STAKTEK HOLDINGS INC - 10-Q Quarterly Report

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 ¨

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

The number of shares of the registrant’s common stock, $0.001 par value, outstanding as of March 31, 2005, was 50,291,805.

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 “FACTORS AFFECTING OUR FUTURE OPERATING RESULTS” AND ELSEWHERE IN THIS REPORT. STAKTEK HOLDINGS, INC. DISCLAIMS ANY INTENTION OR OBLIGATION TO UPDATE OR REVISE ANY FORWARD-LOOKING STATEMENTS, WHETHER AS A RESULT OF NEW INFORMATION, FUTURE EVENTS OR OTHERWISE.

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

The accompanying unaudited consolidated condensed financial statements of Staktek Holdings, Inc. and all of its subsidiaries (“we,” “us,” “our”) 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-month period ended March 31, 2005 are not necessarily indicative of the results that may be expected for the year ending December 31, 2005, or for any other period.

These financial statements and notes should be read in conjunction with our annual report on Form 10-K for the year ended December 31, 2004 filed with the SEC on March 9, 2005.

In December 2004, the Financial Accounting Standards Board (“FASB”) issued a revised Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Share-Based Payment– an Amendment of FASB Statements No. 123 and 95.” SFAS No. 123(R) establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services or incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments, focusing primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. SFAS No. 123(R) requires public entities to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award (with limited exceptions) and recognize the cost over the period during which an employee is required to provide service in exchange for the award. Adoption requires either a modified prospective or a modified retrospective application. Management is evaluating both approaches to determine the most appropriate.

We are required to adopt SFAS No. 123(R) in the first quarter of 2006. We are evaluating SFAS No. 123(R) and believe it may have a material effect on our financial position and results of operations.

We have invested in securities with original maturities greater than three months. These securities are classified as available-for-sale. The amortized cost, gross unrealized gains and losses and fair value of these securities were as follows at the respective dates (in thousands):

Gross unrealized losses at March 31, 2005 and December 31, 2004 are temporary and the result of fluctuations in the current market value of these securities in the marketplace.

Investment securities classified as available-for-sale are shown below by contractual maturity. Expected maturities will vary from contractual maturities because borrowers may have the right to recall or prepay obligations with or without call or prepayment penalties.

We sold or redeemed approximately $21.2 million in investment securities held as available-for-sale in the three months ended March 31, 2005.

The gross carrying amounts and accumulated amortization of our other intangible assets and patents consisted of the following (in thousands) at the respective dates:

Amortization expense for all intangibles in the first quarter of 2005 and 2004 was $3.5 million and $4.4 million, respectively.

The following table details the estimated aggregate annual amortization expense (in thousands) for 2005 and each of the four succeeding fiscal years for all of the intangibles we own that are subject to amortization:

On March 10, 2005, we entered into an unsecured revolving credit agreement with Guaranty Bank (the “Lender”), under which we may borrow up to $20 million at any given time for a one-year term (the “Credit Agreement”). The Credit Agreement is guaranteed by Staktek Group, L.P. Other than nominal closing costs associated with implementing the agreement, there are no ongoing fees associated with this Credit Agreement unless we borrow. The interest rate on borrowings outstanding is based on the London interbank offered rate (“LIBOR”) plus between 1.25% and 1.60%, depending upon the amount of cash or liquid investments that we have on deposit with the Lender. We are required to maintain at least $5 million on deposit with the Lender during the term of the Credit Agreement. As of March 31, 2005, we had not borrowed under this agreement.

The Credit Agreement contains customary covenants that preclude us, among other things, from making material changes to the nature and scope of our business, entering into liquidation, merger or consolidation agreements in which we would not be the surviving entity, or incurring indebtedness in excess of $10 million with a third party outside the scope of the agreement.

At March 31, 2005, we were in compliance with all covenants under the Credit Agreement. We anticipate that we will be able to remain in compliance with these covenants for the duration of the agreement.

At March 31, 2005 we had advance payments on assets under development of approximately $0.6 million related to the purchase of certain capital equipment and services. Approximately $0.1 million will be due in 2005 related to assets under development as of March 31, 2005.

At March 31, 2005, we had a minimum purchase contract with one of our vendors. The minimum purchase terms stipulate the purchase of 2 million units within an 18-month period that began in October 2004. At March 31, 2005, we had fulfilled approximately 5% of this contract and expect to make full use of the minimum purchase requirement within the agreed-upon time frame.

On October 22, 2004, a class action complaint for violations of U.S. federal securities laws was filed in the U.S. District Court in New Mexico against us and two of our executive officers (the “Defendants”). The plaintiff claims that the Defendants failed to disclose to the public an anticipated shortage of computer memory chips and that they knew or recklessly disregarded that the anticipated shortage would have a materially adverse impact on our revenue and earnings. In addition, the plaintiff claims that the Defendants failed to disclose to investors that the industry’s transition to a new generation of higher-capacity memory chips was causing computer makers to stockpile supplies of older memory chips, increasing the shortage. The suit covers individuals who purchased our stock between November 26, 2003 and May 19, 2004.

We do not believe there is any merit to the claims asserted by the plaintiff in this complaint and plan to vigorously defend ourselves. Due to the early stage of this lawsuit, we cannot estimate the outcome of this matter or the resulting financial impact to us, if any.

From time to time, we may be subject to legal proceedings and claims in the ordinary course of business. As of March 31, 2005, we were not involved in any other material legal proceedings.

Of the 51,235,563 shares and 51,102,215 shares of common stock issued as of March 31, 2005 and December 31, 2004, respectively, 1,686,031 shares and 1,854,481 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. During the first quarter of 2005, employees exercised 134,074 stock options.

