**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

----

 

**FORM 10-Q**

 

**(MarkOne)**

**ý**** QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934.**

 

**For thequarterly period ended March 31, 2006**

 

**OR**

 

**o**** TRANSITION REPORT PURSUANT TO SECTION 13 OR15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.**

 

**For thetransition period from                to                .**

 

**Commission File Number 0-26944**

 

 

**SILICON STORAGETECHNOLOGY, INC.**

(Exact name of Registrant as Specified in its Charter)

 

| **California**                           | ** ** | **77-0225590**         |
|------------------------------------------|------------|------------------------|
| (State or Other Jurisdiction of          |       | (I.R.S. Employer       |
| Incorporation or Organization)           |       | Identification Number) |
|                                     |       |                   |
| **1171 Sonora Court, Sunnyvale, CA**     | ** ** | **94086**              |
| (Address of Principal Executive Offices) |       | (Zip Code)             |

 

**(408) 735-9110**

(Registrant’s Telephone Number, including Area Code)

 

----

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days. Yes o  No ý

 

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

 

| Large  Accelerated filer o |   | Accelerated  filer ý |   | Non-accelerated  filer o |
|----------------------------|--------|---------------------------|--------|--------------------------|

 

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

 

Number of sharesoutstanding of our Common Stock, no par value, as of the latest practicabledate, April 20, 2006:   **103,155,985.**

 

 

----

 

**SILICON STORAGE TECHNOLOGY, INC.**

 

**FORM 10-Q: QUARTER ENDED MARCH 31, 2006**

**TABLE OF CONTENTS**

 
| **Part I - FINANCIAL INFORMATION** |   |
|------------------------------------|--------|
|                               |   |   |   |
| Item 1.                            |   | Condensed Consolidated  Financial Statements (Unaudited): |   |
|                               |   | Condensed  Consolidated Statements of Operations |   |
|                               |   | Condensed  Consolidated Balance Sheets |   |
|                               |   | Condensed  Consolidated Statements of Cash Flows |   |
|                               |   | Notes  to Condensed Consolidated Financial Statements |   |
|                               |   |   |   |
| Item 2.                            |   | Management’s Discussion and  Analysis of Financial Condition and Results of Operations |   |
|                               |   |   |   |
| Item 3.                            |   | Quantitative  and Qualitative Disclosures About Market Risk |   |
|                               |   |   |   |
| Item 4.                            |   | Controls and  Procedures |   |
|                               |   |   |   |
| **Part  II - OTHER INFORMATION**   |   |
|                               |   |   |   |
| Item 1.                            |   | Legal Proceedings |   |
|                               |   |   |   |
| Item 1A.                           |   | Risk Factors |   |
|                               |   |   |   |
| Item 5.                            |   | Other Information |   |
|                               |   |   |   |
| Item 6.                            |   | Exhibits |   |
|                               |   |   |   |
| Signatures                         |   |

 

2

----

 

**PART I - FINANCIAL INFORMATION**

 

**Item 1. CondensedConsolidated Financial Statements (Unaudited)**

 

**SILICON STORAGE TECHNOLOGY, INC. AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTSOF OPERATIONS**

**(Unaudited)**

**(in thousands, except per share data)**

 
| ** **                                                                            | ** ** | **Three Months Ended  March 31,** | ** ** |
|---------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                            | ** ** | **2005**                                         | ** ** | **2006** | ** ** |
|                                                                                  |       |                                             |       |   |   |
| Net revenues:                                                                         |       |                                             |       |   |   |
| Product revenues  - unrelated parties                                                 |       | $                                                | 37,621     |   | $ | 38,032 |   |
| Product revenues  - related parties                                                   |       | 41,649                                           |       | 62,271 |   |
| Technology  licensing                                                                 |       | 6,943                                            |       | 8,850 |   |
| Technology  licensing - related parties                                               |       | 102                                              |       | 1,378 |   |
| Total net  revenues                                                                   |       | 86,315                                           |       | 110,531 |   |
| Cost of  revenues:                                                                    |       |                                             |       |   |   |
| Cost of revenues  - unrelated parties                                                 |       | 32,441                                           |       | 27,815 |   |
| Cost of revenues  - related parties                                                   |       | 41,281                                           |       | 48,803 |   |
| Total cost of  revenues                                                               |       | 73,722                                           |       | 76,618 |   |
| Gross profit                                                                          |       | 12,593                                           |       | 33,913 |   |
| Operating  expenses:                                                                  |       |                                             |       |   |   |
| Research and  development                                                             |       | 11,965                                           |       | 15,167 |   |
| Sales and  marketing                                                                  |       | 7,340                                            |       | 8,161 |   |
| General and  administrative                                                           |       | 6,702                                            |       | 6,037 |   |
| Total operating  expenses                                                             |       | 26,007                                           |       | 29,365 |   |
| Income (loss)  from operations                                                        |       | (13,414                                          | )          | 4,548 |   |
| Other income  (expense), net                                                          |       | 201                                              |       | 439 |   |
| Interest expense                                                                      |       | (21                                              | )          | (79 | ) |
| Gain on sale of  equity investments                                                   |       | —                                           |       | 12,206 |   |
| Impairment of  equity investments                                                     |       | —                                           |       | (3,523 | ) |
| Income (loss)  before provision for (benefit from) income taxes and minority interest |       | (13,234                                          | )          | 13,591 |   |
| Provision for  income taxes                                                           |       | 746                                              |       | 2,301 |   |
| Minority  interest                                                                    |       | (84                                              | )          | — |   |
| Net income  (loss)                                                                    |       | $                                                | (13,896    | ) | $ | 11,290 |   |
| Net income  (loss) per share - basic                                                  |       | $                                                | (0.14      | ) | $ | 0.11 |   |
| Shares used in  per share calculation - basic                                         |       | 97,820                                           |       | 103,140 |   |
| Net income  (loss) per share - diluted                                                |       | $                                                | (0.14      | ) | $ | 0.11 |   |
| Shares used in  per share calculation - diluted                                       |       | 97,820                                           |       | 104,739 |   |

 

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

 

3

----

 

**SILICON STORAGE TECHNOLOGY, INC. AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED BALANCESHEETS**

**(Unaudited)**

**(in thousands)**

 

** **
| ** **                                                                                                                                    | ** ** | **December 31,** | ** ** | **March 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------|------------|---------------|------------|
| ** **                                                                                                                                    | ** ** | **2005**         | ** ** | **2006**      | ** ** |
| **ASSETS**                                                                                                                                    |       |             |       |          |       |
| Current assets:                                                                                                                               |       |             |       |          |       |
| Cash and cash  equivalents                                                                                                                    |       | $                | 77,382     |          | $          | 95,100 |   |
| Short-term  available-for-sale investments                                                                                                    |       | 1,008            |       | 12,164        |       |
| Trade accounts  receivable-unrelated parties, net of allowance for doubtful accounts of $758  at December 31, 2005 and $905 at March 31, 2006 |       | 21,378           |       | 17,548        |       |
| Trade accounts  receivable-related parties                                                                                                    |       | 55,858           |       | 37,413        |       |
| Inventories                                                                                                                                   |       | 108,343          |       | 104,541       |       |
| Other current  assets                                                                                                                         |       | 13,109           |       | 13,222        |       |
| Total current  assets                                                                                                                         |       | 277,078          |       | 279,988       |       |
| Property and  equipment, net                                                                                                                  |       | 19,415           |       | 19,552        |       |
| Long-term  available-for-sale investments                                                                                                     |       | 39,057           |       | 25,156        |       |
| Equity  investments, GSMC                                                                                                                     |       | 83,150           |       | 83,150        |       |
| Equity  investments, others                                                                                                                   |       | 12,962           |       | 9,640         |       |
| Goodwill                                                                                                                                      |       | 29,637           |       | 29,637        |       |
| Intangible  assets, net                                                                                                                       |       | 11,816           |       | 10,920        |       |
| Other assets                                                                                                                                  |       | 4,722            |       | 4,778         |       |
| Total assets                                                                                                                                  |       | $                | 477,837    |          | $          | 462,821 |   |
| **LIABILITIES**                                                                                                                               |       |             |       |          |       |
| Current  liabilities:                                                                                                                         |       |             |       |          |       |
| Notes payable,  current portion                                                                                                               |       | $                | 39         |          | $          | 218 |   |
| Borrowing under  line of credit facility                                                                                                      |       | 3,000            |       | 3,000         |       |
| Trade accounts  payable-unrelated parties                                                                                                     |       | 48,660           |       | 34,362        |       |
| Trade accounts  payable-related parties                                                                                                       |       | 21,867           |       | 17,244        |       |
| Accrued expenses  and other liabilities                                                                                                       |       | 17,318           |       | 20,333        |       |
| Deferred revenue                                                                                                                              |       | 4,493            |       | 3,554         |       |
| Total current  liabilities                                                                                                                    |       | 95,377           |       | 78,711        |       |
| Other  liabilities                                                                                                                            |       | 2,627            |       | 2,294         |       |
| Total  liabilities                                                                                                                            |       | 98,004           |       | 81,005        |       |
| Commitments  (Note 6) and Contingencies (Note 7)                                                                                              |       |             |       |          |       |
|                                                                                                                                          |       |             |       |          |       |
| **SHAREHOLDERS’ EQUITY**                                                                                                                 |       |             |       |          |       |
| ** **                                                                                                                                    |       |             |       |          |       |
| Preferred stock,  no par value:                                                                                                               |       |             |       |          |       |
| Authorized:  7,000 shares                                                                                                                     |       |             |       |          |       |
| Series A Junior  Participating Preferred Stock, no par value                                                                                  |       |             |       |          |       |
| Designated: 450  shares                                                                                                                       |       |             |       |          |       |
| Issued and  outstanding: none                                                                                                                 |       | —           |       | —        |       |
| Common stock, no  par value:                                                                                                                  |       |             |       |          |       |
| Authorized:  250,000 shares  Issued and outstanding: 102,827 shares at December 31, 2005 and 103,153  shares at March 31, 2006                |       | 377,027          |       | 380,335       |       |
| Accumulated  other comprehensive income                                                                                                       |       | 31,780           |       | 19,165        |       |
| Accumulated  deficit                                                                                                                          |       | (28,974          | )          | (17,684       | )     |
| Total  shareholders’ equity                                                                                                              |       | 379,833          |       | 381,816       |       |
| Total  liabilities and shareholders’ equity                                                                                              |       | $                | 477,837    |          | $          | 462,821 |   |

 

The accompanyingnotes are an integral part of these unaudited condensed consolidated financialstatements.

