirements. Our fourth generation solution, the High Performance Stakpak®, was introduced in 2003 and offers next-generation memory and performance capabilities in a non-leaded stacked memory package.

     The vast majority of the stacked solutions provided by us to date have been to semiconductor manufacturers, memory module manufacturers and contract manufacturers for inclusion in midrange and high-performance servers and storage systems products of large original equipment manufacturers, or OEMs, such as Cisco Systems, Dell, Hewlett-Packard, IBM, Intel and Sun Microsystems. To a lesser extent, we sell our stacked solutions directly to OEMs. Some of our customers place blanket purchase orders up to three months in advance to cover shipments for the relevant period. These purchase orders do not represent commitments to purchase given quantities of our products, but serve as non-binding forecasts for pricing, administrative and general scheduling purposes. In some

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instances, purchase orders from customers are received no more than a day in advance or in the same shipment as the consigned DRAM chips that are supplied to us for stacking. However, we have no long-term purchase agreements with any of our customers.

     Through our flexible OEM-centric business model, our customers can license our proprietary stacking technologies. To date, we have entered into license agreements with Samsung Electronics Co., Ltd. and Infineon Technologies A.G. Under these license arrangements, Samsung and Infineon are licensed to manufacture and sell memory modules containing stacked DRAM chips incorporating our leaded-package stacking technologies. In 2002, 2003 and the first nine months of 2004, 14%, 26% and 43% of our total revenue in such respective periods were derived from royalties recognized under our agreement with Samsung. Our license to Infineon is more limited in scope than our license to Samsung. We recognized a small amount of revenue from this license agreement in the second and third quarters of 2004, and we do not anticipate that we will derive material revenue from this license in the near term.

     We price our stacked memory solutions based on a number of factors, and in particular, on the estimated quarterly volumes reflected in our customers’ forecasts. While relative demand for stacked memory products may fluctuate with variations in the average selling price of DRAM chips, the average selling prices for our manufacturing services and technologies are not directly impacted by changes in the price of memory. Through our investments in greater automation within our manufacturing operations and the implementation of other efficiencies in our internal processes, over time we have achieved significant reductions in our internal manufacturing costs on a per-unit basis. By passing these cost savings through to our customers in the form of lower average selling prices for our services, we are able to provide greater opportunities for OEMs to cost-effectively increase the memory capacity of their products. By increasing our production volumes within a lower cost structure, combined with increased license revenue, which generally entails lower cost of revenue, our gross margins have improved from 27% and 29% in 1999 and 2000, respectively, to 49%, 51%, 49% and 43% in 2001, 2002, 2003 and the first nine months of 2004, respectively.

     Two investment funds affiliated with Austin Ventures (“Austin Ventures”) formed us in May 2003 for the purpose of acquiring Staktek Corporation. Our predecessor company, Staktek Corporation, was incorporated in Texas in June 1990. In August 2003, Austin Ventures acquired Staktek Corporation through a merger of a wholly owned subsidiary of our Company with and into Staktek Corporation (the “Staktek acquisition”). As a result of this merger, Staktek Corporation became our wholly owned subsidiary. We did not have any operations prior to August 21, 2003, other than in connection with the Staktek acquisition.

     On February 11, 2004, we completed our initial public offering in which we sold 10 million shares of our common stock at $13 per share, for an aggregate public offering price of $130 million. On March 5, 2004, we sold an additional 1.19 million shares in connection with the underwriters’ over-allotment option, for an aggregate public offering price of approximately $15.5 million. Our sale of shares of common stock, including the underwriters’ exercise of their over-allotment option, resulted in aggregate net proceeds of approximately $133.4 million. See Note 2 of Notes to the Consolidated Condensed Financial Statements for additional information.

     In June 2004, we acquired from DPAC Technologies Corp. (“DPAC”) its stacking patents and patent applications as well as certain customer information, as DPAC exited the stacking business to focus on other areas. We paid DPAC $600,000 in June and paid additional amounts totaling approximately $134,000, including payments for related transaction costs, in the third quarter. We are working with former DPAC customers to transition them to our Value Stakpak or Performance Stakpak products.

     The following text describes certain line items of our statements of operations.

     Revenue. Revenue consists of services revenue recognized from our manufacture of Stakpaks and of license revenue recognized under our license agreements with Samsung and Infineon. In most instances, our customers provide high-density memory packages to us for stacking on a consignment basis. In some instances, we purchase high-density memory packages from the vendor specified by the customer, typically in quantities at or below the amounts that either the customer is obligated to purchase or we are able to return to the vendor. We exclude from services revenue the costs of memory packages purchased by us and then sold to our customers since we do not bear meaningful inventory risk.

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     Cost of Revenue. Cost of revenue includes depreciation of equipment, direct and indirect labor costs, costs of flex circuits and other components and raw materials and facilities costs associated with our manufacturing operations. Cost of revenue also includes the amortization of intangible assets associated with the Staktek acquisition and amortization of certain patents. A portion of our cost of revenue, such as depreciation of equipment, is fixed in any given period.

     Selling, General and Administrative. Selling, general and administrative expenses consist of salaries and wages for executive, sales and marketing and administrative personnel, travel expenses and other marketing costs. Additional expenses include administrative and information technology costs, legal costs, amortization of customer relationships and non-compete agreements and other supporting costs. These expenses also include allocations or direct charges for insurance, consultants and other professional fees, utilities and office supplies. Beginning in the third quarter of 2004, these expenses also include amortization of the customer list intangible purchased from DPAC.

     Research and Development. Research and development expenses include expenses related to product development and design, engineering, process development, equipment and tooling design, fabrication and implementation, test hardware and software design and implementation and amortization of certain patents. Research and development expenses, however, do not necessarily reflect all of our engineering efforts. Our engineering group also provides various support functions in the manufacturing of products currently in production. The costs of such support are included in manufacturing overhead. Therefore, significant fluctuations in research and development expenses may occur from period to period depending on the nature and extent of engineering activities over any given time frame. In addition, we devote significant resources to design, develop and implement automated machinery for our products. When we believe that such machinery will include significant engineering time to design, develop, and install or assemble, all costs associated with that machine, including internal labor and overhead, are capitalized as part of its cost. General product and process development costs that are not associated with either a specific customer product or a standard product to be offered for sale are considered to be research and development activities and are accounted for as research and development expenses.

     Business Restructuring and Acquisition. Business restructuring and acquisition costs consist of expenses associated with the Staktek acquisition and costs associated with the reduction of our workforce in Austin, Texas during 2003 as the result of the move of our high-volume manufacturing facility to Reynosa, Mexico.

     Amortization of Acquisition Intangibles. Amortization of acquisition intangibles consists of amortization of acquired identified intangible assets resulting from the Staktek acquisition in August 2003.

     Amortization of Deferred Stock-Based Compensation and Stock Compensation Expense. We recorded deferred stock-based compensation for the difference between the exercise price of option grants and the fair value of our common stock at the time of these grants. We are amortizing this amount over the vesting periods of the applicable options.

     Other Income (Expense), Net. Other income (expense), net generally consists of net interest income and interest expense and other non-recurring items, such as the gain or loss on the disposition of assets.