During 2004, 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. During the first quarter of 2005, we purchased 470,758 shares of our stock on the open market under this program at a total cost of $1.8 million.

The following table illustrates the pro forma effect on income available to common stockholders and earnings per share if we had applied the fair value recognition provisions of SFAS No. 123 to stock-based compensation (in thousands, except per share data):

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, 2005, our effective tax rate is estimated to be 27%. The difference between our effective tax rate and the statutory tax rate is primarily the result of permanent differences arising from the tax implications of our stock-based compensation. For the three months ended March 31, 2005, our effective tax rate was approximately 5% as the result of an approximately $0.2 million adjustment to our deferred tax assets and liabilities arising from the reduction in our combined state and federal tax rate.

The components of our accumulated other comprehensive loss were as follows at the respective dates (in thousands):

The components of our comprehensive income, net of tax, were as follows (in thousands):

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

A reconciliation of the numerator and denominator used in the calculation of basic and diluted earnings per share follows (in thousands, except per share data):

For the three months ended March 31, 2005, there were approximately 1,067,000 potentially dilutive weighted common share equivalents that were not included in our earnings per share calculation as their impact would have been anti-dilutive.

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

The following discussion should be read along with the unaudited consolidated condensed financial statements and notes included in Item 1 of this quarterly report on Form 10-Q, 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, 2004 filed with the Securities and Exchange Commission (“SEC”) on March 9, 2005. 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 second 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; our expectations regarding borrowing under our new credit agreement; 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 “Factors Affecting Our Future Operating 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 “Factors Affecting Our Future Operating Results” below, as well as in the documents filed by us with the Securities and Exchange Commission, specifically our annual report on Form 10-K for the year ended December 31, 2004 filed with the Securities and Exchange Commission (the “SEC”) on March 9, 2005, 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.

We provide manufacturing services to deliver 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.

Value Stakpak^®, which targets the low-end server market and potentially certain consumer electronics products, which do not demand the same thermal performance as the high-end server market;

Performance Stakpak^®, which is targeted at the server and router markets and is designed to deliver superior thermal performance and high reliability; and

High Performance Stakpak^®, which is also targeted at the server and router markets, and is designed to utilize next-generation memory devices that are packaged in non-leaded packages.

The vast majority of the stacked solutions provided by us to date has 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 (or HP), IBM, Intel and Sun Microsystems. To a lesser extent, we sell our stacked solutions directly to OEMs. We typically receive the silicon on a consignment basis and provide a quick turnaround service to

our customers. Under this business model, we avoid taking price risk on the memory devices. Some of our customers place non-binding blanket purchase orders up to three months in advance to cover shipments for the relevant period. These purchase orders serve as forecasts for pricing, administrative and general scheduling purposes and are not binding orders. In some instances, purchase orders from customers are received no more than a day in advance or in the same shipment as the consigned dynamic random access memory (“DRAM”) chips that are supplied to us for stacking. We have no long-term purchase agreements with any of our customers.

Through our flexible 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 and intellectual property.

Our research and development efforts are focused primarily on refining the new High Performance Stakpak product and on developing new technologies for continuing the cost-effective miniaturization of electronic components and systems. An example of this is our System Stakpak^®. This technology enables the stacking of multiple heterogeneous integrated circuit subsystem components into a single surface-mountable module.

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

Our services revenue for the first quarter of 2005 was $8.1 million, a decrease of 36% from the $12.6 million services revenue for the first quarter of 2004. License revenue for the first quarter of 2005 was $7.4 million, a decrease of 20% from the $9.2 million license revenue for the first quarter of 2004.

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 memory packages to us for stacking on a consignment basis. In some instances, we purchase 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.

Our reduced services revenue in the first three months of 2005, as compared to the first three months of 2004, was the result of a decline in our unit volume. 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. 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 the first quarter of 2005, as compared to similar units shipped in the first quarter of 2004, and we expect that this trend will continue over the next several quarters.

Another market driver for our decrease in unit volume was 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 are currently 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.

In addition, our industry is transitioning from leaded to non-leaded packaging technology, a significant portion of which we expect to occur this year. Our Value Stakpak and Performance Stakpak products used leaded packaging technology, while our High Performance Stakpak is our first non-leaded product.

It is not possible to specifically quantify the impact of these three transitions on our business; however, we do expect decreased revenue 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.

The reduction in our license revenue in the first three months of 2005 as compared with the first three months of 2004 was the result of decreased royalties from Samsung.

Our license agreement with Samsung expires in July 2005. This license agreement provides that, during the term of the agreement, Samsung will not directly or indirectly sell, or invest in any company that sells, stacked products other than our solutions for use in general and scientific computers such as mainframes, servers, work stations and desk top computers. Following the expiration of this license agreement in July 2005, Samsung may be able to compete using other technologies in the stacked products markets currently restricted by the non-compete

provision of the agreement. By the terms of the agreement, Samsung and we will be able to use each other’s non-patented technology, information, know-how and processes related to the licensed technologies. However, we believe that our patent rights and the products sold under our patents are the most significant elements of our relationship with Samsung, and we do not believe that Samsung would be able to continue to produce its current stacked memory products without infringing our patent rights. Furthermore, Samsung has made significant investments in tooling, manufacturing and testing facilities and expertise as well as in product acceptance activities related to products that utilize our intellectual property. We also believe that Samsung realizes substantial financial benefits from the sale of stacked memory solutions and that its continued ability to provide these solutions to its customers is important to its relationships with its customers and OEMs.