 

4

----

 

**SILICON STORAGE TECHNOLOGY, INC. AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTSOF CASH FLOWS**

**(Unaudited)**

**(in thousands)**

 

** **
| ** **                                                                                                  | ** ** | **Three Months Ended  March 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                                  | ** ** | **2005**                                         | ** ** | **2006** | ** ** |
| Cash flows from  operating activities:                                                                      |       |                                             |       |   |   |
| Net income  (loss)                                                                                          |       | $                                                | (13,896    | ) | $ | 11,290 |   |
| Adjustments to  reconcile net income (loss) to net cash provided by (used in) operating  activities:        |       |                                             |       |   |   |
| Depreciation and  amortization                                                                              |       | 2,030                                            |       | 2,493 |   |
| Stock-based  compensation expense                                                                           |       | —                                           |       | 2,037 |   |
| Provision  (credits) for doubtful accounts receivable                                                       |       | (90                                              | )          | 147 |   |
| Provision for  sales returns                                                                                |       | 895                                              |       | 229 |   |
| Provision for  excess and obsolete inventories, write-down of inventories and adverse  purchase commitments |       | 10,766                                           |       | 1,707 |   |
| Loss in equity  interest                                                                                    |       | 120                                              |       | 24 |   |
| Impairment loss  on equity investment                                                                       |       | —                                           |       | 3,523 |   |
| Gain on sale of equity  investments                                                                         |       | —                                           |       | (12,206 | ) |
| (Gain) loss on  disposal of equipment                                                                       |       | 2                                                |       | (5 | ) |
| Minority  interest                                                                                          |       | (84                                              | )          | — |   |
| Changes in  operating assets and liabilities:                                                               |       |                                             |       |   |   |
| Trade accounts  receivable-unrelated parties                                                                |       | 1,276                                            |       | 3,437 |   |
| Trade accounts  receivable-related parties                                                                  |       | 10,308                                           |       | 18,462 |   |
| Inventories                                                                                                 |       | (37,559                                          | )          | 1,463 |   |
| Other current  and non-current assets                                                                       |       | 1,725                                            |       | (389 | ) |
| Trade accounts  payable-unrelated parties                                                                   |       | (8,981                                           | )          | (13,858 | ) |
| Trade accounts  payable-related parties                                                                     |       | 4,123                                            |       | (4,623 | ) |
| Accrued expenses  and other liabilities                                                                     |       | (929                                             | )          | 3,117 |   |
| Deferred revenue                                                                                            |       | 178                                              |       | (939 | ) |
| Net cash  provided by (used in) operating activities                                                        |       | (30,116                                          | )          | 15,909 |   |
| Cash flows from  investing activities:                                                                      |       |                                             |       |   |   |
| Investments in  equity securities                                                                           |       | (333                                             | )          | — |   |
| Purchase of  property and equipment                                                                         |       | (818                                             | )          | (1,441 | ) |
| Proceeds from  sale of equipment                                                                            |       | —                                           |       | 5 |   |
| Purchases of  available-for-sale investments                                                                |       | (19,105                                          | )          | (12,000 | ) |
| Sales and  maturities of available-for-sale and equity investments                                          |       | 42,669                                           |       | 14,325 |   |
| Net cash  provided by investing activities                                                                  |       | 22,413                                           |       | 889 |   |
| Cash flows from  financing activities:                                                                      |       |                                             |       |   |   |
| Debt repayments                                                                                             |       | (106                                             | )          | (39 | ) |
| Borrowing  against line of credit                                                                           |       | 1,000                                            |       | — |   |
| Issuance of  shares of common stock                                                                         |       | 1,630                                            |       | 1,271 |   |
| Capital lease  payments                                                                                     |       | —                                           |       | (312 | ) |
| Net cash  provided by financing activities                                                                  |       | 2,524                                            |       | 920 |   |
| Net increase  (decrease) in cash and cash equivalents                                                       |       | (5,179                                           | )          | 17,718 |   |
| Cash and cash  equivalents at beginning of period                                                           |       | 35,365                                           |       | 77,382 |   |
| Cash and cash  equivalents at end of period                                                                 |       | $                                                | 30,186     |   | $ | 95,100 |   |

 

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

 

5

----

 

**SILICON STORAGE TECHNOLOGY, INC. AND SUBSIDIARIES**

 

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS (UNAUDITED):**

 

**1.****              Basisof Presentation**

 

In the opinion ofmanagement, the accompanying unaudited condensed interim consolidated financialstatements contain all adjustments, all of which are normal and recurring innature, necessary to fairly state our financial position, results of operationsand cash flows. The results of operations for the interim periods presented arenot necessarily indicative of the results that may be expected for any futureinterim periods or for the full fiscal year. These interim financial statementsshould be read in conjunction with the consolidated financial statements in ourAnnual Report on Form 10-K for the year ended December 31, 2005.

 

The year-end balancesheet at December 31, 2005 was derived from audited financial statements, butdoes not include all disclosures required by U.S. generally accepted accountingprinciples. Please refer to the audited financial statements in our AnnualReport on Form 10-K for the year ended December 31, 2005.

 

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires us to make estimates andassumptions that affect the reported amounts of assets and liabilities and thedisclosure of contingent assets and liabilities at the date of the financial statementsand the reported amounts of revenues and expenses during the reporting period. Actualresults could differ from those estimates.

 

*Stock Based Compensation*

 

Effective January 1,2006, we adopted the fair value recognition provisions of Financial AccountingStandards Board, or FASB, Statement of Financial Accounting Standards, or SFASNo. 123(R), *“Share-Based Payments*,”using the modified prospective application method. Under this transitionmethod, compensation cost recognized in the quarter ended March 31, 2006,includes the applicable amounts of: (a) compensation cost of allstock-based payments granted prior to, but not yet vested as of January 1,2006 (based on the grant-date fair value estimated in accordance with theoriginal provisions of SFAS No. 123 and previously presented in the proforma footnote disclosures), and (b) compensation cost for all stock-basedpayments granted subsequent to January 1, 2006 (based on the grant-date fairvalue estimated in accordance with the new provisions of SFAS No. 123(R)).Results for prior periods have not been restated to reflect the adoption of SFASNo. 123(R).

 

#### *Recent Accounting Pronouncements*

#### * *

In September 2005, theFASB ratified Emerging Issues Task Force Issue No. 04-13, “*Accountingfor Purchases and Sales of Inventory with the Same Counterparty”,*or**EITF 04-13. EITF 04-13discusses whether inventory purchase and sales transactions with the samecounterparty that are entered into in contemplation of one another should becombined and treated as a nonmonetary exchange and addresses (a) underwhat circumstances should two or more transactions with the same counterparty(counterparties) be viewed as a single nonmonetary transaction within thescope of APB Opinion No. 29, “*Accounting**for Nonmonetary Transactions*”,**or**APB 29,and Financial Accounting Standard No. 153, *“Exchanges of Nonmonetary Assets, an Amendment of APB 29”,*or SFAS 153, and (b) ifnonmonetary transactions within the scope of APB 29 and SFAS 153involve inventory, are there any circumstances under which the transactionsshould be recognized at fair value. The pronouncement is effective for newinventory arrangements entered into, or modifications or renewals of existinginventory arrangements occurring in interim or annual reporting periods beginningafter March 15, 2006. We do not expect that this pronouncement will have amaterial effect on our consolidated financial statements.

 

**2.****              Computationof Net Income (Loss) Per Share**

 

We have computed and presented net income (loss) per share under twomethods, basic and diluted. Basic net income (loss) per share is computed bydividing net income (loss) by the weighted average number of common sharesoutstanding for the period. Diluted net income (loss) per share is computed by dividingnet income (loss) by the sum of the weighted average number of common sharesoutstanding and potential common shares (when dilutive). A reconciliation ofthe numerator and the denominator of basic and diluted net income (loss) pershare is as follows (in thousands, except per share amounts):

 

6

----

 

 
| ** **                                      | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|
| ** **                                      | ** ** | **March 31,**               | ** ** |
| ** **                                      | ** ** | **2005**                         | ** ** | **2006** | ** ** |
| Numerator -basic                                |       |                             |       |   |   |
| Net income  (loss)                              |       | $                                | (13,896    | ) | $ | 11,290 |   |
|                                            |       |                             |       |   |   |
| Denominator -  basic                            |       |                             |       |   |   |
| Weighted average  common stock outstanding      |       | 97,820                           |       | 103,140 |   |
|                                            |       |                             |       |   |   |
| Basic net income  (loss) per share              |       | $                                | (0.14      | ) | $ | 0.11 |   |
|                                            |       |                             |       |   |   |
| Denominator -  diluted                          |       |                             |       |   |   |
| Weighted average  common stock outstanding      |       | 97,820                           |       | 103,140 |   |
| Dilutive  potential of common stock equivalents |       | —                           |       | 1,599 |   |
| Options                                         |       | 97,820                           |       | 104,739 |   |
|                                            |       |                             |       |   |   |
| Diluted net  income (loss) per share            |       | $                                | (0.14      | ) | $ | 0.11 |   |

 

Stock options to purchase 10,605,000 shares of common stock wereoutstanding as of March 31, 2005 with a weighted average exercise price of$8.09. These stock options were not included in the computation of diluted netloss per share for the three months ended March 31, 2005 because we had a netloss for this period. Stock options to purchase 7,120,303 shares wereoutstanding and not included in the computation of diluted net income per sharefor the three months ended March 31, 2006 since the exercise price of theseoptions exceeded the average fair market value of our common stock for thethree months ended March 31, 2006.

 

***3. Stock Compensation:***

 

Effective  January 1, 2006, we adopted SFAS No.123(R),  “*Share-Based  Payments*.” This  statement requires  us to  expense the fair  value of grants of  various stock-based  compensation programs  over the vesting  period of the awards. We elected to adopt the“modified prospective application” transition method which does not requirethe  restatement  of previously issued  financial  statements. Compensation expense is measuredand recognized beginning in 2006 as follows:

 

Awards granted afterDecember 31, 2005 are measured at their fair value at date of grant. The  resulting compensation  expense  is recognized  in the condensed consolidated  statement of operations  ratably  over the vesting  period of the award and is adjusted basedupon an estimated forfeiture rate which is derived from historical data.

 

Awards  granted prior to December 31, 2005 were measured at their fair value at the dateof original grant. Compensation expense  associated with theunvested  portion  of these options at  January  1, 2006 is recognized  in the consolidatedstatement of operations ratably over the remaining vesting period.

 

Our employee stockpurchase plan provides for eligible employees to purchase shares of commonstock at a price equal to 90% of the fair value of our common stock as of theoption grant date. The compensation is the difference between the fair valueand purchase price on the date of purchase. Compensation expense associatedwith the purchase plan is recognized in the condensed consolidated statement ofoperations as of the date of purchase.

 

The following table showstotal stock-based compensation expense included in the Condensed ConsolidatedStatement of Operations (in thousands):

 

7

----

 
| ** **                  | ** ** | **Three Months Ended** | ** ** |
|-----------------------------|------------|----------------------------------|------------|
| ** **                  | ** ** | **March 31, 2006**     | ** ** |
| Cost of goods  sold         |       | $                                | 157        |   |
| Research and  development   |       | 980                              |       |
| Sales and  marketing        |       | 260                              |       |
| General and  administrative |       | 640                              |       |
| Effect on net  income       |       | $                                | 2,037      |   |

 

No similar expense wascharged against income in the prior periods as we had elected to apply the provisionsof APB No. 25, “*Accounting for Stock Issued to Employees*”to those periods as permitted by SFAS No. 123.

 

SFAS No. 123(R) alsorequires that the tax benefit from the exercise of options be reflected in the statementof cash flows as a cash inflow from financing activities. Prior to the adoptionof SFAS No. 123(R), these tax benefits were reflected as a cash inflow fromoperations. Because we elected to adopt the “modified prospective application”transition method, the prior year statements of cash flows have not beenrestated. The tax benefit from the exercise of options was zero for the threemonths ended March 31, 2006.

 

Stock Option Plans

 

Pursuant to our 1995Equity Incentive Plan and 1995 Non-Employee Director’s Stock Option Plan, stockoptions are granted with an exercise price equal to the market price of ourcommon stock at the date of grant. Substantially all of the options granted toemployees are exercisable pursuant to a four-year vesting schedule. The fairvalue of these options is estimated using the Black-Scholes option pricingmodel which incorporates the assumptions noted in the table below. Expectedvolatilities are based on the historical performance of our common stock. Wealso use historical data to estimate the timing and amount of option exercisesand forfeitures within the valuation model. The expected term of the options isderived from the output of the option pricing model and represents the periodof time that options are expected to remain unexercised. The risk-free interestrate for periods within the expected life of the option is based on the U.S.Treasury bond rate in effect at the time of grant.