     Provision for Income Taxes. We accrue a provision for federal, state and foreign income taxes at the applicable statutory rates adjusted for non-deductible expenses. Foreign income tax includes withholding tax on certain royalty income received from foreign customers. For the year ending December 31, 2004, the Company’s effective tax rate is estimated to be 40%. For the nine months ended September 30, 2004, the Company’s effective tax rate was approximately 39% due to the recognition in the first quarter of 2004 of certain deferred tax assets not previously recognized.

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Results of Operations

     The following tables present our operating results for periods indicated as a percentage of revenue:

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     We were formed in May 2003 for purposes of acquiring Staktek Corporation. We had no operations prior to August 21, 2003 other than in connection with the Staktek acquisition. In our discussion of our results of operations in 2003, we discuss each line item in the statement of operations on a combined basis for comparative purposes. These combined amounts represent the sum of the financial data for Staktek Corporation and us for the periods from July 1, 2003 through September 30, 2003 and January 1, 2003 through September 30, 2003. These combined amounts are for informational purposes only.

     Revenue. Revenue for the three months ended September 30, 2004 was $16.1 million, compared to revenue of $19.0 million for the three months ended September 30, 2003, resulting in a decrease of $2.9 million, or 15%. Services revenue in the third quarter of 2004 was $8.3 million, compared to $14.2 million in the third quarter of 2003, resulting in a decrease of $5.9 million, or 42%. In addition, in the third quarter of 2004, license revenue was $7.8 million, compared to $4.8 million in the third quarter of 2003, resulting in an increase of $3.0 million, or 63%.

     Revenue in the third quarter of 2004 decreased primarily due to lower units shipped of our products and a shift in customer demand to our lower-priced Value Stakpak product, partially offset by an increase in license revenue. The decrease in demand for our Performance Stakpak product was due mainly to three factors. The first factor was that as a result of the price parity between stacked 256-megabit DRAM densities and non-stacked, monolithic 512-megabit DRAM densities, our customers did not need to utilize stacked 256-megabit DRAM but instead could use a single monolithic 512-megabit DRAM for the same cost. The second factor regarding the decrease in demand was the overall DRAM supply shortage during the quarter. Third, we had been selling to Celestica as a supply-chain partner of another OEM, but this OEM adopted a different business model by sourcing more of its high-density needs directly through silicon providers rather than indirectly through Staktek. The principle effect of this change was to shift some service revenue to license revenue. In addition, this shift may result in the potential loss of some business to alternative technologies.

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     License revenue increased $3.0 million during the third quarter of 2004, compared with the same period of the prior year due primarily to higher royalty revenue from Samsung. License revenue increased slightly due to the addition of Infineon as a licensee in 2004.

     Revenue for the nine months ended September 30, 2004 was $56.0 million, compared to $49.8 million in the first nine months of 2003, resulting in an increase of $6.2 million, or 12%. Services revenue for the first nine months of 2004 was $31.3 million, compared to $37.2 million in the first quarter of 2003, resulting in a decrease of $5.9 million, or 16%. In the first nine months of 2004, license revenue was $24.7 million, compared to $12.6 million in the first nine months of 2003, resulting in an increase of $12.1 million, or 95%. Revenue in the first nine months of 2004 increased primarily due to higher royalty revenue from Samsung and, to a much lesser degree, royalty revenue from Infineon. Service revenue declined due to a shift in mix from our Performance Stakpak product to our lower-priced Value Stakpak product.

     We anticipated a decrease in the rate of overall unit growth in the demand for stacked memory solutions during the transition period from current-generation stacked products, which are based on 256-megabit memory TSOPs, to next-generation stacked products, which are based on 512-megabit memory TSOPs. We actually experienced a decrease in total units from the second quarter to the third quarter of 2004 of 3%, in addition to the approximately 9% unit decline we experienced from the first quarter to the second quarter of 2004. Because the next-generation TSOPs deliver twice as many bits of memory as the current generation, the demand for stacked memory packages, as measured in megabits, will be satisfied at lower levels of unit volumes. This transition is underway, and accordingly, we are experiencing an increase in the number of units based on 512-megabit memory TSOPs shipped in 2004, as compared to similar units shipped in 2003. We anticipate that the transition cycle will run its course in the next three to four quarters, but may repeat with future generations of DRAM chips, such as when one gigabit chips displace 512 megabit chips as the lowest cost-per-bit memory chip.

     In addition to this transition, there are two other transitions that are impacting us. The first is the transition from leaded to non-leaded packaging technology, a significant portion of which we expect to occur next year. Our Value Stakpak and Performance Stakpak products use leaded packaging technology, while our High Performance Stakpak is our first non-leaded product.

     The second transition is an increased use of planar solutions, which allow additional memory devices to be directly attached on the printed circuit board without the need for stacking. We believe that some of the major OEMs and DRAM suppliers currently are using planar solutions and we expect them to utilize a greater percentage of planar solutions in the near future in legacy DDR technologies as well as in next-generation DDR-II technologies. However, we believe that these planar solutions will have a limited window of opportunity, since increasing die sizes and higher speed requirements are expected to limit their use over time.

     It is not possible to specifically quantify the impact of these three ongoing transitions on our future business. We do expect decreased revenues in the short term with the combination of the transition from 256 megabit DRAM to 512 megabit DRAM, the transition from leaded to non-leaded packaging technology, and the increased use of competitive technologies, such as planar solutions. We do believe that once these transitions are complete, we will be well positioned in our market.

     Our license agreement with Samsung expires in July 2005, and to date, we have not had substantive discussions with Samsung about extending this agreement. We anticipate that we will extend or renegotiate the terms of this agreement. Samsung has made significant investments in tooling, manufacturing, testing facilities and expertise as well as in product acceptance activities. We also believe that Samsung realizes substantial financial benefits from the sale of stacked memory solutions incorporating our proprietary technologies, and that Samsung’s continued ability to provide these solutions is important to its relationships with its customers and OEMs. We believe that if Samsung does not extend or renegotiate this agreement, Samsung would not be able to continue to produce its current stacked memory products without infringing our patent rights. If we enter into a relationship with Samsung whereby we provide manufacturing services to them, we expect that our gross profit per unit would improve while our gross margins would decline as the proportion of our license revenue to overall revenue declines. If we are unable to extend this agreement on terms favorable to us or at all, if Samsung renews but does not utilize as much of our stacking technology as it currently uses, or if Samsung terminates this agreement, our license revenue from this agreement could be reduced or eliminated. If Samsung’s customers do not use our manufacturing services or buy the

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stacked high-density memory solutions from one of our other supply-chain partners, our revenue, operating results and cash flows could be reduced.

     The following tables summarize sales to customers that represent 10% or more of consolidated total revenue for the periods indicated:

* Amount does not exceed 10% for the indicated period.

* Amount does not exceed 10% for the indicated period.

     In the fourth quarter of 2004, we expect total revenue to be down from the third quarter of 2004.