Currently, we are in the process of negotiating with Samsung to renew this agreement. It is too early in the process to determine whether Samsung and we will reach agreement. 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, our license revenue from this agreement could be reduced or eliminated. If Samsung’s customers do not use our manufacturing services or buy the stacked high-density memory solutions from one of our other supply-chain partners, our revenue, operating results and cash flows could be reduced. As of March 31, 2005, the remaining residual value of the customer relationship intangible asset associated with this contract was $12.8 million. The value was initially recorded based upon the projected discounted net cash flows attributable to this relationship. We may have to record an impairment charge for some or all of the value of this asset, depending upon the outcome of our negotiations, since estimated reductions in the future cash flow from this contract may cause an impairment. If we do not renew this contract, we will record an impairment charge for the full remaining amount of the asset. As of March 31, 2005 no impairment had been recorded.

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

Gross profit for the three months ended March 31, 2005 was $5.0 million, or 32.5% of our total revenue, as compared to $10.4 million, or 47.7% of our total revenue for the three months ended March 31, 2004.

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 large portion of our cost of revenue is fixed in any given period.

The reduction in our gross margin for the three months ended March 31, 2005, as compared to March 31, 2004, was primarily the result of fixed costs of manufacturing being spread over fewer leaded package-based units. Additionally, as we increase production of our new non-leaded package-based product, we have invested in manufacturing capacity in advance of demand.

Selling, general and administrative expense for the three months ended March 31, 2005 was $2.4 million, or 15.5% of revenue. This amount reflected a decrease of $0.2 million, or 8%, as compared to selling, general and administrative expense of $2.6 million, or 12.0% of revenue, in the three months ended March 31, 2004.

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.

Selling, general and administrative expense was slightly higher in the first quarter of 2004 as compared to the first quarter of 2005, due to $0.5 million in legal fees related to litigation that has been resolved. Partially offsetting this decline is an increase in public company costs. The increase in selling, general and administrative expense as a percentage of revenue in the first quarter of 2005 as compared to the first quarter of 2004 was due to the decline in our total revenue. We expect to incur selling, general and administrative expenses of 23 to 26% of revenue over the next several quarters.

Research and development expense for the three months ended March 31, 2005 was $0.9 million, or 5.9% of revenue, which reflected an increase of $0.5 million, or 113%, as compared with research and development expense of $0.4 million, or 2.0% of revenue for the three months ended March 31, 2004.

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. 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. 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.

Increased research and development expense in the three months ended March 31, 2005, as compared to the three months ended March 31, 2004, resulted from our expenditures in the development of our non-leaded technologies and our System Stakpak product. 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 non-leaded packages, non-DRAM homogeneous circuits and heterogeneous circuits. As a result, we expect research and development expenses to range between 8 and 10% of revenue over 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 to qualify and manufacture products based on these new technologies.

Amortization of acquisition intangibles was $3.5 million for the three months ended March 31, 2005, a decrease of $0.9 million, or 21%, as compared to $4.4 million for the three months ended March 31, 2004.

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

These acquired intangibles were amortized over their estimated useful lives in relation to the discounted cash flow of the assets, as estimated at the time of acquisition. Each year the annual amortization expense of these intangibles declines. For interim periods within each year, the amortization expense is recorded on a straight-line basis.

Amortization of deferred stock-based compensation was $1.2 million for the three months ended March 31, 2005, a decrease of $0.2 million, or 13%, as compared to $1.4 million for the three months ended March 31, 2004.

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.

Interest and other income (expense), net, for the three months ended March 31, 2005 was income of $0.3 million, as compared to expense of $1.2 million for the three months ended March 31, 2004.

Interest and 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.

The change in interest and other income (expense), net, from the first quarter of 2004 to the first quarter of 2005 was due primarily to the fact we carried significant debt during a portion of the first quarter of 2004 on which we recorded interest expense. We repaid this debt in the first quarter of 2004. In the first quarter of 2005, we had investments and cash equivalents, initially purchased in the fourth quarter of 2004, earning interest income.

For the three months ended March 31, 2005, our effective tax rate was approximately 5% as the result of an approximately $0.2 million adjustment to our deferred tax assets and liabilities arising from the reduction in our combined state and federal tax rate.

As of March 31, 2005, we had working capital of $82.9 million, including $77.6 million of cash, cash equivalents and investments, compared to working capital of $82.0 million, including $77.4 million of cash, cash equivalents and investments, as of December 31, 2004.

Net cash provided by operating activities was $4.8 million for the first three months of 2005, as compared to $0.7 million net cash used in operating activities for the first three months of 2004. This change was primarily due to an $8.4 million net increase in cash flows from operating assets and liabilities, offset by a $2.2 million decrease in net income. The change in cash flows from operating assets and liabilities is due in large part to the decrease of our accounts receivable in the first three months of 2005 as opposed to an increase in our accounts receivable during the first three months of 2004.

Net cash used in investing activities was $0.9 million for the first three months of 2005, compared to $1.4 million for the first three months of 2004. The decrease in net cash used in investing activities was due primarily to $1.7 million sales and maturities of investments, net of purchases, offset by an increase in additions to property and equipment. Additions to property and equipment in the first three months of 2005 were $2.4 million as compared to $1.3 million during the first three months of 2004, and were related primarily to adding equipment capacity for our High Performance Stakpak. We will continue to add equipment capacity as necessary in anticipation of an increase in demand for this product.

Net cash used by financing activities during the first three months of 2005 was $2.0 million, primarily related to the purchase of stock under our stock repurchase program. In the first three months of 2004, net proceeds from our initial public offering and the repayment of all of our outstanding long-term debt were the primary events leading to net cash provided by financing activities of $26.0 million.