 

The fair values of grantsin the stated period were computed using the following assumptions for ourstock option plans:

 
| ** **               | ** ** | **Three Months Ended** | ** ** |
|--------------------------|------------|----------------------------------|------------|
| ** **               | ** ** | **March 31, 2006**     | ** ** |
| Risk-free  interest rate |       | 4.3                              | %          |
| Dividend yield           |       | 0.0                              | %          |
| Expected  volatility     |       | 77.0                             | %          |
| Expected life            |       | 6.0 years                        |       |

 

The following is asummary of all option activity for the three months ended March 31, 2006:

 
| ** **                        | ** ** | ** **         | ** ** | ** **   | ** ** | **Agregate**               | ** ** |
|-----------------------------------|------------|--------------------|------------|--------------|------------|----------------------------|------------|
| ** **                        | ** ** | ** **         | ** ** | **Weighted** | ** ** | **Intrinsic Value**   | ** ** |
| ** **                        | ** ** | **Number of** | ** ** | **Average**  | ** ** | **at March 31,** | ** ** |
| ** **                        | ** ** | **Shares**         | ** ** | **Price**    | ** ** | **2006**                   | ** ** |
| Outstanding at  December 31, 2005 |       | 11,687             |       | $            | 7.33       |                       |       |   |
| Granted                           |       | 116                |       | $            | 4.72       |                       |       |   |
| Exercised                         |       | (82                | )          | $            | 2.57       |                       |       |   |
| Forfeited                         |       | (195               | )          | $            | 5.89       |                       |       |   |
| Expired                           |       | (45                | )          | $            | 14.00      |                       |       |   |
| Outstanding at  March 31, 2006    |       | 11,481             |       | $            | 7.30       |                       | $          | 6,782 |   |
|                              |       |               |       |         |       |                       |       |
| Exercisable at  March 31, 2006    |       | 7,244              |       | $            | 7.93       |                       | $          | 6,003 |   |

 

8

----

 

A summary of our stockoptions outstanding at March 31, 2006 as follows:

 
| ** **               | ** **     | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|--------------------------|----------------|------------------------------|------------|------------------------------|------------|
| ** **               | ** **     | ** **                   | ** ** | **Weighted-**                | ** ** | **Weighted-** | ** ** | ** ** | ** ** | **Weighted-** | ** ** |
| ** **               | ** **     | ** **                   | ** ** | **Average**                  | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| **Range of**        | ** **     | **Number**                   | ** ** | **Remaining**                | ** ** | **Exercise** | ** ** | **Number** | ** ** | **Exercise** | ** ** |
| **Exercise Prices** | ** **     | **Outstanding**              | ** ** | **Life**                     | ** ** | **Price** | ** ** | **Outstanding** | ** ** | **Price** | ** ** |
| $                        | 0.44 - $1.46   |                         | 1,129      |                         | 1.97       |   | $ | 0.99 |   | 1,129 |   | $ | 0.99 |   |
| $                        | 1.54 - $2.83   |                         | 1,148      |                         | 5.12       |   | $ | 2.38 |   | 809 |   | $ | 2.26 |   |
| $                        | 3.07 - $4.42   |                         | 1,121      |                         | 6.44       |   | $ | 3.80 |   | 816 |   | $ | 3.83 |   |
| $                        | 4.46 - $4.86   |                         | 1,183      |                         | 7.08       |   | $ | 4.60 |   | 725 |   | $ | 4.53 |   |
| $                        | 4.90 - $5.36   |                         | 1,213      |                         | 8.27       |   | $ | 4.97 |   | 236 |   | $ | 5.00 |   |
| $                        | 5.38 - $7.05   |                         | 1,132      |                         | 8.28       |   | $ | 6.24 |   | 238 |   | $ | 6.02 |   |
| $                        | 7.45 - $8.61   |                         | 1,115      |                         | 7.70       |   | $ | 7.75 |   | 548 |   | $ | 7.97 |   |
| $                        | 8.63 - $9.92   |                         | 1,187      |                         | 5.98       |   | $ | 9.31 |   | 752 |   | $ | 9.32 |   |
| $                        | 9.97 - $16.34  |                         | 1,081      |                         | 6.14       |   | $ | 11.91 |   | 819 |   | $ | 11.68 |   |
| $                        | 17.79 - $29.44 |                         | 1,172      |                         | 4.24       |   | $ | 20.97 |   | 1,172 |   | $ | 20.97 |   |
| $                        | 0.44 - $29.44  |                         | 11,481     |                         | 6.13       |   | $ | 7.30 |   | 7,244 |   | $ | 7.93 |   |

 

In the first quarter of2006, the weighted-average fair value of an option was $435 thousand. The totalintrinsic value, the difference between the exercise price and the market priceon the date of exercise, of all options exercised during the period wasapproximately $205 thousand. Total unrecognized compensation expense from stockoptions was $10.9 million excluding estimated forfeitures, which is expected tobe recognized over a weighted-average period of 1.5 years as follows, (inthousands):

 

 
| ** **                    | ** ** | **Compensation**               | ** ** |
|-------------------------------|------------|--------------------------------|------------|
| ** **                    | ** ** | **Expense excluding**     | ** ** |
| ** **                    | ** ** | **Estimated Forfeitures** | ** ** |
| 2006 (remaining  nine months) |       | $                              | 4,974      |   |
| 2007                          |       | 3,799                          |       |
| 2008                          |       | 1,629                          |       |
| 2009                          |       | 425                            |       |
| 2010                          |       | 29                             |       |
| Total                         |       | $                              | 10,856     |   |

 

For the three monthsended March 31, 2005, we applied the intrinsic value based method of accountingfor stock options prescribed by APB No. 25. Accordingly, no compensationexpense was recognized for these stock options since all options granted havean exercise price equal to the market value of the underlying stock on thegrant date. If compensation expense had been recognized based on the estimateof the fair value of each option granted in accordance with the provisions ofSFAS No. 123 “*Accounting for Stock-Based Compensation*”as amended by SFAS No. 148 “*Accounting for Stock-BasedCompensation – Transition and Disclosure –An Amendment of FASB Statement No.123*”, our net income would have been reduced to the following proforma amounts as follows, in thousands:

 

9

----

 

 
| ** **                                                                                                                                    | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                                                    | ** ** | **March 31, 2005**     | ** ** |
| Net loss as  reported                                                                                                                         |       | $                                | (13,896    | ) |
| Deduct: total  stock-based employee compensation expense determined under fair value based  method for all awards, net of related tax effects |       | (2,434                           | )          |
| Pro forma net  loss                                                                                                                           |       | $                                | (16,330    | ) |
| Basic loss per  share                                                                                                                         |       |                             |       |
| As reported:                                                                                                                                  |       | $                                | (0.14      | ) |
| Pro forma:                                                                                                                                    |       | $                                | (0.17      | ) |
| Diluted net loss  per share                                                                                                                   |       |                             |       |
| As reported:                                                                                                                                  |       | $                                | (0.14      | ) |
| Pro forma:                                                                                                                                    |       | $                                | (0.17      | ) |

 

Pro forma compensationexpense recognized under SFAS No. 123 does not consider potential forfeitures.

 

**4.****                    Investments**

 

We consider cash and allhighly liquid investments purchased with an original or remaining maturity ofless than three months at the date of purchase to be cash equivalents. Substantiallyall of our cash and cash equivalents are in the custody of three majorfinancial institutions.

 

Short and long-terminvestments, which are comprised of federal, state and municipal governmentobligations, foreign and public corporate debt securities and marketable equitysecurities, are classified as available-for-sale and carried at fair value,based on quoted market prices, with the unrealized gains or losses, net of tax,reported in shareholders’ equity as other comprehensive income. The cost ofdebt securities is adjusted for amortization of premiums and accretion ofdiscounts to maturity, both of which are included in interest income. Realizedgains and losses are recorded on the specific identification method. In thethree months ended March 31, 2006, we sold 4.0 million common shares of ourinvestment in Powertech Technology, Incorporated, or PTI, for a pre-tax gain ofapproximately $12.2 million. We owned approximately 5.5 million shares of PTIat March 31, 2006.

 

King Yuan ElectronicsCompany Limited, or KYE, Insyde Software Corporation, or Insyde, PTI, andProfessional Computer Technology Limited, or PCT, are Taiwanese companies thatare listed on the Taiwan Stock Exchange. Equity investments in these companieshave been included in “Long-term available-for-sale investments.”  The investments that are not available forresale due to local securities regulations within one year at the balance sheetdate are recorded at the investment cost. The investments that are availablefor resale within one year at the balance sheet date are recorded at fairmarket value, with unrealized gains and losses, net of tax, reported inShareholders’ Equity as Other Comprehensive Income. If a decline in value isjudged to be other than temporary, it is reported as an “Impairment of equityinvestments.”  Cash dividends and otherdistributions of earnings from the investees, if any, are included in otherincome when declared. During March 2006, we determined our investment inNanotech Corporation, or Nanotech, a privately held Cayman Island company, hadbecome impaired as Nanotech defaulted on loan payments to certain of itsbusiness partners and is now in the process of discontinuing operations.Consequently, our remaining investment of $3.3 million along with a loan of$225 thousand were written down to a net realizable value of zero.

 

The fair values ofavailable-for-sale investments as of March 31, 2006 were as follows (inthousands):

 
| ** **                                                | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair**  | ** ** |
|-----------------------------------------------------------|------------|---------------|------------|----------------|------------|----------------|------------|-----------|------------|
| ** **                                                | ** ** | **Cost**      | ** ** | **Gain**       | ** ** | **Loss**       | ** ** | **Value** | ** ** |
| Corporate bonds  and notes                                |       | $             | 67         |           | $          | —         | ** ** | **$**     | **—** |   | $ | 67 |   |
| Government bonds  and notes                               |       | 22,656        |       | —         |       | (9             | )          | 22,647    |       |
| Foreign listed  equity securities                         |       | 5,999         |       | 19,157         |       | —         |       | 25,156    |       |
| Total bonds,  notes and equity securities                 |       | $             | 28,722     |           | $          | 19,157         |       | $         | (9         | ) | $ | 47,870 |   |
| Less amounts  classified as cash equivalents              |       |          |       |           |       |           |       | (10,550   | )          |
| Total short and  long-term available-for-sale investments |       |          |       |           |       |           |       | $         | 37,320     |   |

 

10

----

 

Contractual maturity dates of our available-for-saleinvestments for debt securities are all in 2006. All of these securities areclassified as current as they are expected to be realized in cash or sold orconsumed during the normal operating cycle of our business.

 

The unrealized gains andlosses as of March 31, 2006 are recorded in accumulated other comprehensiveincome, net of tax.

 

The fair values ofavailable-for-sale investments as of December 31, 2005 were as follows (inthousands):

 
| ** **                                                | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair**  | ** ** |
|-----------------------------------------------------------|------------|---------------|------------|----------------|------------|----------------|------------|-----------|------------|
| ** **                                                | ** ** | **Cost**      | ** ** | **Gain**       | ** ** | **Loss**       | ** ** | **Value** | ** ** |
| Corporate bonds  and notes                                |       | $             | 67         |           | $          | —         |       | $         | —     |   | $ | 67 |   |
| Government bonds  and notes                               |       | 5,632         |       | —         |       | (1             | )          | 5,631     |       |
| Foreign listed  equity securities                         |       | 7,283         |       | 31,774         |       | —         |       | 39,057    |       |
| Total bonds,  notes and equity securities                 |       | $             | 12,982     |           | $          | 31,774         |       | $         | (1         | ) | $ | 44,755 |   |
|                                                      |       |          |       |           |       |           |       |      |       |
| Less amounts  classified as cash equivalents              |       |          |       |           |       |           |       | (4,691    | )          |
| Total short and  long-term available-for-sale investments |       |          |       |           |       |           |       | $         | 40,064     |   |

 

The unrealized gains andlosses as of December 31, 2005 are recorded in accumulated other comprehensiveincome, net of tax.