     Gross Profit. Gross profit for the three months ended September 30, 2004 was $6.2 million, or 38.4% of revenue. This amount is a decrease of $4.2 million, compared to gross profit of $10.4 million, or 55.0% of revenue, in the three months ended September 30, 2003. The decrease in gross profit dollars for the most recent quarter was due to the $2.5 million increase in amortization of acquisition intangibles recorded in the third quarter of 2004 versus the third quarter of 2003, a shift in our mix of products to our lower-margin Value Stakpak product and an overall decline in in-house stacked units in the third quarter of 2004. These decreases were partially offset by reduced direct labor and benefits as a result of the increased utilization of our high-volume manufacturing facility in Reynosa, Mexico in 2004 and by the substantial increase in license revenue as a percentage of total revenue. License revenue increased to 48.7% of total revenue in the third quarter of 2004 from 25.4% of total revenue in the third quarter of 2003. Gross profit as a percentage of revenue was reduced by 25.5 percentage points during the third quarter of 2004, due to the amortization of acquisition intangibles and the amortization of deferred stock-based compensation and stock compensation expense allocated to cost of revenue, as compared with a 7.5 percentage point impact of these items on overall gross margin during the same period of the prior year. Our manufacturing services’ gross margin percentage decreased by approximately 20.0 percentage points during the third quarter of 2004 from the same period of the prior year, due mainly to fixed costs being spread over fewer units and the shift in mix to our Value Stakpak product, partially offset by the reduction in manufacturing costs resulting from the increased utilization of our high-volume manufacturing facility in Mexico in 2004.

     Gross profit for the nine months ended September 30, 2004 was $24.1 million, or 43.0% of revenue, as compared with gross profit of $25.8 million, or 51.7% of revenue, for the nine months ended September 30, 2003. The decrease in gross profit dollars for the most recent nine months was primarily due to the $10.4 million increase in amortization of acquisition intangibles recorded in the first nine months of 2004 versus the same period of 2003 and the mix shift to Value Stakpak, partially offset by the substantial increase in license revenue as a percentage of

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total revenue. License revenue increased to 44.1% of total revenue in the first nine months of 2004 from 25.3% of total revenue in the first nine months of 2003. Our gross margin percentage was reduced by 22.0 percentage points during the first nine months of 2004, due to the amortization of acquisition intangibles and the amortization of deferred stock-based compensation and stock compensation expense allocated to cost of revenue as compared with a 2.9 percentage point impact of these items on overall gross margin during the same period of the prior year. Gross margin percentage of our manufacturing services decreased by approximately 1.9 percentage points during the first nine months of 2004 over the comparable period of the prior year due to the mix shift from our Performance Stakpak product to the Value Stakpak product, partially offset by the reduced direct labor and benefits as a result of the move of our high-volume manufacturing facility to Reynosa, Mexico in 2003.

     Selling, General and Administrative. Selling, general and administrative expense for the three months ended September 30, 2004 was $2.2 million, or 13.5% of revenue. This amount reflected an increase of $579,000, or 36%, as compared to selling, general and administrative expense of $1.6 million, or 8.4% of revenue, in the three months ended September 30, 2003. The increase in selling, general and administrative expense during the third quarter of 2004 from the comparable period of the prior year was primarily due to higher directors’ and officers’ insurance costs of $363,000, increased staffing costs of $150,000 and audit and tax services of $94,000, mainly as a result of being a public company. We expect selling, general and administrative expense to range between 12 to 15% of revenue over the next several quarters.

     Selling, general and administrative expense for the nine months ended September 30, 2004 was $6.6 million, or 11.9% of revenue. This amount reflected an increase of $2.6 million, or 67%, as compared to selling, general and administrative expense of $4.0 million, or 8.0% of revenue, in the nine months ended September 30, 2003. The increase in the dollar amount of selling, general and administrative expense during the first nine months of 2004 from the comparable period of the prior year was primarily due to higher directors’ and officers’ insurance costs of $968,000, increased staffing and associated costs of $886,000 and higher audit and tax services of $258,000, mainly as a result of being a public company. In addition, we incurred higher legal fees of $319,000 in the first nine months of 2004, mainly as a result of prior litigation with Infineon and SimpleTech.

     Research and Development. Research and development expense for the three months ended September 30, 2004 was $634,000, or 3.9% of revenue, which reflected an increase of $14,000, or 2%, as compared with research and development expense of $620,000, or 3.3% of revenue for the three months ended September 30, 2003. Research and development expense for the first nine months of 2004 was $1.6 million, or 2.9% of revenue, which reflected a decrease of $164,000, or 9%, as compared with research and development expense of $1.8 million, or 3.6% of revenue for the comparable period of 2003. The increase in the dollar amount of research and development expense for the three-month period in 2004, in comparison with the same period in 2003, was principally due to amortization of the patents acquired from DPAC in the second quarter of 2004. The decrease in costs for the nine-month period was primarily due to lower process development expenses, partially offset by increased materials costs as we develop our processes for stacking new fBGA packages. We intend to devote additional resources to research and development in future periods to address market opportunities for advanced technologies, such as DDR-II, DRAM chips in fBGA packages, non-DRAM homogeneous circuits, and heterogeneous circuits (our System Stakpak®). As a result, we expect research and development expenses to range between 3 to 5% of revenue in the next several quarters. Our increased spending on research and development will be used to design and develop the tooling, testing capabilities and automation equipment to position us for qualification and manufacturing of products based on these new technologies.

     Business Restructuring and Acquisition. During the third quarter of 2003, we recorded business restructuring and acquisition expenses of $4.2 million, comprised almost entirely of expenses associated with the Staktek acquisition. During the first nine months of 2003, we recorded business restructuring and acquisition expenses of $4.7 million, comprised of $4.2 million of expenses associated with the Staktek acquisition and severance costs of $537,000 associated with the move of our high-volume manufacturing facility to Reynosa, Mexico. There were no business restructuring or acquisition-related costs in 2004.

     Amortization of Acquisition Intangibles. During the three and nine months ended September 30, 2004, we amortized $4.4 million and $13.2 million, respectively, of intangible assets resulting from the Staktek acquisition during the third quarter of 2003. During the three and nine months ended September 30, 2003, we amortized $1.7 million of intangible assets from that acquisition.

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     Amortization of Deferred Stock-Based Compensation and Stock Compensation Expense. We recorded amortization expense associated with deferred stock-based compensation of $1.2 million and $3.8 million for the three and nine months ended September 30, 2004, respectively. We recorded amortization expense associated with deferred stock-based compensation of $1,000 and $42,000 for the three and nine months ended September 30, 2003, respectively.

     Interest and Other Income (Expense). Interest and other income (expense), net for the three months ended September 30, 2004, was income of $117,000, as compared to expense of $992,000 for the same period of the prior year. Interest and other income (expense), net for the first nine months of 2004 was expense of $1.0 million, as compared to expense of $910,000 for the first nine months of 2003. The change in other income (expense), net during the three- and nine-month periods was mainly due to interest expenses associated with the senior and subordinated debt incurred to finance the Staktek acquisition in 2003, which was repaid following the Company’s initial public offering in February 2004.

     Provision for Income Taxes. We incurred income taxes of $736,000 and $2.0 million in the third quarter of 2004 and 2003, respectively. We incurred income taxes of $3.9 million and $6.0 million in the first nine months of 2004 and 2003, respectively. For the year ending December 31, 2004, the Company’s effective tax rate is estimated to be 40%. For the nine months ended September 30, 2004, the Company’s effective tax rate was approximately 39% due to the recognition in the first quarter of 2004 of certain deferred tax assets not previously recognized. Provision for income taxes as a percentage of income before income taxes in the first nine months of 2003 was 45%. The tax provision rates differ from the federal statutory rate of 35% due to the impact of certain stock compensation and other permanent items.