On March 10, 2005, we entered into an unsecured revolving credit agreement with Guaranty Bank under which we may borrow up to $20 million at any given time for a one-year term. This credit agreement is guaranteed by Staktek Group, L.P. Other than nominal closing costs associated with implementing the agreement, there are no ongoing fees associated with this credit agreement unless we borrow. The interest rate on borrowings outstanding is based on the London interbank offered rate (“LIBOR”), plus between 1.25% and 1.60%, depending upon the amount of cash or liquid investments that we have on deposit with the Guaranty Bank. We are required to maintain at least $5 million on deposit with Guaranty Bank during the term of this credit agreement.

As of March 31, 2005, we had not borrowed under this credit agreement, nor do we expect we will need to make any substantial borrowings under this agreement in the near term.

We believe that our current assets, including cash and cash equivalents, investments and expected cash flow from operating activities will be sufficient to fund our operations, our anticipated additions to property and equipment and any share repurchases under our stock repurchase program 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 these 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 additional 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. The credit agreement we entered into on March 10, 2005 may, by its terms, hinder attempts to borrow additional funds from other parties. 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.

The preparation of financial statements in conformity with generally accepted accounting principles requires that management make estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ significantly from those estimates. We believe that the following discussion addresses our most critical accounting policies, which are those that are most important to the portrayal of our financial condition and results of operations and require management’s most difficult, subjective and complex judgments.

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 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 increases in both revenue and the cost of revenue. We recognize revenue when there is persuasive evidence of an arrangement, delivery has occurred, the fee is fixed or determinable, and collectibility of the resulting receivable is reasonably assured.

Revenue from our license agreements with Samsung and Infineon is recognized per unit stacked 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 and the collection of these royalties is considered probable.

Impairment of Assets. We evaluate the recoverability of losses on long-lived assets, such as property and equipment and intangible assets 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 flows could be different than those estimated by us.

Goodwill and our trademarks are evaluated annually for impairment and are 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. We periodically assess our goodwill for indications of impairment on a reporting unit level. A reporting unit is defined as a component of an entity for which the operating results are regularly reviewed by management and discrete financial information is available. The trademark impairment test requires judgment regarding the timing and amount of future cash flows.

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.

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, a ready market did not exist for our common stock. As a result, we estimated fair value for our common stock using traditional valuation methodologies, such as multiples of earnings or cash flows.

We are required to adopt SFAS No. 123(R) in the first quarter of 2006. We are evaluating SFAS No. 123(R) and believe it may have a material effect on our financial position and results of operations.

Effective May 9, 2005, Wayne R. Lieberman joined Staktek as President. Mr. Lieberman will be responsible for our overall operations and financial objectives and will play a key role in establishing and managing corporate strategy, customer relationships, technology alliances, product development and overall corporate performance. Prior to joining Staktek, Mr. Lieberman spent 25 years in the semiconductor and software industries, serving in a variety of executive positions. James W. Cady resigned his position as President and will retain the title of Chief Executive Officer.

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 elsewhere in this quarterly report on Form 10-Q and the following additional factors:

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.

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 93% of our total revenue in the first quarter of 2005, 86% of our total revenue in 2004 and 88% of our total revenue in 2003. In particular, Samsung accounted for most of our license revenue and 47% of our total revenue in the first quarter of 2005, and Micron Technology, Hewlett-Packard and SMART Modular Technologies accounted for 13%, 13% and 11%, respectively, of our total revenue in the first quarter of 2005. SMART Modular is a supply-chain partner of Hewlett-Packard, so units incorporating our stacking solutions are ultimately sold through to Hewlett-Packard 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. 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 stacked 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 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 47% of our total revenue in the first quarter of 2005. 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.

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:

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.

We receive the substantial majority of our license revenue from our license agreement with Samsung. 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. Currently, we are in the process of negotiating with Samsung to extend the term of this agreement. It is too early in the process to determine whether we and Samsung will reach agreement. If we are unable to extend this agreement on terms favorable to us or at all, 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. As of March 31, 2005, the remaining residual value of the customer relationship intangible asset associated with this contract was $12.8 million. The value was initially recorded based upon the projected discounted net cash flows attributable to this relationship. We may have to record an impairment charge for some or all of the value of this asset, depending upon the outcome of our negotiations, since estimated reductions in the future cash flow from this contract may cause an impairment. If we do not renew this contract, we will record an impairment charge for the full remaining amount of the asset. As of March 31, 2005 no impairment had been recorded.

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 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:

We are particularly dependent on sales of our Performance Stakpak solutions for use in the high-end and midrange server market, which constituted 72% of our total services revenue in the first quarter of 2005, 82% of our total services revenue in 2004 and 98% of our total services revenue in 2003. 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 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.

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 Samsung, Micron and Infineon, 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:

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:

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 sales and marketing 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 operating. 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 second and third quarters of 2004, 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 in shipments in these quarters. Any future shortage could result in a similar decrease in shipments, which would adversely impact our operating results and financial condition.

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, other infectious diseases 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 and results of operations 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 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:

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 limited sources to take advantage of volume pricing discounts. 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 three months ended March 31, 2005, we manufactured over 95% of our units in Mexico. In addition, we shifted all of the production of our Performance Stakpak to this facility in the fourth quarter of 2004. 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 may 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.