 

Market values weredetermined for each individual security in our investment portfolio. Thedeclines in value of the government bonds and notes primarily relate to changesin the interest rates and are considered temporary in nature. With respect toour foreign listed equity securities, our policy is to review our equityholdings on a regular basis to evaluate whether or not such securities haveexperienced an other than temporary decline in fair value. Our policy includes,but is not limited to, reviewing each company’s cash position, earnings andrevenue outlook, stock price performance over the past six months, liquidity,management and ownership. If we believe that an other-than-temporary decline invalue exists, it is our policy to write down these investments to the marketvalue and record the related write-down in our consolidated statement ofoperations.

 

Investments in privatelyheld enterprises and certain restricted stocks are accounted for using eitherthe cost or equity method of accounting. As of March 31, 2006, the carryingvalue of these investments was $92.8 million which includes an investment of$83.2 million in Grace Semiconductor Manufacturing Corporation, or GSMC, whichrepresents a 10% interest. As of December 31, 2005, the carrying value of theseinvestments was $96.1 million.

 

11

----

 

**5.****                    SelectedBalance Sheet Detail**

 

Details of selectedbalance sheet accounts are as follows (in thousands):

 

Inventories comprise:

 
| ** **                                           | ** ** | **December 31,** | ** ** | **March 31,** | ** ** |
|------------------------------------------------------|------------|-----------------------|------------|--------------------|------------|
| ** **                                           | ** ** | **2005**              | ** ** | **2006**           | ** ** |
| Raw materials                                        |       | $                     | 65,404     |               | $          | 51,421 |   |
| Work in process                                      |       | 6,491                 |       | 11,430             |       |
| Finished goods                                       |       | 29,450                |       | 33,495             |       |
| Finished goods  inventories held at logistics center |       | 6,998                 |       | 8,195              |       |
|                                                 |       | $                     | 108,343    |               | $          | 104,541 |   |

 

Inventories are stated atthe lower of cost, determined on a first-in, first-out basis, or market value. Wetypically plan our production and inventory levels based on internal forecastsof customer demand, which are highly unpredictable and can fluctuatesubstantially. The value of our inventory is dependent on our estimate offuture average selling prices, and, if our projected average selling prices areover estimated, we may be required to adjust our inventory value. If we overestimate future market demand, we may end up with excess inventory levels thatcannot be sold within a normal operating cycle and we may be required to recorda provision for excess inventory. Our inventories include high technology partsand components that are specialized in nature or subject to rapid technologicalobsolescence. Some of our customers have requested that we ship them productthat has a finished goods date of manufacture less than one year old. In theevent that this becomes a common requirement, it may be necessary for us toprovide for an additional allowance for our on-hand finished goods inventorywith a date of manufacture of greater than one year old, which could result ina material adjustment and could harm our financial results. We review on-handinventory including inventory held at the logistic center for potential excess,obsolescence and lower of cost or market exposure and record provisions accordingly.Due to the large number of units in our inventory, even a small change inaverage selling prices could result in a significant adjustment and have amaterial impact on our financial position and results of operations.

 

Our allowance for excessand obsolete inventories includes an allowance for finished goods inventorywith a date of manufacture of greater than two years old and for certainproducts with a date of manufacture of greater than one year old. In addition,our allowance includes an allowance for die, work-in-process and finished goodsthat exceed our estimated forecast for the next twelve to twenty four months. Forthe obsolete inventory analysis, we review inventory items in detail andconsider date code, customer base requirements, known product defects, plannedor recent product revisions, end of life plans and diminished market demand. Forexcess inventory analysis, we review inventory items in detail and consider ourcustomer base requirements and market demand. While we have programs tominimize inventories on hand and we consider technological obsolescence whenestimating allowances for potentially excess and obsolete inventories and thoserequired to reduce recorded amounts to market values, it is reasonably possiblethat such estimates could change in the near term. Such changes in estimatescould have a material impact on our financial position and results ofoperations.

 

Accrued expenses andother liabilities comprise (in thousands):

 
| ** **                              | ** ** | **December 31,** | ** ** | **March 31,** | ** ** |
|-----------------------------------------|------------|-----------------------|------------|--------------------|------------|
| ** **                              | ** ** | **2005**              | ** ** | **2006**           | ** ** |
| Accrued  compensation and related items |       | $                     | 5,934      |               | $          | 6,043 |   |
| Accrued adverse  purchase commitments   |       | 1,752                 |       | 1,120              |       |
| Accrued  commission                     |       | 2,762                 |       | 2,916              |       |
| Accrued income  tax payable             |       | 1,319                 |       | 3,244              |       |
| Accrued warranty                        |       | 803                   |       | 831                |       |
| Other accrued  liabilities              |       | 4,748                 |       | 6,179              |       |
|                                    |       | $                     | 17,318     |               | $          | 20,333 |   |

 

Changes in the warranty reserves during the threemonths ended March 31, 2005 and 2006 were as follows (in thousands):

 

12

----

 
| ** **                                  | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------------|------------|----------------------------------|------------|
| ** **                                  | ** ** | **March 31,**               | ** ** |
| ** **                                  | ** ** | **2005**                         | ** ** | **2006** | ** ** |
| Beginning  balance                          |       | $                                | 3,826      |   | $ | 803 |   |
| Provisions for  warranty                    |       | 72                               |       | 674 |   |
| Change in  estimate of prior period accrual |       | (500                             | )          | — |   |
| Consumption of  reserves                    |       | (754                             | )          | (646 | ) |
| Ending balance                              |       | $                                | 2,644      |   | $ | 831 |   |

 

Our products aregenerally subject to warranty and we provide for the estimated future costs ofrepair, replacement or customer accommodation upon shipment of the product in ourcondensed consolidated statements of operations. Our warranty accrual isestimated based on historical claims compared to historical revenues. For newproducts, we use our historical percentage for the appropriate class of product.The higher warranty reserve as of March 31, 2005 compared to March 31, 2006 relatedmainly to the rescreening work related to two specific customers. The work wascompleted during 2005 so there is no comparable reserve as of March 31, 2006

 

**6.****              Commitments**

 

Our technology licenseagreements generally include an indemnification clause that indemnifies thelicensee against liability and damages (including legal defense costs) arisingfrom any claims of patent, copyright, trademark or trade secret infringement byour proprietary technology. The terms of these guarantees approximate the termsof the technology license agreements, which typically range from five to tenyears. Our current license agreements expire from 2006 through 2014. Themaximum possible amount of future payments we could be required to make, ifsuch indemnifications were required on all of these agreements, is $41.7million. We have not recorded any liabilities as of March 31, 2006 related tothese indemnities as no such claims have been made or asserted.

 

During our normal course of business, we have madecertain indemnities, commitments and guarantees under which we may be requiredto make payments in relation to certain transactions. These include indemnitiesto various lessors in connection with facility leases for certain claimsarising from such facility or lease and indemnities to our directors andofficers to the maximum extent permitted under the laws of California. Inaddition, we have contractual commitments to some customers, which couldrequire us to incur costs to repair an epidemic defect with respect to ourproducts outside the normal warranty period if such defect were to occur. Theduration of these indemnities, commitments and guarantees varies. The majorityof these indemnities, commitments and guarantees do not provide for anylimitation of the maximum potential future payments that we could be obligatedto make. We have not recorded any liability for these indemnities, commitmentsand guarantees in the accompanying condensed consolidated balance sheets. Wedo, however, accrue for losses for any known contingent liability, includingthose that may arise from indemnification provisions, when future payment isprobable and the amount is reasonably estimatable.

 

**7.****              Contingencies**

 

In January and February2005, multiple putative shareholder class action complaints were filed againstSST and certain directors and officers, in the United States District Court forthe Northern District of California, following our announcement of anticipatedfinancial results for the fourth quarter of 2004. On March 24, 2005, theputative class actions were consolidated under the caption *In re Silicon Storage Technology, Inc., SecuritiesLitigation,* Case No. C 05 00295 PJH (N.D. Cal.). On May 3, 2005, theHonorable Phyllis J. Hamilton appointed the “Louisiana Funds Group,” consistingof the Louisiana School Employees’ Retirement System and the Louisiana DistrictAttorneys’ Retirement System, to serve as lead plaintiff and the law firms ofPomeranz Haudek Block Grossman & Gross LLP and Berman DeValerio PeaseTabacco Burt & Pucillo to serve as lead counsel and liason counsel,respectively, for the class. The lead plaintiff filed a Consolidated AmendedClass Action Complaint on July 15, 2005. The complaint seeks unspecifieddamages on alleged violations of federal securities laws during the period fromApril 21, 2004 to December 20, 2004. We moved to dismiss the complaint on September16, 2005. Plaintiff served an opposition to the motion to dismiss on November4, 2005. Our reply in further support of the motion to dismiss was filed onDecember 19, 2005. On January 18, 2006, the Court heard arguments on the motionto dismiss. On March 10, 2006, the Court granted our motion to dismiss theconsolidated amended complaint, with leave to file an amended complaint. Plaintiffsfiled a second amended complaint on May 1, 2006. We intend to take allappropriate

 

13

----

 

action in response tothese lawsuits. The impact related to the outcome of these matters isundeterminable at this time.

 

In January and February2005, following the filing of the putative class actions, multiple shareholderderivative complaints were filed in California Superior Court for the County ofSanta Clara, purportedly on behalf of SST against certain of our directors andofficers. The factual allegations of these complaints are substantiallyidentical to those contained in the putative shareholder class actions filed infederal court. The derivative complaints assert claims for, among other things,breach of fiduciary duty and violations of the California Corporations Code. Thesederivative actions have been consolidated under the caption *In Re Silicon Storage Technology, Inc. Derivative Litigation*,Lead Case No. 1:05CV034387 (Cal. Super. Ct., Santa Clara Co.). On April 28,2005, the derivative action was stayed by court order. We intend to take allappropriate action in response to these lawsuits. The impact related to theoutcome of these matters is undeterminable at this time.

 

From time to time, we arealso involved in other legal actions arising in the ordinary course of business.We have accrued certain costs associated with defending these matters. Therecan be no assurance that the shareholder class action complaints, theshareholder derivative complaints or other third party assertions will beresolved without costly litigation, in a manner that is not adverse to our financialposition, results of operations or cash flows or without requiring royaltypayments in the future which may adversely impact gross margins. No estimatecan be made of the possible loss or possible range of loss associated with theresolution of these contingencies. As a result, no losses have been accrued inour financial statements as of March 31, 2006.

 

**8.Line of Credit**

** **

On August 11, 2005, weentered into a 1-year loan and security agreement with Cathay Bank, a U.S.bank, for a $35.0 million revolving line of credit, all of which was availableto us as of March 31, 2006. The line of credit will be used for working capitalbut there are no restrictions in the agreement as to how the funds may be used.The interest rate for the line of credit is 1% below the prime rate reportedfrom time to time by the Wall Street Journal, Western Edition (7.75% at March31, 2006). The line of credit is collateralized by substantially all of theassets of SST other than intellectual property. The agreement contains certainfinancial covenants, including the levels of qualifying accounts receivable andinventories, which could limit the availability of funds under the agreement.There were no borrowings under this line as of March 31, 2006.