Liquidity and Capital Resources

     As of September 30, 2004, we had working capital of $78.8 million, including $69.7 million of cash and cash equivalents, compared to working capital of $25.4 million, including $31.2 million of cash and cash equivalents as of December 31, 2003. The $53.4 million increase in working capital during the first nine months of 2004 was primarily due to the $38.5 million increase in cash and cash equivalents and the $12.5 million reduction in notes payable and current maturities of long-term debt due to the repayment of debt incurred to finance the Staktek acquisition. We received an aggregate of approximately $145.5 million gross proceeds from our initial public offering, including the underwriters’ exercise of their over-allotment option.

     Net cash provided by operating activities was $19.0 million for the first nine months of 2004, and resulted primarily from net income adjusted by non-cash expenses and a decrease in accounts receivable, partially offset by total tax payments exceeding our book tax provision, a reduction in accrued liabilities due to payment of accrued interest on the debt from the Staktek acquisition and a decrease in trade accounts payable. Net cash provided by operating activities during the first nine months of 2003 was $5.6 million and resulted mainly from net income adjusted by non-cash expenses, partially offset by a decrease in accounts receivable and prepaid expenses and other assets.

     Net cash used in investing activities was $3.5 million for the first nine months of 2004, compared to $91.6 million during the comparable period of 2003. Investing activities during the first nine months of 2004 were comprised primarily of additions to property and equipment. Additionally, in the first nine months of 2004 we paid $734,000 to DPAC in connection with the purchase of its patents, patent applications and certain customer information (see Note 5 of Notes to the Consolidated Condensed Financial Statements). Investing activities during the first nine months of 2003 were comprised primarily of the $85.8 million paid for the acquisition of Staktek, net of the cash acquired, and additions to property and equipment of $5.7 million.

     Net cash provided by financing activities during the first nine months of 2004 was $23.0 million, primarily due to the $133.8 million in proceeds received from our initial public offering, including the underwriters’ exercise of their over-allotment option, net of associated expenses paid during the nine-month period. These net proceeds were partially offset by debt payments totaling $77.6 million and the $30.6 million redemption of the redeemable preferred stock. As of March 31, 2004, all debt issued in connection with the Staktek acquisition had been repaid and all redeemable preferred stock previously issued to Austin Ventures had been redeemed. Further, the senior revolving credit notes were terminated in February 2004, so there is no amount available for issuance under these

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notes. Additionally, we spent $2.4 million during the first nine months of 2004 to purchase our stock on the open market as part of the approved stock repurchase program (see Note 9 of Notes to the Consolidated Condensed Financial Statements). Net cash provided by financing activities during the first nine months of 2003 was $109.5 million, primarily due to the $79.5 million and the $29.5 million in proceeds received from the issuance of debt and preferred stock, respectively, in connection with the Staktek acquisition.

     We believe that our current assets, including cash and cash equivalents and expected cash flow from operations will be sufficient to fund our operations, our anticipated additions to property and equipment and any share repurchases under the approved stock repurchase for at least the next 12 months. However, it is possible that we may need or elect to raise additional funds to fund our activities beyond the next year or to acquire other businesses, products or technologies. We could raise such funds by borrowing money or selling more stock to the public or to selected investors. In addition, while we may not need additional funds, we may elect to sell additional equity securities or obtain credit facilities for other reasons. We cannot assure you that we will be able to obtain additional funds on commercially favorable terms, or at all. If we raise additional funds by issuing more equity or convertible debt securities, the ownership percentages of existing stockholders would be reduced. In addition, the equity or debt securities that we issue may have rights, preferences or privileges senior to those of the holders of our common stock.

Critical Accounting Policies and Estimates

     We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

     Revenue Recognition and Presentation. We evaluate our customer arrangements for manufacturing services to determine whether revenue from these arrangements should be recorded on a gross basis or a net basis. When evaluating our customer arrangements, we determine whether the arrangement represents a consigned inventory transaction or a purchase and resale of inventory. In making this determination, we consider the following: (i) we are only responsible for the functionality of our stacking process, (ii) we do not select the vendor to provide the memory packages, and (iii) we do not set the price for the memory packages. We have determined that a net basis of revenue recognition is appropriate for our customer arrangements for manufacturing services, including arrangements where the customer has instructed us to purchase specified memory packages from a specified vendor for purposes of stacking and shipping to the customer. Should the considerations described above change, we may determine that future customer arrangements should be recorded on a gross basis that would result in an equal increase in both revenue and the cost of revenue.

     Revenue from our license agreements with Samsung and Infineon are recognized in the period in which they report royalties to us. Neither licensee typically provides us with forward estimates or current-quarter information concerning its shipments. Because we are not able to reasonably estimate the amount of royalties earned during the period in which the licensees actually ship products using our stacking technologies, we do not recognize royalty revenue until the royalties are reported to us.

     Impairment of Assets. We evaluate the recoverability of losses on long-lived assets, such as property and equipment and intangible assets, but excluding goodwill. Impairment losses on long-lived assets are recognized when events or changes in circumstances indicate that the undiscounted cash flows estimated to be generated by such assets are less than the carrying value of these assets, and accordingly, all or a portion of this carrying value may not be recoverable. Impairment losses are then measured by comparing the fair value of the assets to the carrying amounts. Actual useful lives and cash flow could be different than those estimated by us.

     Goodwill is evaluated annually for impairment and is not amortized. The goodwill impairment test requires judgment regarding the determination of fair value of the reporting unit, which we determined to be our company as a whole, and the determination of fair value of our assets and liabilities.

     Income Taxes. We determine deferred tax assets and liabilities based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the years in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized.

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     Deferred Stock-Based Compensation. We account for our employee stock-based compensation using the intrinsic value method. The intrinsic value method specifies that compensation exists if the fair value of the common stock exceeds the exercise price of the stock option at the date of grant. Prior to the successful completion of our initial public offering during the first quarter of 2004, the determination of fair value of our common stock was based upon assumptions and other considerations. Since a ready market did not exist for our common stock prior to the completion of our initial public offering, we used to estimate fair value for our common stock using traditional valuation methodologies, such as multiples of earnings or cash flows. The estimated fair value of our common stock could differ significantly from the fair value had our common stock been traded on the public market on the dates of grant.

Recent Accounting Pronouncement

     In January 2003, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 46, or FIN 46, Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51. FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective immediately for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period ending after March 15, 2004. The adoption of FIN 46 had no impact on our financial position, results of operations or cash flows.

Risks That May Affect Future Results

     Our business faces significant risks. The risk factors set forth below may not be the only ones that we face. Additional risks that we are not aware of yet or that currently are not material may adversely affect our business operations.

     We may not be able to increase our revenue and our operating results are likely to fluctuate, which may cause the trading price of our common stock to decline.

     We may not be able to increase revenue or generate gross profits or net income. Our revenue and operating results are likely to fluctuate, causing our stock price to fluctuate. If our revenue or operating results fall below the expectations of market analysts or investors, the market price of our common stock could decline substantially.