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

Our high-volume manufacturing facility in Reynosa, Mexico provided over 95% of our unit production in the three months ended March 31, 2005. In addition, we shifted 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:

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 our 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 three months ended March 31, 2005, we manufactured over 95% 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, 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:

Because assembly operations in Mexico continue to be less expensive than comparable operations in the United States, in recent years many companies have established Maquiladora operations in the Reynosa area to take advantage of lower labor costs. Increasing demand for labor, particularly skilled labor and professionals, from new and existing Maquiladora operations could in the future result in increased labor costs. The loss of our Maquiladora status, changes in the Maquiladora program, the inability to recruit, hire and retain qualified employees, a significant increase in labor costs, unfavorable exchange rates or interruptions in the trade relations between the United States and Mexico could have a material adverse effect on our business, operating results and financial condition.

While we are not party to any collective bargaining agreements with any of our employees in the United States, as of March 31, 2005, 58% of our employees in Mexico were represented by a labor organization that has entered into a labor contract with us. As a result, our Reynosa operations are subject to union activities, including organized strikes or other work stoppages, and cost factors arising from our negotiations of employment terms with the representatives of this union. To date, we have not experienced any organized strikes or other work stoppages at our facilities in Reynosa, Mexico.

Our operations could be disrupted by power outages, political unrest, natural disasters or other disasters.

As our manufacturing facilities are located in Reynosa, Mexico and in Austin, Texas, earthquakes, fires, flooding or other natural disasters in these locations, or an epidemic, political unrest, war, labor strikes or work stoppages, or interruptions in supply or utilities at either of these locations would likely result in the disruption of our manufacturing services, would cause significant delays in shipments of our products and materially and adversely affect our operating results.

We intend to expand our research and development activities and other operations, and this expansion may strain our resources and increase our operating expenses.

We intend to increase our research and development activities and other operations, both in the United States and in Mexico, as we grow our business and expand our technology offerings. We may do so through both internal growth and acquisitions. We expect that this expansion could strain our systems and operational and financial controls. In addition, we are likely to incur higher operating costs as a publicly held company and as we seek to expand our business. To manage our growth effectively, we must continue to improve and expand our systems and controls. If we fail to do so, our growth would be limited.

Products that incorporate our stacking technologies must conform to industry standards in order to be widely accepted by OEMs for use in their products.

Our services and technologies are used to create products that comprise only a part of a larger system. Typically, the components of these systems comply with industry standards in order to operate efficiently together. We depend on companies that provide other components of systems and devices to support prevailing industry standards. Many of these companies are significantly larger and more influential in affecting industry standards than we are. Some industry standards may not be widely adopted or implemented consistently, and competing standards may emerge that may be preferred by our customers or end users. If larger companies do not support the same industry standards that we do, or if competing standards emerge, market acceptance of our products could be adversely affected which would harm our business.

Industry standards are continually evolving, and our ability to compete in the future will depend on our ability to identify and ensure compliance with these evolving industry standards. The emergence of new industry standards could render our products incompatible with products developed by other suppliers. As a result, we could be required to invest significant time and effort and to incur significant expense to implement new services and technologies to ensure compliance with relevant standards. If our products or those of our customers are not in compliance with prevailing industry standards for a significant period of time, we may not be able to sell our services and technologies and our operating results would suffer. In addition, if we do not correctly anticipate new technologies and standards, or if the products that we develop based on these new technologies and standards fail to achieve market acceptance, our competitors may be better able to address market demand than we would and our business and results of operations would be adversely affected.

We depend on a few key personnel to manage our business effectively, and if we lose the services of any of those personnel or are unable to hire additional personnel, our business could be harmed.

We believe our future success will depend in large part upon our ability to attract and retain highly skilled managerial, engineering, sales and marketing personnel. Our success to date has been highly dependent on James W. Cady, our President and Chief Executive Officer, and other members of our senior management team. We believe that our future success will be dependent on retaining the services of these key personnel, developing their successors, modifying our internal processes to reduce our reliance on specific individuals, and on properly managing the transition of key roles should departures or additions to the management team occur. For example, we recently hired a new President, who will significantly influence the future direction and strategy of the Company. The loss of any of our key employees or the inability to attract or retain qualified personnel, including engineers and sales and marketing personnel, could delay the development and introduction of, and negatively impact our ability to sell, our services and technologies.

If our stacking services and technologies are used in defective products or include defective parts, we may be subject to product liability or other claims.

If we manufacture stacked memory products that are defectively manufactured, used in defective or malfunctioning products or contain defective components, we could be subject to product liability claims and product recalls, safety alerts or advisory notices. While we have product liability insurance coverage, we cannot assume that it will be adequate to satisfy claims made against us in the future or that we will be able to obtain insurance in the future at satisfactory rates or in adequate amounts. Product liability claims or product recalls in the future, regardless of their ultimate outcome, could have a material adverse effect on our business, financial condition, results of operations and reputation, and on our ability to attract and retain licensees and customers.

We may be involved in costly legal proceedings to enforce or protect our intellectual property rights or to defend against claims that we infringe the intellectual property rights of others.

Litigation is inherently uncertain, and an adverse outcome could subject us to significant liability for damages or invalidate our proprietary rights. Legal proceedings we initiate to protect our intellectual property rights could also result in counterclaims or countersuits against us. Any litigation, regardless of its outcome, could be time consuming and expensive to resolve and could divert our management’s time and attention. Any intellectual property litigation also could force us to take specific actions, including:

We have found it necessary to litigate against others, including our customers, to enforce our intellectual property and contractual and commercial rights including, in particular, our trade secrets, as well as to challenge the validity and scope of the proprietary rights of others and to defend against claims of infringement or invalidity. In some cases, our legal disputes may involve a key customer.

Our failure to comply with environmental laws and regulations could subject us to significant fines and liabilities, and new laws and regulations or changes in regulatory interpretation or enforcement could make compliance more difficult and costly.