 

OnJuly 16, 2004, we entered into a 2-year loan agreement with Cathay Bank, a U.S.bank, for a $3.0 million revolving line of credit. The interest rate for theline of credit is 3.475% per annum. The line of credit is collateralized by a$3.0 million certificate of deposit which is included in non-current otherassets. The certificate of deposit matures in July 2006 and carries an interestrate of 2.6% per annum. As of December 31, 2005, and March 31, 2006, we hadborrowed $3.0 million under our line of credit.

 

14

----

 

**9.Goodwill and Intangible Assets:**

 

Our acquisitions in prioryears included the acquisition of $16.5 million of finite-lived intangibleassets. Certain of our acquisitions also included an aggregate of $29.6 millionof goodwill. The goodwill is not being amortized but is tested for impairmentannually, as well as when an event or circumstance occurs indicating a possibleimpairment in value.

 

As of March 31, 2006, ourintangible assets consisted of the following (in thousands):

 
| ** **              | ** ** | ** ** | ** ** | **Accumulated**  | ** ** | ** ** | ** ** |
|-------------------------|------------|------------|------------|------------------|------------|------------|------------|
| ** **              | ** ** | **Cost**   | ** ** | **Amortization** | ** ** | **Net**    | ** ** |
| Existing  technology    |       | $          | 11,791     |             | $          | 3,476      |       | $ | 8,315 |   |
| Trade name              |       | 1,198      |       | 373              |       | 825        |       |
| Customer  relationships |       | 1,857      |       | 653              |       | 1,204      |       |
| Backlog                 |       | 811        |       | 810              |       | 1          |       |
| Non-Compete  Agreements |       | 810        |       | 235              |       | 575        |       |
|                    |       | $          | 16,467     |             | $          | 5,547      |       | $ | 10,920 |   |

 

As of December 31, 2005,our intangible assets consisted of the following (in thousands):

 
| ** **              | ** ** | ** ** | ** ** | **Accumulated**  | ** ** | ** ** | ** ** |
|-------------------------|------------|------------|------------|------------------|------------|------------|------------|
| ** **              | ** ** | **Cost**   | ** ** | **Amortization** | ** ** | **Net**    | ** ** |
| Existing  technology    |       | $          | 11,791     |             | 2,830      |       | $          | 8,961 |   |
| Trade name              |       | 1,198      |       | 313              |       | 885        |       |
| Customer  relationships |       | 1,857      |       | 528              |       | 1,329      |       |
| Backlog                 |       | 811        |       | 806              |       | 5          |       |
| Non-Compete  Agreements |       | 810        |       | 174              |       | 636        |       |
|                    |       | $          | 16,467     |             | $          | 4,651      |       | $ | 11,816 |   |
|                         |            |            |            |                  |            |            |            |  |  |  |

 

All intangible assets arebeing amortized on a straight-line method over their estimated useful lives. Existingtechnologies have been assigned useful lives of between four and five years,with a weighted average life of approximately 4.6 years. Non-compete agreementshave been assigned useful lives between two and four years, with a weightedaverage of 3.6 years. Trade names, customer relationships and backlogs havebeen assigned useful lives of five years, three years and one year,respectively. Amortization expense for intangible assets for the three monthsended March 31, 2006 was $896 thousand.

 

Estimated futureintangible asset amortization expense for the next five years is as follows (inthousands):

 
| ** **                  | ** ** | **Amortization of**        | ** ** |
|-----------------------------|------------|----------------------------|------------|
| **Fiscal Year**        | ** ** | **Intangible Assets** | ** ** |
| 2006 remaining  nine months |       | $                          | 2,674      |   |
| 2007                        |       | 3,427                      |       |
| 2008                        |       | 3,096                      |       |
| 2009                        |       | 1,634                      |       |
| 2010                        |       | 89                         |       |
|                        |       | $                          | 10,920     |   |

 

There was no change inthe carrying amount of goodwill for the three months ended March 31, 2006 fromDecember 31, 2005.

 

15

----

 

**10. SegmentReporting**

 

Management has beenfocusing SST with a key objective to transform ourselves from a pure-play inflash to a multi-product line company. Our objective is to be a leadingworldwide supplier of low to medium density NOR flash memory devices, a leadingsupplier of other semiconductor products in the consumer electronics market anda leading licensor of embedded flash technology. As a result, the operatingresults that the company’s chief operating decision maker reviews to makedecisions about resource allocations and to assess performance have changed. EffectiveJanuary 1, 2006, we have re-evaluated our operating segments to bring them inline with our key objectives and focus. The new segments include MemoryProducts, Non-Memory Products and Technology Licensing.

 

Memory includes ourstandard flash memory product families: the Multi-Purpose Flash, or MPF,family, the Multi-Purpose Flash Plus, or MPF+, family, the ConcurrentSuperFlash, or CSF, family, the Firmware Hub, or FWH, family, the Serial Flashfamily, the ComboMemory family, the Many-Time Programmable, or MTP, family, andthe Small Sector Flash, or SSF, family. These product families are designed to produce products optimized forcost and functionality to support a broad range of mainstream applications thatuse nonvolatile memory products.

 

Our Non-Memory Productssegment includes other semiconductor products including flash microcontrollers smartcard integrated circuit (ICs) and modules, radio frequency, or RF, ICs andmodules and NAND controllers and modules.

 

Technology Licensingincludes both license fees and royalties generated from the licensing of ourSuperFlash technology to semiconductor manufacturers for use in embedded flashapplications.

 

We do not allocateamortization expense, operating expenses, interest and other income, interestexpense, impairment of equity investments and provision for or benefit fromincome taxes to any of these segments for internal reporting purposes, as we donot believe that allocating these expenses are material in evaluating segmentperformance.

 

Prior period segmentinformation has been reclassified to conform to the current period’spresentation.

 

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

 
| ** **            | ** ** | **Three Months Ended** | ** ** | **Three Months Ended** | ** ** |
|-----------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **            | ** ** | **March 31, 2005**     | ** ** | **March 31, 2006**     | ** ** |
| ** **            | ** ** | **Gross**                        | ** ** | ** **                       | ** ** | ** ** | ** ** | **Gross** | ** ** |
| ** **            | ** ** | **Revenues**                     | ** ** | **Profit**                       | ** ** | **Revenues** | ** ** | **Profit** | ** ** |
| Memory                |       | $                                | 68,062     |                             | $          | 993 |   | $ | 80,038 |   | $ | 17,936 |   |
| Non-Memory            |       | 11,208                           |       | 4,555                            |       | 20,265 |   | 5,749 |   |
| Technology  Licensing |       | 7,045                            |       | 7,045                            |       | 10,228 |   | 10,228 |   |
|                  |       | $                                | 86,315     |                             | $          | 12,593 |   | $ | 110,531 |   | $ | 33,913 |   |

 

16

----

 

**11.          Comprehensive Income (Loss)**

 

The components ofcomprehensive income (loss), net of tax, are as follows (in thousands):

 
| ** **                                             | ** ** | **For the Three Months Ended** | ** ** |
|--------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                             | ** ** | **March 31, 2005**                       | ** ** | **March 31, 2006** | ** ** |
|                                                   |       |                                               |       |   |   |
| Net income  (loss)                                     |       | $                                                  | (13,896    | ) | $ | 11,290 |   |
| Other  comprehensive income:                           |       |                                               |       |   |   |
| Change in  unrealized gains on investments, net of tax |       | 3,901                                              |       | (12,626 | ) |
| Change in  cumulative translation adjustment           |       | 68                                                 |       | 11 |   |
| Total  comprehensive income                            |       | $                                                  | (9,927     | ) | $ | (1,325 | ) |

 

The components ofaccumulated other comprehensive income are as follows (in thousands):

 
| ** **                                                                     | ** ** | **Balances as of**    | ** ** |
|--------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                     | ** ** | **December 31, 2005** | ** ** | **March 31, 2006** | ** ** |
| Components of accumulated other comprehensive income: |       |                            |       |   |   |
| Net unrealized  gains on investments, net of tax                               |       | $                               | 31,774     |   | $ | 19,148 |   |
| Cumulative  translation adjustment                                             |       | 6                               |       | 17 |   |
|                                                                           |       | $                               | 31,780     |   | $ | 19,165 |   |

 

17

----

 

**12. RelatedParty Transactions and Balances**

 

Thefollowing table is a summary of our related party revenues and purchases forthe three months ended March 31, 2005 and 2006, and our related party accountsreceivable and accounts payable and accruals as of December 31, 2005 and March31, 2006 (in thousands):

 
| ** **                                      | ** ** | **Three Months Ended** | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                      | ** ** | **March 31, 2005**     | ** ** | **March 31, 2006**     | ** ** |
| ** **                                      | ** ** | **Revenues**                     | ** ** | **Purchases**                    | ** ** | **Revenues** | ** ** | **Purchases** | ** ** |
| Silicon  Technology Co., Ltd                    |       | $                                | 699        |                             | $          | — |   | $ | 226 |   | $ | — |   |
| Apacer  Technology, Inc. & related entities |       | 324                              |       | —                           |       | 966 |   | — |   |
| Silicon  Professional Technology Ltd            |       | 40,626                           |       | —                           |       | 61,079 |   | — |   |
| Grace  Semiconductor Manufacturing Corp         |       | 102                              |       | 23,341                           |       | 1,378 |   | 9,823 |   |
| King Yuan  Electronics Company, Limited         |       | —                           |       | 9,168                            |       | — |   | 8,004 |   |
| Powertech  Technology, Incorporated             |       | —                           |       | 3,702                            |       | — |   | 3,791 |   |
|                                            |       | $                                | 41,751     |                             | $          | 36,211 |   | $ | 63,649 |   | $ | 21,618 |   |

 
| ** **                                      | ** ** | **December 31, 2005** | ** ** | **March 31, 2006** | ** ** |
|-------------------------------------------------|------------|---------------------------------|------------|------------------------------|------------|
| ** **                                      | ** ** | **Trade**                       | ** ** | **Accounts**                 | ** ** | **Trade** | ** ** | **Accounts** | ** ** |
| ** **                                      | ** ** | **Accounts**                    | ** ** | **Payable and**         | ** ** | **Accounts** | ** ** | **Payable and** | ** ** |
| ** **                                      | ** ** | **Receivable**                  | ** ** | **Accruals**                 | ** ** | **Receivable** | ** ** | **Accruals** | ** ** |
| Silicon  Technology Co., Ltd                    |       | $                               | 370        |                         | $          | — |   | $ | 68 |   | $ | — |   |
| Apacer  Technology, Inc. & related entities |       | 237                             |       | —                       |       | 782 |   | — |   |
| Professional  Computer Technology Limited       |       | —                          |       | 123                          |       | — |   | 120 |   |
| Silicon  Professional Technology Ltd            |       | 53,785                          |       | 846                          |       | 36,459 |   | 590 |   |
| Grace  Semiconductor Manufacturing Corp         |       | 1,466                           |       | 4,949                        |       | 104 |   | 7,457 |   |
| King Yuan Electronics  Company, Limited         |       | —                          |       | 10,004                       |       | — |   | 5,925 |   |
| Powertech  Technology, Incorporated             |       | —                          |       | 5,945                        |       | — |   | 3,152 |   |
|                                            |       | $                               | 55,858     |                         | $          | 21,867 |   | $ | 37,413 |   | $ | 17,244 |   |

 

ProfessionalComputer Technology Limited, or PCT, earns commissions for point-of-sales transactionsto  customers. PCT’s commissions are paidat the same rate as all of our other stocking representatives in Asia. Inaddition, we pay Silicon Professional Technology Ltd., or SPT, a wholly-ownedsubsidiary of PCT, a fee for providing logistics center functions. This fee isbased on a percentage of revenue for each product shipped through SPT to ourend customers. The fee paid to SPT covers the costs of warehousing and insuringinventory and processing accounts receivable, the personnel costs required tomaintain logistics and information technology functions and the costs toperform demand forecasting, billing and collection of accounts receivable.