     Factors that may contribute to fluctuations in our revenue and operating results include the risk factors discussed in this Form 10-Q and the following additional factors:

•

the timing and volume of orders received from our customers;

•

market demand for, and changes in the average sales prices of, our services and technologies;

•

the rate of qualification and adoption of our services and technologies by original equipment manufacturers including, but not limited to, the transition from DDR-I to DDR-II technology and from leaded to non-leaded packages;

•

a shortage of DRAM chips, which may negatively impact our ability to fulfill customer orders;

•

the impact of the transition from current-generation stacked products, which are based on 256 megabit monolithic DRAMs to next-generation stacked products, which are based on 512 megabit monolithic DRAMs, resulting in lower unit volumes of stacked memory products;

•

the impact of a current reduction in the prices of 512 megabit monolithic DRAM, making this memory a competitive cost alternative to stacked 256 megabit monolithic DRAMs;

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•

the increasing adoption of small-package planar solutions instead of our stacking solutions by OEMs as well as DRAM suppliers;

•

fluctuating demand for, and life cycles of, the products and systems that incorporate our stacked solutions;

•

changes in OEMs’ DRAM and dual in-line memory module buying processes;

•

changes in the level of our operating expenses;

•

our ability to manufacture and ship products within a particular reporting period;

•

deferrals or cancellations of customer orders in anticipation of the development and commercialization of new technologies or for other reasons;

•

our ability to enter into new licensing arrangements, and the terms and conditions for payment to us of license fees under those arrangements;

•

changes in our services and technologies and revenue mix;

•

seasonal purchasing patterns for our products with lower revenue generally occurring in the first and second quarters;

•

the timing of the introduction by others of competing, replacement or substitute technologies or manufacturing services;

•

our ability to procure DRAM and other required components or fluctuations in the cost of such components;

•

our ability to enforce our intellectual property rights or to defend claims that we infringe the intellectual property rights of others, and the significant costs to us of related litigation;

•

cyclical fluctuations in semiconductor markets generally; and

•

general economic conditions that may affect end-user demand for products that use our technologies.

     Fluctuations in the demand for our stacking solutions occur as the price of next-generation monolithic memory chips declines and as OEMs respond to demand for their products, which will contribute to volatility in our revenue and operating results and may adversely impact our stock price. The rate at which OEMs adopt stacked memory products using a particular generation of high-density memory chips, if they adopt stacked memory products at all, may affect our revenue and operating results. In the past, it has taken several quarters for new, higher-density memory chips to achieve market acceptance. Once accepted by the market, demand for stacked memory products using these chips can accelerate rapidly and then level off such that rapid growth in sales of these products is not indicative of continued future growth. Likewise, demand for legacy memory chips can quickly decline when a new, higher-density memory chip is introduced and receives market acceptance. Sales of our products and product lines toward the end of a product’s market life may fluctuate significantly, and the precise timing of these fluctuations is difficult, if not impossible, to predict.

     In other cases, revenue may decline as customers anticipate making new product purchases. The need for continued significant expenditures for capital equipment purchases, research and development and ongoing customer service and support, among other factors, makes it difficult for us to reduce our operating expenses in any particular period if our expectations for revenue for that period are not met. Due to the various factors mentioned above, the results of any prior quarterly or annual periods should not be relied upon as an indication of our future operating performance.

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     Because we do not have long-term agreements with our customers and generally do not have a significant backlog of unfilled orders, our revenue and operating results in any quarter are difficult to forecast and are substantially dependent upon customer orders received and fulfilled in that quarter.

     We do not have long-term purchase agreements with customers. Our customers generally place purchase orders for deliveries no more than three months in advance and sometimes no more than a day in advance. These purchase orders generally have no cancellation or rescheduling penalty provisions. Therefore, cancellations, reductions or delays of orders from any significant customer could have a material adverse effect upon our business, financial condition and results of operations.

     Our revenue is difficult to forecast because we do not have a sufficient backlog of unfilled orders to meet our quarterly revenue targets at the beginning of a quarter. Rather, a majority of our revenue and earnings in any quarter depends upon customer orders for our products that we receive and fulfill in that quarter. Because our expense levels are based in part on our expectations as to future revenue and to a large extent are fixed in the short term, we likely will be unable to adjust spending on a timely basis to compensate for any unexpected shortfall in revenue. Accordingly, any significant shortfall of revenue in relation to our expectations could hurt our operating results and depress our stock price.

     We depend on a limited number of customers for a substantial portion of our revenue, and the loss of, or a significant reduction in orders from, any key customer could significantly reduce our revenue.

     The loss of any of our key customers, or a significant reduction in sales to any one of them, would significantly reduce our revenue and adversely affect our business. Our five largest customers accounted for 97% of our total revenue in 2001, 93% of our total revenue in 2002, 88% of our total revenue in 2003 and 88% of our total revenue during the first nine months of 2004. In particular, Samsung accounted for most of our license revenue and 43% of our total revenue in the first nine months of 2004, and Micron Technology, Celestica Corporation and SMART Modular Technologies accounted for 15%, 12% and 12%, respectively, of our total revenue in the first nine months of 2004. SMART Modular is a supply-chain partner of Hewlett-Packard, so units incorporating our stacking solutions are ultimately sold through to HP as the OEM. We sold to Celestica as a supply-chain partner of another OEM, but this OEM adopted a different business model by sourcing more of its high-density needs directly through silicon providers rather than indirectly through Staktek. The principle effect of this change was to shift some service revenue to license revenue. In addition, this shift may result in the potential loss of some business to alternative technologies. Most of the markets for our services and technologies are dominated by a small number of potential customers. Therefore, our operating results in the foreseeable future will continue to depend on our ability to effect sales to these dominant customers, as well as the ability of these customers to sell products that incorporate our stacked high-density memory utilizing our stacking technologies. In the future, these customers may decide not to specify products that incorporate our stacking technologies for use in their systems, purchase fewer stacked memory products than they did in the past or alter their purchasing patterns.

     Some of our customers have sought or are seeking to design alternative solutions, either internally or through third parties, to address their need for greater memory capacity. The success of these efforts could have an adverse effect on the prices we are able to charge to our customers, and the volume of units that incorporate our stacking solutions, which would negatively affect our revenue and operating results.

     Consolidation in some of our customers’ industries may result in increased customer concentration and the potential loss of customers. From time to time, the composition of our major customer base has changed from quarter to quarter as the market demand for our customers’ products has changed, and we expect this variability to continue in the future. We expect that sales of our products to a limited number of customers will continue to represent a majority of our revenue in the foreseeable future. The loss of, or a significant reduction in purchases by, any of our major customers could harm our business, financial condition and results of operations.

     A natural disaster, epidemic, labor strike, war or political unrest where our customers’ facilities are located could reduce our sales to such customers. For example, Samsung Electronics is based in South Korea and represented most of our license revenue and 43% of our total revenue in the first nine months of 2004. North Korea’s decision to withdraw from the Nuclear Non-Proliferation Treaty and related geopolitical developments have created unrest. This unrest could create economic uncertainty or instability, could escalate to war or otherwise adversely affect South Korea and Samsung, which could materially and adversely affect our operating results.

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     If we fail to protect our proprietary rights, our customers or our competitors might gain access to our technologies, which could adversely affect our ability to sell or license our stacked memory solutions or to compete successfully in our markets and harm our operating results.

     Our solutions rely on our proprietary rights, and we believe that the strength of our intellectual property rights is, and will continue to be, critical to the success of our business. If any of our key patents or other intellectual property rights are invalidated or deemed unenforceable, or if a court limits the scope of the claims in any of our key patents or other intellectual property rights, the likelihood that companies will continue to purchase or license our stacked memory solutions could be significantly reduced. The resulting loss in revenue could significantly harm our business and our operating results.