We are subject to various and frequently changing U.S. federal, state and local, and foreign governmental laws and regulations relating to the protection of the environment, including those governing the discharge of pollutants into the air and water, the management and disposal of hazardous substances and wastes, the cleanup of contaminated sites and the maintenance of a safe workplace. We could incur substantial costs, including clean-up costs, civil or criminal fines or sanctions and third-party claims for property damage or personal injury, as a result of violations of or liabilities under environmental laws and regulations or non-compliance with the environmental permits required for our facilities. These laws, regulations and permits also could require the installation of costly pollution control equipment or operational changes to limit pollutant emissions or decrease the likelihood of accidental releases of hazardous substances.

In addition, new laws and regulations, stricter enforcement of existing laws and regulations, the discovery of previously unknown contamination at our sites or the imposition of new clean-up requirements could require us to curtail our operations, restrict our future expansion, subject us to liability and cause us to incur future costs that would have a negative effect on our operating results and cash flow.

Economic, political and other risks associated with international sales and operations could adversely affect our revenue.

Since we sell our services and technologies worldwide, our business is subject to risks associated with doing business internationally. Our revenue originating outside the United States, including license revenue from Samsung and Infineon and services revenue from our United States and Mexico manufacturing facilities derived from foreign customers, as a percentage of our total revenue, was 49% in the first quarter of 2005, 59% in 2004 and 49% in 2003. International turmoil, exacerbated by the war in Iraq and the escalating tensions in North Korea, have contributed to an uncertain political and economic climate, both in the United States and globally, which may affect our ability to generate revenue on a predictable basis. In addition, terrorist attacks and the threat of future terrorist attacks both domestically and internationally have negatively impacted the worldwide economy. As we ship stacked memory units both in the United States and internationally, the threat of future terrorist attacks may adversely affect our business. These conditions make it difficult for us and for our customers to accurately forecast and plan future business activities and could have a material adverse effect on our business, financial condition and results of operations.

A portion of our revenue is derived from customers based in Asia. The economies of Asia have been highly volatile and recessionary in the past, resulting in significant fluctuations in local currencies and other instabilities. Many countries in Asia have recently been affected by the occurrence of SARS and other infectious diseases. These instabilities continue and may occur again in the future. Our exposure to the business risks presented by the economies of Asia will increase to the extent that we continue to expand our customer base and activities in that region. An outbreak of SARS or another infectious disease could result in reduced demand for products incorporating our stacking technologies, extend the qualification periods for our technologies or otherwise adversely affect our business.

If we acquire other businesses or technologies in the future, these acquisitions could disrupt our business and harm our financial condition.

As part of our growth and product diversification strategy, we will evaluate opportunities to acquire other businesses, intellectual property or technologies that would complement our current offerings, expand the breadth of our markets or enhance our technical capabilities. Acquisitions entail a number of risks that could materially and adversely affect our business and operating results, including:

Future acquisitions also could cause us to incur debt or contingent liabilities or cause us to issue equity securities that could negatively impact the ownership percentages of our existing stockholders.

Our reported financial results may be adversely affected by changes in accounting principles generally accepted in the United States.

We prepare our financial statements in conformity with accounting principles generally accepted in the United States. These accounting principles are subject to interpretation by the Financial Accounting Standards Board, the American Institute of Certified Public Accountants, the Securities and Exchange Commission and various bodies

formed to interpret and create appropriate accounting principles. A change in these principles or interpretations could have a significant effect on our reported financial results, and could affect the reporting of transactions completed before the announcement of a change.

Recently enacted and proposed changes in securities laws and regulations have increased our costs.

The Sarbanes-Oxley Act of 2002 that became law in July 2002, as well as new rules and regulations subsequently implemented by the SEC, have required changes to some of our corporate governance practices. The Sarbanes-Oxley Act also requires the Securities and Exchange Commission to promulgate additional new rules on a variety of subjects. In addition to final rules and rule proposals already made by the SEC, the National Association of Securities Dealers, or NASD, has adopted revisions to its requirements for companies, such as us, that propose to have securities listed on the Nasdaq Stock Market. These new rules and regulations have increased our legal and financial compliance costs, and have made some activities more difficult, time consuming and costly. These new rules and regulations have made it more difficult and more expensive for us to obtain director and officer liability insurance. These new rules and regulations could also make it more difficult for us to attract and retain qualified members for our board of directors, particularly to serve on our audit committee, as well as qualified executive officers.

We maintain a web site at www.staktek.com, which makes available free of charge our filings with the SEC. Our quarterly reports on Form 10-Q, annual report on Form 10-K, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities and Exchange Act of 1934 are available through the Investor Relations page of our web site as soon as reasonably practicable after we electronically file this material with, or furnish it to, the SEC. Our web site and the information contained therein or connected thereto are not intended to be incorporated into this quarterly report on Form 10-Q.

Foreign Currency Exchange Risk. Nearly all of our transactions are denominated in U.S. dollars. The functional currency of our subsidiaries in Mexico is the U.S. dollar. As a result, we have very little exposure to currency exchange risks and foreign exchange losses have been minimal to date. We do not currently enter into forward exchange contracts to hedge exposure denominated in foreign currencies or any other derivative financial instruments for trading or speculative purposes. In the future, if we believe that our currency exposure has increased, we may consider entering into hedging transactions to help mitigate that risk.