 

**13. IncomeTaxes**

 

We have determined thatbased upon our historical losses and other available objective evidence thatthere is sufficient uncertainty regarding the realizability of our deferred taxassets such that a full valuation allowance was required. Accordingly, wemaintain a valuation allowance against our deferred tax assets at March 31,2006. Our provision for the three months ended March 31, 2006 of $2.3 million isprimarily related to foreign withholding taxes and tentative minimum tax.

 

18

----

 

**Item 2. Management’sDiscussion and Analysis of Financial Condition and Results of Operations.**

 

*Thefollowing discussion may be understood more fully by reference to theconsolidated financial statements, notes to the consolidated financialstatements and management’s discussion and analysis of financial condition andresults of operations contained in our Annual Report on Form 10-K for the yearended December 31, 2005, as filed with the Securities and Exchange Commission.*

 

*Thefollowing discussion contains forward-looking statements, which involve riskand uncertainties. All forward-looking statements included in this document arebased on information available to us on the date hereof, and we assume noobligation to update any such forward-looking statements. Our actual resultscould differ materially from those anticipated in these forward-lookingstatements as a result of certain factors which are difficult to forecast andcan materially affect our quarterly or annual operating results. Fluctuationsin revenues and operating results may cause volatility in our stock price. Pleasealso see Part II, Item 1A. “Risk Factors.”*

 

###### **Overview**

###### ** **

We are a leading supplierof flash memory semiconductor devices for the digital consumer, networking,wireless communications and Internet computing markets. Flash memory is a formof non-volatile memory that allows electronic systems to retain informationwhen the system is turned off. Flash memory is now used in hundreds of millionsof consumer electronics and computing products annually.

 

We produce and sell manyproducts based on our SuperFlash design and manufacturing process technology.Our products are incorporated into products sold by many well-known companiesincluding Apple, Asustek, BenQ, Cisco, Dell, First International Computer, orFIC, Gigabyte, Huawei, Infineon, Intel, IBM, Inventec, Legend Lenovo, LGElectronics, Freescale Semiconductor, Inc, NEC, Nintendo, Panasonic, Philips,Quanta, Samsung, Sanyo, Seagate, Sony, Sony Ericsson, Texas Instruments andVTech.

 

We also produce and sellother semiconductor products including flash microcontrollers, subscriberidentification module, or SIM, cards, radio frequency, or RF, ICs and modulesand memory controllers.

 

One of our key initiatives is the activedevelopment of our non-memory business. Our objective is to transform SST from a pure-play in flash to amulti-product line company. We continue to execute on our plan to derive, bymid-2008, 30% of our revenue from non-memory products, which includes embeddedcontrollers, NAND controller based products, smart card ICs and radio frequencyICs and modules. We believe non-memory products represent anarea in which we have significant competitive advantages and also an area thatcan yield profitable revenue with higher and more stable gross margins than ourmemory products in the long run.

 

As a result of thetransition in our objectives, the operating results that our chief operatingdecision maker reviews to make decisions about resource allocations and toassess our performance have changed. Effective January 1, 2006, we have re-evaluatedour operating segments to bring them in line with our key objectives and focus.The new segments include Memory Products, Non-Memory Products and TechnologyLicensing. For other information related to our segments, see “Note 10 –Segment Reporting” to our Notes to the Consolidated Financial Statements.

 

While we entered thefirst quarter of 2006 with strong bookings, our customers began canceling orpushing out orders after the lunar New Year in January. The slowdown was theresult of weaker than expected demand in a number of key applications,including desktop PCs, printers, graphics cards, optical drives and MP3players.We also experienced fabrication issues with oneof our wafer foundries and capacity constraints for certain package types atone of our backend suppliers. As a result, unit shipments in the first quarter of2006 decreased 20.1% compared with the prior quarter. However, these factorsaffected more of our lower margin products, allowing us to achieve higher thanexpected gross margin results.

 

Looking at our productshipments by application, Internet computing and digital consumer applicationsexperienced the greatest declines. Units shipped to Internet computing applicationswere down by 22.0% compared to the prior quarter largely due to the weakerdemand in the desktop, workstation, LCD monitor, printer, hard disk drive andgraphics card applications. Units shipped to digital consumer applications weredown 24.3% from the prior quarter, driven by weakness in the MP3 player, DVDrecorder, DVD-RW drive, digital TV and video game applications. Units shippedto wireless communications applications were down 11.2% from the prior quarter.Major shipments for these applications were in Bluetooth, cordless phone, cellphone, GPS module, and SIM card applications.

 

19

----

 

Networking applicationsdecreased by 11.7% from the prior quarter, mainly due to fewer shipments tonetworking equipment and wireless LAN applications.

 

Inthe area of memory technologies, we are continuing to reduce manufacturing coststhrough the transition to smaller geometries. Substantially all of our newwafer starts are now in 0.25 micron and 0.18 micron geometries. We are in theprocess of developing 0.13 micron and 0.12 micron process technologies in theembedded flash technology area.

 

The semiconductorindustry has historically been cyclical, characterized by periodic changes inbusiness conditions caused by product supply and demand imbalance. When theindustry experiences downturns, they often occur in connection with, or inanticipation of, maturing product cycles and declines in general economicconditions. These downturns are characterized by weak product demand, excessiveinventory and accelerated decline of selling prices. We experienced a decreasein the average selling prices of our products as a result of the industry-wideoversupply and excessive inventory in the market in the second half of 2004 andthe first half of 2005. Although we saw strengthening of market demand in the secondhalf of 2005 demand for some of our products weakened in the first quarter of2006 although pricing remained stable. Our business could be further harmed byindustry-wide prolonged downturns in the future.

 

Our product sales aremade primarily using short-term cancelable purchase orders. The quantitiesactually purchased by the customer, as well as shipment schedules, arefrequently revised to reflect changes in the customer’s needs and in our supplyof product. Accordingly, our backlog of open purchase orders at any given timeis not a meaningful indicator of future sales. Changes in the amount of ourbacklog do not necessarily reflect a corresponding change in the level ofactual or potential sales.

 

We derived 86.0%, 87.6%and 86.2% of our net product revenues during 2004, 2005 and the three monthsended March 31, 2006, respectively, from product shipments to Asia.Additionally, substantially all of our wafer suppliers and packaging andtesting subcontractors are located in Asia.

 

Our top ten endcustomers, excluding transactions through stocking representatives anddistributors, accounted for 29.1%, 27.2% and 20.7% of our net product revenuesin 2004, 2005 and the three months ended March 31, 2006, respectively.

 

No single end customer,which we define as original equipment manufacturers, or OEMs, original designmanufacturers, or ODMs, contract electronic manufacturers, or CEMs, or endusers, represented 10.0% or more of our net product revenues during 2004, 2005or the three months ended March 31, 2006.

 

We out-source our endcustomer service logistics in Asia to Silicon Professional Technology Ltd., orSPT, which supports our customers in Taiwan, China and other Southeast Asiacountries. SPT provides forecasting, planning, warehousing, delivery, billing,collection and other logistic functions for us in these regions. SPT is awholly-owned subsidiary of Professional Computer Technology Limited, or PCT,one of our stocking representatives in Taiwan. Please see a description of ourrelationship with PCT under “Item 7. Management’s Discussion and Analysis ofFinancial Condition and Results of Operations - Related Party Transactions” inour Annual Report on Form 10-K for the year ended December 31, 2005. Productsshipped to SPT are accounted for as our inventory held at our logistics center,and revenue is recognized when the products have been delivered and areconsidered as a sale to our end customers by SPT. For 2004 and 2005 and thethree months ended March 31, 2006, SPT serviced end customer sales accountingfor 52.9%, 58.5% and 60.9%, respectively, of our net product revenuesrecognized. As of December 31, 2005 and March 31, 2006, SPT represented 69.6%and 53.6% of our net accounts receivable, respectively.

 

We ship products to, andhave accounts receivable from, OEMs, ODMs, CEMs, stocking representatives,distributors and our logistics center. Our stocking representatives,distributors and logistics center reship our products to our end customers,including OEMs, ODMs, CEMs and end users. Shipments, by us or our logisticscenter, to our top three stocking representatives for reshipment accounted for 34.0%,40.3% and 58.1% of our product shipments in 2004, 2005 and the three monthsended March 31, 2006, respectively. In addition, the same three stockingrepresentatives solicited sales, for which they received a commission, for 25.1%,18.3% and 13.6% of our shipments to end users in 2004, 2005 and the three monthsended March 31, 2006, respectively.

 

20

----

 

**Critical Accounting Estimates**

 

Effective January 1,2006, we adopted the fair value recognition provisions of Financial AccountingStandards Board, or FASB, Statement of Financial Accounting Standards, or SFAS,No. 123(R), *“Share-Based Payments*,”using the modified prospective application method. Under this transitionmethod, compensation cost recognized in the quarter ended March 31, 2006,includes the applicable amounts of: (a) compensation cost of allstock-based payments granted prior to, but not yet vested as of, January 1,2006 (based on the grant-date fair value estimated in accordance with theoriginal provisions of SFAS No. 123 and previously presented in the proforma footnote disclosures), and (b) compensation cost for all stock-basedpayments granted subsequent to January 1, 2006 (based on the grant-date fairvalue estimated in accordance with the new provisions of SFAS No. 123(R)).Results for prior periods have not been restated to reflect our adoption ofSFAS No. 123(R).

 

For other informationrelated to our revenue recognition and other critical accounting estimates,please refer to the “Critical Accounting Estimates” section of “Management’sDiscussion and Analysis of Financial Condition and Results of Operations”contained in our Annual Report on Form 10-K for the year ended December 31, 2005.

 

**Resultsof Operations: Three Months Ended March 31, 2006**

 

**Net Revenues**

 
| ** **            | ** ** | **Three Months Ended** | ** ** | ** **       | ** ** | ** **         | ** ** | ** **           | ** ** | ** **           | ** ** |
|-----------------------|------------|----------------------------------|------------|------------------|------------|--------------------|------------|----------------------|------------|----------------------|------------|
| ** **            | ** ** | **March 31,**               | ** ** | **Dec 31,** | ** ** | **March 31,** | ** ** | **1Q06-Over-**       | ** ** | **1Q06-Over-**       | ** ** |
| ** **            | ** ** | **2005**                         | ** ** | **2005**         | ** ** | **2006**           | ** ** | **4Q05 Change** | ** ** | **1Q05 Change** | ** ** |
| Memory Revenue        |       | $                                | 68,062     |             | $          | 99,229             |       | $                    | 80,038     |                 | $          | (19,191 | ) | (19.3 | )% | $ | 11,976 |   | 17.6 | % |
| Non-Memory  Revenue   |       | $                                | 11,208     |             | $          | 22,991             |       | $                    | 20,265     |                 | $          | (2,726 | ) | (11.9 | )% | $ | 9,057 |   | 80.8 | % |
| Product revenues      |       | $                                | 79,270     |             | $          | 122,220            |       | $                    | 100,303    |                 | $          | (21,917 | ) | (17.9 | )% | $ | 21,033 |   | 26.5 | % |
| Technology  licensing |       | $                                | 7,045      |             | $          | 10,993             |       | $                    | 10,228     |                 | $          | (765 | ) | (7.0 | )% | $ | 3,183 |   | 45.2 | % |
| Total net  revenues   |       | $                                | 86,315     |             | $          | 133,213            |       | $                    | 110,531    |                 | $          | (22,682 | ) | (17.0 | )% | $ | 24,216 |   | 28.1 | % |

 

Net revenues decreased17.0% in the first quarter of 2006 from the prior quarter primarily due to a20.1% decline in unit shipments and lower technology license revenue due mainlyto the timing of up-front license fees. While our pricing remained relativelyflat from the fourth quarter of 2005, average selling prices of our productsfor the first quarter of 2006 increased 2.7% due to product mix that favored higher margin products. Netrevenues for the first quarter 2006 increased 28.1% compared to the firstquarter of 2005 due to a 25.4% increase in unit shipments and increased royaltyrevenue.