     We rely on a combination of patent, trademark and trade secret laws and restrictions on disclosure to protect our intellectual property rights. We also enter into confidentiality agreements with our employees, consultants and third parties, and control access to and distribution of our documentation and other proprietary information. It is possible that these efforts to protect our intellectual property rights may not:

•

prevent challenges to, or the invalidation or circumvention of, our existing patents;

•

result in patents that lead to commercially viable products or provide competitive advantages for our products;

•

prevent our competitors from independently developing similar products, duplicating our products or designing around the patents owned by us;

•

prevent third-party patents from having an adverse effect on our ability to do business;

•

provide adequate protection for our intellectual property rights;

•

prevent disputes with third parties regarding ownership of our intellectual property rights;

•

prevent disclosure of our trade secrets and know-how to third parties or into the public domain; or

•

result in valid patents, including international patents, from any of our pending applications.

     Others may attempt to copy or otherwise obtain and use our proprietary technologies without our consent. Because we expect to increasingly license our technologies to new customers and because of the difficulty of monitoring our licensees, the risk that licensees and their customers or others may attempt to copy or otherwise obtain and use our proprietary technologies without our consent may increase. Monitoring unauthorized use of our technologies is difficult, and we cannot be certain that the steps we have taken will prevent unauthorized use of our technologies, particularly in foreign countries where the laws may not protect our proprietary rights to the same extent as the laws of the United States.

     We derive a substantial portion of our revenue from our license agreement with Samsung, which expires in July 2005. We may not be able to extend this agreement on favorable terms or at all, or Samsung may renew but not utilize as much of our stacking technology as it currently utilizes, which could materially harm our business, financial condition and results of operations.

     Through the first quarter of 2004, we derived all of our license revenue from our license agreement with Samsung Electronics. We expect to continue to receive the substantial majority of our license revenue from this license agreement for the foreseeable future. This agreement requires Samsung to pay us royalties based on the number of stacked memory products Samsung sells or bundles within its own products. This license expires in July 2005, and, to date, we have not had substantive discussions with Samsung about extending this agreement. If we are unable to extend this agreement on terms favorable to us or at all, if Samsung terminates this agreement, or if Samsung renews this agreement but does not continue to utilize as much of our stacking technology as it currently utilizes, our business, financial condition and results of operations could be materially harmed.

     Our license agreement with Samsung requires Samsung to report to us on a quarterly basis the sale of products that incorporate our technologies. Our license agreement with Samsung does not allow us to examine Samsung’s

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records to verify that the amounts being paid to us as license fees are correct. As a result, we rely primarily on the accuracy of the reports from Samsung without independent verification and secondarily on information obtained from customers, suppliers and market analysts and our own production data. Our inability to review Samsung’s books and records may result in our receiving less license revenue than we are entitled to receive under the terms of our license agreement. If we determine that Samsung is not accurately reporting to us the number of units it sold, we may be required to commence litigation against Samsung which, even if meritorious, could be costly and time consuming, could harm our relationship and could adversely affect our business.

     Following the expiration of our license agreement with Samsung, both we and Samsung will be able to use each other’s technology, information, know-how and processes related to the licensed technologies that are not protected by patents, and Samsung will be able to compete in markets currently restricted by a non-compete provision of the agreement. At such time, subject to our patent rights, Samsung may use such technology and its substantial resources to compete in our target markets.

     We are subject to risks relating to product concentration and lack of revenue diversification.

     We derive nearly all of our revenue from sales or licenses of our Stakpak solutions, and we expect these solutions to continue to account for substantially all of our total revenue in the near term. Continued market acceptance of these solutions is critical to our future success. As a result, our business, operating results, financial condition and cash flows could be adversely affected by:

•

any decline in demand for our Stakpak solutions;

•

failure of our services and technologies to achieve continued market acceptance;

•

the introduction of services and technologies that can serve as a substitute for, replacement of or represent an improvement over, our services and technologies such as planar solutions for small packages that do not require stacking;

•

technological innovations that we are unable to address with our services and technologies; and

•

any inability by us to release new products or enhanced versions of our existing services and technologies on a timely basis or the failure of our products to achieve market acceptance.

     We are particularly dependent on sales of our Performance Stakpak solutions for use in the high-end and midrange server market, which constituted 100% of our total services revenue in 2001, 100% of our total services revenue in 2002, 98% of our total services revenue in 2003 and 84% of our total services revenue in the first nine months of 2004. If the market for these servers deteriorates or the use of our stacked services and technologies in this market declines, our operating results would be materially and adversely affected.

     The average selling prices of our services and technologies could decrease rapidly which may negatively impact our revenue and gross margins.

     We may experience substantial period-to-period fluctuations in our future revenue and operating results due to a decline in the average selling prices for our services and technologies. From time to time, we reduce the average unit price of our services and technologies in anticipation of future competitive pricing pressures, declining monolithic dynamic random access memory, or DRAM, chip prices, introductions of new services and technologies by us or our memory suppliers and other factors. The high-density memory market is extremely cost sensitive due to potentially high order volumes combined with memory buyers’ expectations for aggressive price reductions over time. As a consequence, the average selling prices of monolithic DRAM chips historically have declined as new product generations are commercialized. We expect that these factors will continue to create downward pressure on our average selling prices, which may, in turn, negatively impact our revenue and gross margins, particularly if we are unable to offset reductions in average selling prices by increasing our unit volumes or reducing our manufacturing costs. To maintain our gross margins, we will need to develop and introduce new services and technologies on a timely basis and continually reduce our costs. Our failure to do so could cause our revenue and gross margins to decline.

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     We are a relatively small company with limited resources compared to some of our current and potential competitors, and we may not be able to compete effectively and maintain or increase our market share.

     Some of our current and potential competitors have longer operating histories, significantly greater resources and name recognition and a larger base of customers than we have. Some of these companies are better positioned to influence industry acceptance of a particular industry standard or competing technology than we are. These companies may also be able to devote greater resources to the development, promotion and sale of products, and may be able to deliver competitive products or technologies at a lower price. They also may be able to adopt more aggressive pricing policies than we can adopt. In addition, some of our current and potential competitors have established relationships with the decision makers at our current or potential customers. These competitors may be able to leverage their existing relationships to discourage their customers from purchasing products from us or persuade them to replace our products with their products.

     Some of our significant customers, including Infineon Technologies, Micron Technology and Samsung Electronics, also are competitors of ours, and may have the ability to manufacture competitive products at lower costs. Our current or potential competitors may also offer bundled arrangements offering a more complete or cost-effective product despite the technical merits or advantages of our services or technologies. We also face competition from current and prospective customers that continually evaluate our capabilities against the merits of manufacturing products internally. Competition may also arise due to the development of cooperative relationships among our current and potential competitors or third parties to increase the ability of their products to address the needs of our prospective customers. In addition, we expect to face competition from existing competitors and new and emerging companies that may enter our existing or future markets with similar or alternative products, which may be less costly or provide additional features. Accordingly, it is possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share.