Interest Rate Risk. The primary objective of our investment activities is to preserve principal while maximizing the related income without significantly increasing risk. Even so, some of the securities in which we invest may be subject to market risk. This means that a change in prevailing interest rates may cause the principal amount of the investment to fluctuate. To minimize this risk in the future, we intend to maintain our portfolio of cash equivalents and short-term investments in a variety of securities, including commercial paper, money market funds, government and non-government debt securities and certificates of deposit. The risk associated with fluctuating interest rates is limited to our investment portfolio and a 10% fluctuation in our rate of return on those investments would not have a material impact on our financial condition. As of March 31, 2005, all of our cash was held in deposit or money market accounts, or invested in investment grade securities.

Under our credit agreement with Guaranty Bank, borrowings would expose us to risks resulting from fluctuations in the LIBOR rate on which our variable interest charge is based. The potential amount of exposure resulting from a 10% fluctuation in the LIBOR rate would be dependent upon our outstanding borrowings. As of March 31, 2005, we had not borrowed under this credit agreement.

The SEC defines the term “disclosure controls and procedures” to mean a company’s controls and other procedures that are designed to ensure that information required to be disclosed in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Our chief executive officer and chief financial officer have concluded, based upon the evaluation of the effectiveness of our disclosure controls and procedures by our management, as of the end of the period covered by this quarterly report, that our disclosure controls and procedures were effective for this purpose.

It should be noted that in designing and evaluating our disclosure controls and procedures, our management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met due to numerous factors, ranging from errors to conscious acts of an individual, or individuals acting together. In addition, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of inherent limitations in a cost-effective control system, misstatements due to error and/or fraud may occur and not be detected.

On October 22, 2004, a class action complaint for violations of U.S. federal securities laws was filed in the U.S. District Court in New Mexico against us and two of our executive officers (the “Defendants”). In April 2005, this case was transferred to the U.S. District Court for the Western District of Austin. The plaintiff claims that the Defendants failed to disclose to the public an anticipated shortage of computer memory chips and that they knew or recklessly disregarded that the anticipated shortage would have a materially adverse impact on our revenue and earnings. In addition, the plaintiff claims that the Defendants failed to disclose to investors that the industry’s transition to a new generation of higher-capacity memory chips was causing computer makers to stockpile supplies of older memory chips, increasing the shortage. The suit covers individuals who purchased our stock between November 26, 2003 and May 19, 2004.

From time to time, we may be subject to legal proceedings and claims in the ordinary course of business. As of March 31, 2005, we were not involved in any other material legal proceedings.

ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES

The following table provides information with respect to any purchase made by or on behalf of the Company of shares of the Company’s common stock during the quarter ended March 31, 2005:

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

STAKTEK HOLDINGS, INC.

/s/

James W. Cady

Chief Executive Officer

Date: May 11, 2005

/s/

W. Kirk Patterson

Chief Financial Officer and Vice President

Date: May 11, 2005


		Page
	PART I – FINANCIAL INFORMATION

Item 1.	Consolidated Condensed Balance Sheets- March 31, 2005 (unaudited) and December 31, 2004	3
	Consolidated Condensed Statements of Operations (unaudited) for the three months ended March 31, 2005 and 2004	4
	Consolidated Condensed Statements of Cash Flows (unaudited) for the three months ended March 31, 2005 and 2004	5
	Notes to the Consolidated Condensed Financial Statements (unaudited)	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	11
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	34
Item 4.	Controls and Procedures	34

	PART II – OTHER INFORMATION

Item 1.	Legal Proceedings	35
Item 2.	Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities	35
Item 3.	Defaults Upon Senior Securities	35
Item 4.	Submission of Matters to a Vote of Security Holders	35
Item 5.	Other Information	35
Item 6.	Exhibits	36


	March 31, 2005			December 31, 2004
	(unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	41,891		$	39,984
Investments		35,693			37,434
Accounts receivable		2,820			4,493
Inventory held for others		—			3
Inventories		864			833
Prepaid expenses		2,269			590
Other current assets		2,773			2,638

Total current assets		86,310			85,975
Property and equipment, net		11,353			10,162
Goodwill		28,466			28,466
Other intangibles, net		27,039			30,447
Other assets		386			421

Total assets	$	153,554		$	155,471

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	723		$	714
Accrued liabilities		2,200			2,568
Deferred revenue		440			629
Current maturities of capitalized lease obligations		23			53

Total current liabilities		3,386			3,964
Other accrued liabilities		235			190
Deferred tax liabilities		8,126			9,510

Stockholders’ equity:
Common stock; $0.001 par value; 200,000,000 shares authorized; 51,235,563 shares and 51,102,215 shares issued at March 31, 2005 and December 31, 2004, respectively		50			49
Additional paid-in capital		155,818			155,810
Treasury stock, at cost; 943,758 shares and 473,000 shares at March 31, 2005 and December 31, 2004, respectively		(3,816	)		(1,982	)
Deferred stock-based compensation		(12,285	)		(13,462	)
Accumulated other comprehensive loss		(41	)		(2	)
Retained earnings		2,081			1,394

Total stockholders’ equity		141,807			141,807

Total liabilities and stockholders’ equity	$	153,554		$	155,471


	Three Months Ended March 31,
	2005			2004
Revenue:
Services	$	8,063		$	12,614
License		7,448			9,187

Total revenue		15,511			21,801
Cost of revenue:
Services		7,107			7,299
Amortization of acquisition intangibles		3,234			3,946
Amortization of deferred stock-based compensation		139			154

Total cost of revenue		10,480			11,399

Gross profit		5,031			10,402
Operating expenses:
Selling, general and administrative (1)		2,399			2,621
Research and development (1)		916			430
Amortization of acquisition intangibles		253			464
Amortization of deferred stock-based compensation		1,038			1,205