 

*Product Revenues*

 

The following discussionsare based on our reportable segments described in Note 10 of the Notes to theUnaudited Condensed Consolidated Financial Statements.

 

*Memory Products*

 

Memory product revenue declined in the first quarter of 2006 from thefourth quarter of 2005 primarily due to 20.9% decrease in unit shipments,somewhat offset by a 4.6% increase in our average selling price. Weakerdemand  for several consumer electronicand computer applications led to order cancellations and delays. Memory productrevenue increased in the first quarter of 2006 compared to the first quarter of2005 primarily due to a 22.2% increase in unit shipments. The increase camelargely from a 132.4% increase in unit shipments of serial flash devices.

 

*Non-Memory Products*

 

Non-memory productrevenue declined in the first quarter of 2006 from the fourth quarter of 2005primarily due to a 16.7% decrease in unit shipments. The decrease in unitshipments was driven primarily by a decrease in demand for NAND controllerproducts for MP3 applications and a decrease in demand for SIM cardapplications. Non-memory product revenue increased in the first quarter of 2006compared to the first quarter of 2005 primarily due to a 41.0% increase in unitshipments. Non-memory product revenue as a percent of total product revenueincreased to 20.2% in the first quarter of 2006 compared to 18.8% in the priorquarter and 14.1% in the first quarter of 2005.

 

21

----

 

*Technology Licensing Revenue*

 

Technology licenserevenues include a combination of up-front fees and royalties. Technologylicensing revenue for the first quarter of 2006 declined from the fourthquarter of 2005 as a result of lower up-front license fees due to timing of newlicense agreements and milestone completions. Technology licensing revenues forthe first quarter of 2006 increased compared to the first quarter of 2005 dueto new licensing agreements and increased royalty fees. We anticipate revenuesfrom technology licensing may fluctuate significantly in the future.

 

**Gross Profit**

 
| ** **                         | ** ** | **Three Months Ended** | ** ** | ** **       | ** ** | ** **         | ** ** | ** **           | ** ** | ** **           | ** ** |
|------------------------------------|------------|----------------------------------|------------|------------------|------------|--------------------|------------|----------------------|------------|----------------------|------------|
| ** **                         | ** ** | **March 31,**               | ** ** | **Dec 31,** | ** ** | **March 31,** | ** ** | **1Q06-Over-**       | ** ** | **1Q06-Over-**       | ** ** |
| ** **                         | ** ** | **2005**                         | ** ** | **2005**         | ** ** | **2006**           | ** ** | **4Q05 Change** | ** ** | **1Q05 Change** | ** ** |
| Memory gross  profit               |       | $                                | 993        |             | $          | 16,766             |       | $                    | 17,936     |                 | $          | 1,170 |   | 7.0 | % | $ | 16,943 |   | 1706.2 | % |
| Memory gross  margin               |       | 1.5                              | %          | 16.9             | %          | 22.4               | %          |                 |       |                 |       |   |   |   |   |
| Non-Memory gross  profit           |       | $                                | 4,555      |             | $          | 7,012              |       | $                    | 5,749      |                 | $          | (1,263 | ) | (18.0 | )% | $ | 1,194 |   | 26.2 | % |
| Non-Memory gross  margin           |       | 40.6                             | %          | 30.5             | %          | 28.4               | %          |                 |       |                 |       |   |   |   |   |
| Product gross  profit              |       | $                                | 5,548      |             | $          | 23,778             |       | $                    | 23,685     |                 | $          | (93 | ) | (0.4 | )% | $ | 18,137 |   | 326.9 | % |
| Product gross  margin              |       | 7.0                              | %          | 19.5             | %          | 23.6               | %          |                 |       |                 |       |   |   |   |   |
| Technology  licensing gross profit |       | 7,045                            |       | 10,993           |       | 10,228             |       | (765                 | )          | (7.0                 | )%         | 3,183 |   | 45.2 | % |
| Technology licensing  gross margin |       | 100.0                            | %          | 100.0            | %          | 100.0              | %          |                 |       |                 |       |   |   |   |   |
| Total gross  profit                |       | $                                | 12,593     |             | $          | 34,771             |       | $                    | 33,913     |                 | $          | (858 | ) | (2.5 | )% | $ | 21,320 |   | 169.3 | % |
| Total gross  margin                |       | 28.4                             | %          | 15.9             | %          | 33.8               | %          |                 |       |                 |       |   |   |   |   |

 

Gross margin improved forthe first quarter of 2006 compared to the fourth quarter of 2005 as theweakened demand environment had more of an effect on our lower margin products suchas products sold for digital consumer applications including both high and lowdensity NOR. Average selling prices increased 2.7% in the first quarter of 2006from the fourth quarter of 2005 without considering product mix. Lowerprovisions for inventory reserves of $1.7 million in the first quarter of 2006compared to $5.2 million in the prior quarter and $10.8 million in the first quarterof 2005 also had a favorable impact on the first quarter gross profit.

 

For other factors thatcould affect our gross profit, please also see “Part II, Item 1A.”Risk Factors- We incurred material inventory valuation adjustments in 2003, 2004 and 2005,and we may incur additional material inventory valuation adjustments in thefuture.”

 

*Product Gross Profit*

 

*Memory products*

 

Gross profit for memoryproducts increased in the first quarter of 2006 compared to the fourth quarterof 2005 and the first quarter of 2005 largely due to lower charges forprovision against inventory and adverse purchase commitments in the firstquarter of 2006 and lower material and production costs.

 

*Non-memory products*

 

Gross profit fornon-memory products decreased in the first quarter of 2006 compared to thefourth quarter of 2005 as total unit shipments decreased 16.7%. The decrease ingross margin is largely a result of product mix and a 2.8% decrease in the averageselling price of non-memory products. In comparison to the first quarter of2005, unit shipments increased 41.0%. Although average selling prices increased19.7%, the increase was primarily a result of product mix. Actual sellingprices decreased as a result of heavy competition, resulting in lower grossmargin. We expect some revenue fluctuation in non-memory business until atleast late 2007 as we expect to grow and diversify our revenue and customerbase.

 

22

----

 

Operating Expenses

 

*Research and development*

 
| ** **                | ** ** | **Three Months Ended** | ** ** | ** **       | ** ** | ** **         | ** ** | ** **           | ** ** | ** **           | ** ** |
|---------------------------|------------|----------------------------------|------------|------------------|------------|--------------------|------------|----------------------|------------|----------------------|------------|
| ** **                | ** ** | **March 31,**               | ** ** | **Dec 31,** | ** ** | **March 31,** | ** ** | **1Q06-Over-**       | ** ** | **1Q06-Over-**       | ** ** |
| ** **                | ** ** | **2005**                         | ** ** | **2005**         | ** ** | **2006**           | ** ** | **4Q05 Change** | ** ** | **1Q05 Change** | ** ** |
| Research and  development |       | $                                | 11,965     |             | $          | 12,209             |       | $                    | 15,167     |                 | $          | 2,958 |   | 24.2 | % | $ | 3,202 |   | 26.8 | % |
| Percent of  revenue       |       | 13.9                             | %          | 9.2              | %          | 13.7               | %          |                 |       |                 |       |   |   |   |   |
|                           |            |                                  |            |                  |            |                    |            |                      |            |                      |            |  |  |  |  |  |  |  |  |  |

 

Research and development expenses include costs associated with thedevelopment of new products, enhancements to existing products, qualityassurance activities and occupancy costs. These costs consist primarily ofemployee salaries, stock-based compensation expense and other benefit-relatedcosts and the cost of materials such as wafers and masks.

 

Research and development expenses increased in the first quarter of 2006 comparedto the fourth quarter of 2005 primarily due to increased spending in masks of$1.2 million as a result of new technology and product development andenhancements and increased employee benefit related costs. The increase inbenefit related costs came primarily from stock-based compensation expense of$980 thousand as a result of the implementation of SFAS No. 123(R) in the firstquarter of 2006, increased 401k matching of $364 thousand and profit sharing of$303 thousand due to profitability in the first quarter of 2006. Research anddevelopment expenses increased in the first quarter of 2006 compared to thefirst quarter of 2005 due to an increased evaluation parts expense of $620thousand for technology and product development and enhancement and increasedbenefit related costs. The increase in benefit related costs came primarilyfrom stock-based compensation expense of $980 thousand as a result of theimplementation of SFAS No. 123(R) in the first quarter of 2006, increased 401kmatching of $233 thousand and profit sharing of $303 thousand due toprofitability in the first quarter of 2006. We expect that R&D expenseswill fluctuate based on the timing of engineering projects for both new productintroductions and the development of new technologies to support our futuregrowth.

 

*Sales and marketing*

 
| ** **           | ** ** | **Three Months Ended** | ** ** | ** **       | ** ** | ** **         | ** ** | ** **           | ** ** | ** **           | ** ** |
|----------------------|------------|----------------------------------|------------|------------------|------------|--------------------|------------|----------------------|------------|----------------------|------------|
| ** **           | ** ** | **March 31,**               | ** ** | **Dec 31,** | ** ** | **March 31,** | ** ** | **1Q06-Over-**       | ** ** | **1Q06-Over-**       | ** ** |
| ** **           | ** ** | **2005**                         | ** ** | **2005**         | ** ** | **2006**           | ** ** | **4Q05 Change** | ** ** | **1Q05 Change** | ** ** |
| Sales and  marketing |       | $                                | 7,340      |             | $          | 7,096              |       | $                    | 8,161      |                 | $          | 1,065 |   | 15.0 | % | $ | 821 |   | 11.2 | % |
| Percent of  revenue  |       | 8.5                              | %          | 5.3              | %          | 7.4                | %          |                 |       |                 |       |   |   |   |   |
|                      |            |                                  |            |                  |            |                    |            |                      |            |                      |            |  |  |  |  |  |  |  |  |  |

 

Sales and marketingexpenses consist primarily of commissions, employee salaries, stock-basedcompensation expense and other benefit-related costs, as well as travel andentertainment expenses.

 

Sales and marketingexpenses increased in the first quarter of 2006 compared to the fourth quarterof 2005 primarily due to bonuses and profit sharing accrual of $547 thousand asa result of our profitability in the first quarter of 2006 and stock-basedcompensation expense of $260 thousand as a result of SFAS 123(R) in the firstquarter of 2006. The increase from the first quarter of 2005 to the firstquarter of 2006 related to increased commission and logistic fee expense of$711 thousand due to higher product revenues in Asia and stock-basedcompensation expense of $260 thousand. We expect that sales and marketingexpenses may increase in absolute dollars. In addition, fluctuations inrevenues will cause fluctuations in sales and marketing expenses due to ourcommission expenses.