     We have many competitors who have developed competing technologies. For example, planar solutions allow additional memory devices to be directly attached on the printed circuit board without the need for stacking. We believe that some of the major OEMs and DRAM suppliers currently are using planar solutions and we expect them to utilize a greater percentage of planar solutions in the near future in legacy DDR technologies as well as in next-generation DDR-II technologies with the migration to smaller footprint packages in these next-generation technologies. As a result of the increased use of planar solutions, we expect these OEMs and DRAM suppliers to decrease the use of stacked solutions in their products. However, we believe that these planar solutions will have a limited window of opportunity, since increasing die sizes and higher speed requirements are expected to limit their use over time.

     In addition, memory packages have been developed that place two DRAM chips into a single package that allows both DRAM chips to fit in the same area as a single Stakpak. Other competitors utilize competing technologies that stack standard DRAM chips. These traditional stacking competitors include SimpleTech and also included DPAC before we acquired its stacking patents and patent applications in June 2004. We also could face competition from many new technologies, such as 3D memory cells, stacked wafers, stacked die and module innovations or module stacking. These and other new technologies could change the demand for or performance requirements of memory products, and could provide the market with cost-effective memory solutions that outperform our Stakpak solutions.

     We expect our competitors to continue to improve the performance of their current products, reduce their prices and introduce new services and technologies that may offer greater performance and improved pricing, any of which could cause a decline in revenue or loss of market acceptance of our products. In addition, our competitors may develop enhancements to, or future generations of, competitive products that may render our services or technologies obsolete or uncompetitive. These and other competitive pressures may prevent us from competing successfully against current or future competitors, and may materially harm our business. Competition could decrease our prices, reduce our revenue, lower our gross profits or decrease our market share.

     As our current services and technology offerings evolve, we continue to derive a significant portion of our revenue from royalties, which is inherently risky.

     Because we expect a significant portion of our future revenue to be derived from license royalties, our future success depends on:

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our ability to secure broad patent coverage for our new technologies and enter into license agreements with potential licensees; and

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the ability of our licensees to develop and commercialize successful products that incorporate our stacking technologies.

     Although we have engaged in discussions with potential licensees for our Stakpak technologies, we historically have not devoted significant resources to licensing our technologies and currently have only two license arrangements. We face risks inherent in a royalty-based business model, many of which are outside of our control, such as the following:

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the rate of adoption of our technologies by, and the incorporation of our technologies into products of, semiconductor manufacturers and OEMs;

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the extent to which large equipment vendors and materials providers develop and supply tools and materials to enable manufacturing using our stacking technologies on a cost-effective basis and in quantities sufficient to enable volume manufacturing;

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the willingness of our licensees and others to make investments in the manufacturing process that supports our licensed technologies, and the amount and timing of those investments;

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our licensees’ ability to design and assemble memory modules and other system parts that utilize our technologies in components qualified for use by OEMs;

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any failure by our licensees to abide by compliance and quality control guidelines with respect to our proprietary rights;

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actions by our licensees that could severely harm our ability to use our proprietary rights;

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the demand for products incorporating memory modules and other system parts that utilize our licensed technologies;

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our ability to structure, negotiate and enforce agreements for the determination and payment of royalties; and

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the cyclicality of supply and demand for products using our licensed technologies.

     It is difficult to predict when we will enter into additional license agreements, if at all. The time it takes to establish a new licensing arrangement can be lengthy. We may also incur delays or deferrals in the execution of license agreements as we develop new technologies. The timing of our receipt of royalty payments and the timing of how we recognize license revenue under license agreements may fluctuate and significantly impact our quarterly or annual operating results.

     We have limited sales and marketing resources. As our business evolves to become more of a royalty-based model, we may have to employ more rigorous sales and marketing efforts, hire more personnel and engage in lengthy negotiations to reach agreement with potential licensees. As a result, our operating expenses may increase, and we may incur losses in periods that precede the generation of royalties under licensing agreements. If the sales and marketing efforts that we direct at potential licensees of our technologies are unsuccessful, then we may not be able to license our technologies or earn related royalties.

     Our reliance on our memory manufacturer customers for the DRAM chips used in stacked products that incorporate our stacking technologies subjects us to the risk of a shortage of these chips, adversely impacting our ability to fulfill orders from other customers, risks of natural disasters and other factors that could cause disruptions in the supply of DRAM chips.

     Our ability to fulfill customer orders is dependent on a sufficient supply of DRAM chips to which we apply our manufacturing services. Historically, our customers have shipped on consignment their DRAM chips to be stacked, which we stack and then return to them. We have no DRAM supply contracts under which we are currently

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operating other than a supply contract with Elpida Memory for DRAM chips specifically related to the manufacture of our products for IBM. In acquiring DRAM chips, supply options are very limited because of the small number of memory manufacturers. Our dependence on our customers’ provision of DRAM chips to us on a just-in-time consignment basis, rather than through guaranteed supply contracts, subjects our business to risks associated with unforeseen disruptions in the industry availability of DRAM chips. During the third quarter, there was a shortage of DRAM chips available in the market. This shortage negatively impacted our ability to fulfill customer orders, which resulted in a decrease of shipments in the third quarter of 2004.

     In addition, natural disasters or other factors could cause delays or reductions in product shipments that could negatively affect our revenue and operating results. Moreover, since the majority of DRAM chips are manufactured in the Pacific Rim region, we believe that the risk of exposure of DRAM suppliers to earthquakes, typhoons, political unrest, terrorist activity, severe acute respiratory syndrome, or SARS, another infectious disease or other similar events is of particular concern. Any unexpected interruption in the manufacture of other key electronic components used in association with stacked products that incorporate our stacking technologies could disrupt production of devices that use our services and technologies, thereby adversely affecting either our ability to deliver products to our customers or the customers’ demand for our services and technologies.

     If we are unable to manufacture our products efficiently or we experience credit losses or other collections issues, our operating results could suffer.

     We are continuously modifying our manufacturing processes in an effort to maintain satisfactory manufacturing yields and product performance, lower our costs and reduce the time it takes to design products based on our technologies. In addition, we are ramping high-volume production of a new technology with our High Performance Stakpak, which requires a new manufacturing process. We are facing increased risks with this new process and we are incurring significant start-up costs associated with implementing new manufacturing technologies, methods and processes and purchasing new equipment for this product, which could negatively impact our gross margins. We expect to experience manufacturing delays and inefficiencies as we develop or refine new manufacturing technologies and stacking methods, implement them in volume production and qualify them with customers, which could cause our operating results to decline. As we manufacture more complex products, such as our High Performance Stakpak as well as future products, the risk of encountering delays or difficulties increases.

     In addition, if demand for our products increases significantly, we will need to expand our operations to manufacture sufficient quantities of products without increasing our production times or our unit costs. As a result of such expansion, we could be required to purchase new equipment, upgrade existing equipment, develop and implement new manufacturing processes and hire additional technical personnel. Further, new or expanded manufacturing facilities could be subject to qualification by our customers. We cannot be certain that we will be able to add required manufacturing capacity or that we will be able to maintain control over product quality, delivery schedules, manufacturing yields and costs as we increase our output. Any difficulties in expanding our manufacturing operations could cause product delivery delays and lost sales.

     If demand for our products decreases, we could have excess manufacturing capacity. The fixed costs associated with excess manufacturing capacity could cause our operating results to decline. If we are unable to achieve further manufacturing efficiencies and cost reductions, particularly if we are experiencing pricing pressures in the marketplace, our operating results could suffer.