Total operating expenses		4,606			4,720

Income from operations		425			5,682
Other income (expense):
Interest income		329			12
Interest expense		(1	)		(1,201	)
Other		(30	)		(8	)

Income before income taxes		723			4,485
Provision for income taxes		36			1,627

Net income		687			2,858
Preferred stock dividends		—			(266	)

Income available to common stockholders	$	687		$	2,592

Earnings per share:
Basic	$	0.01		$	0.06

Diluted	$	0.01		$	0.05

Shares used in computing earnings per share:
Basic		48,737			43,431
Diluted		50,547			50,005

(1) Excludes the amortization of deferred stock-based compensation as follows:
Selling, general and administrative	$	1,019		$	1,189
Research and development		19			16

	$	1,038		$	1,205


	Three Months Ended March 31,
	2005			2004
Cash flows from operating activities:
Net income	$	687		$	2,858
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization of intangibles		4,757			5,540
Amortization of deferred stock-based compensation		1,177			1,359
Net change in operating assets and liabilities		(1,862	)		(10,420	)

Net cash provided by (used in) operating activities		4,759			(663	)

Cash flows from investing activities:
Purchases of investments		(19,513	)		—
Sales and maturities of investments		21,190			—
Additions to property and equipment		(2,427	)		(1,348	)
Patent application costs		(116	)		(8	)

Net cash used in investing activities		(866	)		(1,356	)

Cash flows from financing activities:
Net proceeds from the issuance of common stock		2			134,337
Repayment of notes payable and long-term debt		—			(43,125	)
Repayment of subordinated loan from related party		—			(34,500	)
Redemption of redeemable preferred stock		—			(30,638	)
Purchase of treasury stock		(1,958	)		—
Payments on capitalized lease obligations		(30	)		(28	)

Net cash provided by (used in) financing activities		(1,986	)		26,046

Net increase in cash and cash equivalents		1,907			24,027
Cash and cash equivalents at beginning of period		39,984			31,165

Cash and cash equivalents at end of period	$	41,891		$	55,192


	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Estimated Fair Value
Auction rate securities	$	10,850	$	—	$	—		$	10,850
Other available for sale securities		24,884		—		(41	)		24,843

	$	35,734	$	—	$	(41	)	$	35,693

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	March 31, 2005				December 31, 2004
	Amortized Cost		Estimated Fair Value		Amortized Cost		Estimated Fair Value
Within 1 year	$	11,417	$	11,408	$	4,016	$	4,014
Between 1 and 2 years		4,041		4,018		2,000		2,000
After 2 years		20,276		20,267		31,420		31,420

	$	35,734	$	35,693	$	37,436	$	37,434


	March 31, 2005		December 31, 2004
Purchased materials	$	741	$	750
Labor and overhead		123		83

	$	864	$	833


	March 31, 2005					December 31, 2004
	Gross Carrying Amount		Accumulated Amortization			Gross Carrying Amount		Accumulated Amortization
Acquired technology and patents	$	20,220	$	(10,300	)	$	20,104	$	(9,092	)
Customer contract		26,100		(13,338	)		26,100		(11,300	)
Other intangible assets		7,598		(3,241	)		7,598		(2,963	)

	$	53,918	$	(26,879	)	$	53,802	$	(23,355	)


	Three Months Ended March 31,				Change
	2005		2004		Change
	(in thousands)
Services revenue	$	8,063	$	12,614	(36	)%
License revenue		7,448		9,187	(20	)

Total revenue	$	15,511	$	21,801	(29	)%


Period	Total Number of Shares Purchased(1)	Average Price Paid per Share(2)		Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs	Maximum Approximate Dollar Value of Shares that May Yet Be Purchased under the Plans or Programs
January 1-31, 2005	122,058	$	4.21	122,058	Approx. $10.1 million
February 1-28, 2005	45,000		3.75	45,000	Approx. $9.9 million
March 1-31, 2005	303,700		3.74	303,700	Approx. $8.8 million

TOTAL	470,758	$	3.86	470,758


3.1.1*		Amended and Restated Certificate of Incorporation, filed with Amendment No. 3 to Registration Statement on Form S-1 (File No. 333-110806) dated January 20, 2004 and incorporated herein by reference.

3.2.1*		Amended and Restated Bylaws filed with Amendment No. 2 to Registration Statement on Form S-1 (File No. 333-110806) dated January 6, 2004 and incorporated herein by reference.

4.1*		Specimen certificate for shares of common stock, filed with Amendment No. 3 to Registration Statement on Form S-1 (File No. 333-110806) dated January 20, 2004 and incorporated herein by reference.

10.1		Loan Agreement by and between Staktek Holdings, Inc. and Guaranty Bank dated March 10, 2005.

10.2		Revolving Promissory Note in connection with the Loan Agreement dated March 10, 2005.

10.3		Guaranty Agreement by and between Staktek Group L.P. and Guaranty Bank dated March 10, 2005.

31.1		Certificate of the Chief Executive Officer pursuant to 18 U.S.C. §1350 (Section 302 of the Sarbanes-Oxley Act of 2002).

31.2		Certificate of the Chief Financial Officer pursuant to 18 U.S.C. §1350 (Section 302 of the Sarbanes-Oxley Act of 2002).

32.1		Certificate of the Chief Executive Officer pursuant to 18 U.S.C. §1350 (Section 906 of the Sarbanes-Oxley Act of 2002).

32.2		Certificate of the Chief Financial Officer pursuant to 18 U.S.C. §1350 (Section 906 of the Sarbanes-Oxley Act of 2002).


2005	$	14,096
2006		7,535
2007		4,667
2008		1,458
2009		139