     We have not historically recorded a bad debt allowance or established reserves for our accounts receivable because we have not had significant credit losses or other collections issues during the periods for which financial information is presented. Although we do not believe that we will incur any material credit losses in the foreseeable future, if we were to do so our financial condition could be harmed. Furthermore, should we face any collections issues in the future, it could become necessary to begin recording a bad debt allowance, which could negatively impact our results of operations.

     If we are unable to develop new and enhanced solutions that achieve market acceptance in a timely manner, our operating results and competitive position could be harmed.

     Our future success will be based in large part on our ability to reduce our dependence on our current Performance Stakpak solution for the vast majority of our revenue by increasing revenue associated with our other

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Stakpak solutions, such as our High Performance Stakpak, and by developing new stacking and packaging technologies and enhancements that can achieve market acceptance in a timely and cost-effective manner. Successful development and introduction of new technologies on a timely basis require that we:

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identify and adjust to changing requirements of customers within the memory and semiconductor markets generally;

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identify and adapt to emerging technological trends in our target markets;

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maintain effective marketing strategies;

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timely design and introduce cost-effective, innovative and performance-enhancing features that differentiate our services and technologies from those of our competitors;

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timely qualify and certify our stacking technologies for use in our customers’ products; and

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successfully develop our relationships with existing and potential customers, OEMs and supplier and channel partners.

     Our research and development efforts are focused primarily on furthering the technologies related to our High Performance Stakpak solution, which we recently introduced, and our System Stakpak solution, which we are currently developing. If the development of these technologies is delayed or abandoned, or if these new technologies fail to achieve market acceptance, our growth prospects, operating results and competitive position could be adversely affected. Furthermore, if markets for these new technologies develop later than we anticipate, or do not develop at all, demand for our solutions that are currently in development would suffer, resulting in lower sales of these products than we currently anticipate.

     Products that incorporate our stacking technologies generally have long sales and implementation periods, and our customers require that our stacking technologies undergo a lengthy and expensive qualification process without any assurance of revenue.

     Products that incorporate our stacking technologies are complex and are typically intended for use in applications that may be critical to the systems being developed by our customers. Prospective customers generally must make a significant commitment of resources to test and evaluate our stacking technologies and to integrate memory modules and other system parts into larger systems. As a result, our sales process is often subject to delays associated with lengthy approval processes that typically accompany the design, testing and adoption of new, technologically complex products. This may delay the time in which we recognize revenue and result in our investing significant resources well in advance of orders for our products.

     Prior to incorporating memory products utilizing our stacking technologies, OEMs require our stacking process and technologies to undergo an extensive qualification process, which involves testing of products utilizing our stacking technologies in the customer’s system as well as rigorous reliability testing. This qualification process may continue for six months or longer. However, qualification by a customer does not ensure any sales to that customer. Even after successful qualification and sales to a customer of products incorporating our stacking technologies, changes in our technologies may require a new qualification process, which may result in additional delays. After our products are qualified, it can take an additional six months or more before the customer commences production of components or devices that incorporate our products. Despite these uncertainties, we devote substantial resources, including design, engineering, sales, marketing and management efforts, toward qualifying our products with customers in anticipation of sales. If we are unsuccessful or delayed in qualifying any of our products with a customer, such failure or delay would preclude or delay sales of such products to the customer, which may impede our growth and cause our business to suffer.

     If the supply of materials used to manufacture our products is interrupted, or our manufacturing turnaround times are extended, our results of operations could be adversely affected.

     In order to manufacture our Stakpak solutions, we require raw materials and components such as flex circuits, printed circuit boards, epoxy adhesive, solder, nitrogen, ink marking supplies and tape and reel supplies. We typically procure these materials from single or limited sources to take advantage of volume pricing discounts.

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Shortages in these materials may occur from time to time. In addition to shortages, we could experience quality problems with these materials, which could result in returning them to our supplier. These shortages and returns could extend the turnaround times of our manufacturing services. If our supply of materials is interrupted for any reason, or our manufacturing turnaround times are extended, our results of operations could be adversely affected.

     We shifted the substantial majority of our manufacturing operations from Austin, Texas to Reynosa, Mexico, and our failure to continue to manage this shift in our operations and our growth could materially and adversely affect our business.

     We shifted our high-volume manufacturing capacity from our Austin, Texas facility to a new manufacturing facility in Reynosa, Mexico. We began manufacturing operations in our Mexico facility in the first quarter of 2003, and in the nine months ended September 30, 2004, we manufactured over 80% of our units in Mexico. This shift in our operations, combined with the growth in our business overall in recent periods, has placed, and any future growth of our operations will continue to place, a significant strain on our management personnel, systems and resources. We will need to implement a variety of new and upgraded operational and financial systems, procedures and controls, including the improvement of our accounting and other internal management systems. We also expect that we will need to continue to expand, train, manage and motivate our workforce. All of these endeavors will require substantial management time and attention, and we anticipate that we will require additional management personnel and internal processes to manage these efforts. If we are unable to effectively manage our expanding operations, our business could be materially and adversely affected. In addition, we are shifting all of the production of our Performance Stakpak to this facility in the fourth quarter of 2004.

     Our manufacturing facility in Reynosa, Mexico could expose us to new and significant risks.

     Our high-volume manufacturing facility in Reynosa, Mexico provided over 80% of our unit production in the nine months ended September 30, 2004. In addition, we are shifting all of the production of our Performance Stakpak to this facility in the fourth quarter of 2004. This facility is exposed to certain risks as a result of its location, including:

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changes in international trade laws, such as the North American Free Trade Agreement, or other governmental regulations or tariffs affecting our import and export activities;

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changes in labor laws and regulations affecting our ability to hire and retain employees;

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fluctuations of foreign currency and exchange controls;

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security measures at the United States-Mexico border;

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potential political instability and changes in the Mexican government; and

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general economic conditions in Mexico.

     Any of these risks could interfere with the operation of this facility or restrict or delay our ability to move components, finished products or manufacturing equipment across the United States–Mexico border and result in reduced production, increased costs, or both. In the event that this facility’s production is reduced or we encounter disruptions or delays in moving products across the border, we could fail to ship products on schedule and could face a reduction in future orders from dissatisfied customers. If our costs to operate this facility increase, our gross margins would decrease. Reduced shipments and margins would have an adverse effect on our financial results and could lead to a decline in our stock price.

     We operate a manufacturing facility in Mexico as a Maquiladora and any loss of this status or change in the laws affecting Maquiladoras, or disputes with the labor union in Mexico, could materially harm our financial results.

     In the nine months ended September 30, 2004, we manufactured over 80% of our stacked memory products at our manufacturing facility in Reynosa, Mexico. This facility is authorized to operate as a Maquiladora by the Ministry of Economy of Mexico. Mexico has enacted this legislation to promote the use of such manufacturing operations by foreign companies, and continuation of these operations depends upon, among other factors,

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compliance with applicable laws and regulations of the United States and Mexico. Maquiladora status allows us to import items into Mexico duty-free, provided that such items, after processing, are re-exported from Mexico within 18 months. Maquiladora status is subject to various restrictions and requirements, including:

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compliance with the terms of the Maquiladora authorization program;

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proper utilization of imported materials;

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hiring and training of Mexican personnel;