 

*General and administrative*

 
| ** **                  | ** ** | **Three Months Ended** | ** ** | ** **       | ** ** | ** **         | ** ** | ** **           | ** ** | ** **           | ** ** |
|-----------------------------|------------|----------------------------------|------------|------------------|------------|--------------------|------------|----------------------|------------|----------------------|------------|
| ** **                  | ** ** | **March 31,**               | ** ** | **Dec 31,** | ** ** | **March 31,** | ** ** | **1Q06-Over-**       | ** ** | **1Q06-Over-**       | ** ** |
| ** **                  | ** ** | **2005**                         | ** ** | **2005**         | ** ** | **2006**           | ** ** | **4Q05 Change** | ** ** | **1Q05 Change** | ** ** |
| General and  administrative |       | $                                | 6,702      |             | $          | 4,418              |       | $                    | 6,037      |                 | $          | 1,619 |   | 36.6 | % | $ | (665 | ) | (9.9 | )% |
| Percent of  revenue         |       | 7.8                              | %          | 3.3              | %          | 5.5                | %          |                 |       |                 |       |   |   |   |   |
|                             |            |                                  |            |                  |            |                    |            |                      |            |                      |            |  |  |  |  |  |  |  |  |  |

 

General andadministrative expenses mainly consist of salaries, stock-based compensation,and other-benefit related costs for administrative, executive and financepersonnel, recruiting costs, professional services and legal fees andallowances for doubtful accounts.

 

General andadministrative expenses increased in the first quarter of 2006 compared to thefourth quarter of 2005 related to stock compensation expense of $640 thousandas a result of the implementation of SFAS No. 123(R) in the first

 

23

----

 

quarter of 2006, increased401k matching expense of $134 thousand and an increase in the allowance for baddebt expense of $648 thousand. The increase in bad debt expense was a replenishmentof allowance reserves released in the fourth quarter of 2005 from increasedcollections against the trade receivables. General and administrative expenses decreasedin the first quarter of 2006 compared to the first quarter of 2005 due to decreasesin outside services of $1.0 million due to lower Sarbanes-Oxley compliancecosts, partially offset by stock-based compensation expense of $640 thousand asa result of the implementation of SFAS No. 123(R) in the first quarter of 2006.In addition to the increased expense related to SFAS No. 123(R), we anticipatethat general and administrative expenses may increase in absolute dollars as wescale our facilities, infrastructure and headcount to support our overallexpected growth.

 

*Other operating expenses*

 
| ** **                | ** ** | **Three Months Ended** | ** ** | ** **       | ** ** | ** **         | ** ** | ** **           | ** ** | ** **           | ** ** |
|---------------------------|------------|----------------------------------|------------|------------------|------------|--------------------|------------|----------------------|------------|----------------------|------------|
| ** **                | ** ** | **March 31,**               | ** ** | **Dec 31,** | ** ** | **March 31,** | ** ** | **1Q06-Over-**       | ** ** | **1Q06-Over-**       | ** ** |
| ** **                | ** ** | **2005**                         | ** ** | **2005**         | ** ** | **2006**           | ** ** | **4Q05 Change** | ** ** | **1Q05 Change** | ** ** |
| Other operating  expenses |       | $                                | —     |             | $          | 50                 |       | $                    | —     |                 | $          | (50 | ) | n/m |   | $ | — |   | n/m |   |
| Percent of  revenue       |       | 0.0                              | %          | 0.0              | %          | 0.0                | %          |                 |       |                 |       |   |   |   |   |
|                           |            |                                  |            |                  |            |                    |            |                      |            |                      |            |  |  |  |  |  |  |  |  |  |

 

We incurred no otheroperating expenses during the first quarter of 2006 or 2005 and had minimalexpense in the fourth quarter of 2005.

 

*Other income and expense, net*

 
| ** **                   | ** ** | **Three Months Ended** | ** ** | ** **       | ** ** | ** **         | ** ** | ** **           | ** ** | ** **           | ** ** |
|------------------------------|------------|----------------------------------|------------|------------------|------------|--------------------|------------|----------------------|------------|----------------------|------------|
| ** **                   | ** ** | **March 31,**               | ** ** | **Dec 31,** | ** ** | **March 31,** | ** ** | **1Q06-Over-**       | ** ** | **1Q06-Over-**       | ** ** |
| ** **                   | ** ** | **2005**                         | ** ** | **2005**         | ** ** | **2006**           | ** ** | **4Q05 Change** | ** ** | **1Q05 Change** | ** ** |
| Other income  (expense), net |       | $                                | 201        |             | $          | 204                |       | $                    | 439        |                 | $          | 235 |   | 115.2 | % | $ | 238 |   | 118.4 | % |
|                         |       | 0.2                              | %          | 0.2              | %          | 0.4                | %          |                 |       |                 |       |   |   |   |   |
|                              |            |                                  |            |                  |            |                    |            |                      |            |                      |            |  |  |  |  |  |  |  |  |  |

 

Other income and expense for the periods presentedincluded mainly interest and dividend income on our cash and investments. Incomparison to the prior quarter and the first quarter of 2005, other income andexpense increased due to higher levels of invested cash and higher short-terminterest rates, resulting in higher interest income for the first quarter of 2006.We expect other income and expense will fluctuate as a result of changes incash balances and the timing for dividends on our investments.

 

*Interest expense*

 
| ** **       | ** ** | **Three Months Ended** | ** ** | ** **       | ** ** | ** **         | ** ** | ** **           | ** ** | ** **           | ** ** |
|------------------|------------|----------------------------------|------------|------------------|------------|--------------------|------------|----------------------|------------|----------------------|------------|
| ** **       | ** ** | **March 31,**               | ** ** | **Dec 31,** | ** ** | **March 31,** | ** ** | **1Q06-Over-**       | ** ** | **1Q06-Over-**       | ** ** |
| ** **       | ** ** | **2005**                         | ** ** | **2005**         | ** ** | **2006**           | ** ** | **4Q05 Change** | ** ** | **1Q05 Change** | ** ** |
| Interest expense |       | $                                | 21         |             | $          | 109                |       | $                    | 79         |                 | $          | (30 | ) | (27.5 | )% | $ | 58 |   | 276.2 | % |
|             |       | 0.0                              | %          | 0.1              | %          | 0.1                | %          |                 |       |                 |       |   |   |   |   |
|                  |            |                                  |            |                  |            |                    |            |                      |            |                      |            |  |  |  |  |  |  |  |  |  |

 

Interest expense remainedrelatively low as we do not have significant outstanding debt. Interest expensein the first quarter of 2006 decreased compared to the fourth quarter of 2005and the first quarter of 2005 as payments against outstanding debt reducedinterest expense. As of March 31, 2006, we had no borrowings against our $35.0million line of credit with Cathay Bank and had $3.0 million in borrowingsagainst our $3.0 million line revolving line of credit with Cathay Bank. If weborrow against our credit lines in the future, interest expense will increaseas a result of the borrowings.

 

*Change in equity investments*

 

During the first quarter of2006, we realized a pre-tax gain of $12.2 million from the sale of 4.0 millionshares of our investment in Power Technology, Inc. or PTI. As of March 21,2006, we owned 5.5 million shares of PTI.

 

Also during the firstquarter of 2006, we determined that our investment in Nanotech, Inc. had becomeimpaired as Nanotech defaulted on its loan payments to certain of its businesspartners and began preparations to liquidate itself. As a result, we wrote our$3.3 million investment down to zero as well as an outstanding loan for $225thousand. We believe the chances of recovering this investment are remote andcannot be reasonably estimated.

 

**Provision for IncomeTaxes**

 

We maintained a full valuation allowance on our netdeferred tax assets as of March 31, 2006. The valuation allowance wasdetermined in accordance with the provisions of Statement of FinancialAccounting Standards No. 109,

 

24

----

 

or SFAS No. 109, “*Accounting for IncomeTaxes*,” which requires an assessment of both positive and negativeevidence when determining whether it is more likely than not that deferred taxassets are recoverable; such assessment is required on a jurisdiction byjurisdiction basis. Cumulative losses incurred in the U.S. in recent yearsrepresented sufficient negative evidence under SFAS No. 109 and accordingly, afull valuation allowance was recorded against U.S. deferred tax assets. Weintend to maintain a full valuation allowance in the U.S. deferred tax assetsuntil sufficient positive evidence exists to support reversal of the valuationallowance.

 

Our tax provision for the first quarter of 2006 was $2.3million, which consists primarily of foreign withholding taxes and tentativeminimum tax.

 

**Liquidityand Capital Resources**

 
| ** **                                      | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|
| ** **                                      | ** ** | **March 31,**               | ** ** | **March 31,** | ** ** |
| ** **                                      | ** ** | **2005**                         | ** ** | **2006** | ** ** |
| Cash provided by (used in): | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Operating  activities                           |       | $                                | (30,116    | ) | $ | 15,909 |   |
| Investing  activities                           |       | $                                | 22,413     |   | $ | 889 |   |
| Financing Activities                            |       | $                                | 2,524      |   | $ | 920 |   |

 

* Operating activities.*Themajor contributing factors to our sources and uses of operating cash over the pastthree months are the reduction of related party receivables of $18.5 million, asa result of payments from our overseas customers. This was offset by decreasedaccounts payable from both related and unrelated parties of $18.4 million. Netincome of $11.3 million was also affected by non-cash charges in the firstquarter of 2006 including a $12.2 million gain on the sale of PTI shares, stock-basedcompensation expense from the required adoption of SFAS No. 123(R) of $2.0million, depreciation and amortization expense of $2.5 million, a $3.5 millioncharge for the impairment of our in investment in Nanotech, Inc. and $1.7 millioncharge to our inventory provision. For the first quarter of 2005, our primaryusage of operating cash flow was the increase in inventory of $37.6 million. Theincrease in inventory was concentrated in the early part of the first quarterfor production that was started in the fourth quarter of 2004. Non-cash chargesin the first quarter of 2005 primarily related to a $10.8 million provisionagainst inventory and depreciation and amortization expense of $2.0 million.

 

* Investing activities.*Theprimary source of cash from investing activities came from the net sales,maturities and purchases of available-for-sale investments, primarily from thesales of PTI shares that provided cash of $14.3 million, offset by the use of $12.0million in cash for the purchase for other available-for-sale instruments aswell as the $1.4 million in purchases of fixed assets to support our operations.For the first quarter of 2005, cash provided by our investing activitiesrelated to $42.7 million sale and maturity of available-for-sale investmentspartially offset by the $19.1 million purchase of them. 

 

* Financing activities.*Cashfrom financing activities in the first quarter of 2006 primarily related to theissuance of common stock under our employee stock purchase plan and theexercise of employee stock options of $1.3 million. In the first quarter of 2005,cash was generated by $1.0 million borrowing against our line of credit and the$1.6 million issuance of common stock under our employee stock purchase planand the exercise of employee stock options.

 

Principal sources ofliquidity at March 31, 2006 consisted of $107.3 million of cash, cashequivalents and short-term available-for-sale investments. In addition, inAugust 2005, we entered into a 1-year loan and security agreement with CathayBank, a U.S. bank, for a $35.0 million revolving line of credit. For moreinformation regarding the line of credit, refer to Note 8 of the Notes to theUnaudited Condensed Consolidated Financial Statements

 

 As of March 31, 2006, other than as describedbelow, there were no material changes in long-term debt obligations, capitallease obligations, operating lease obligations, purchase obligations or anyother long-term liabilities reflected on our condensed consolidated balancesheet as compared to December 31, 2005.

 

* Purchase Commitments.*As of March31, 2006, we had outstanding purchase commitments with our foundry vendors of $38.5million for delivery in 2006. We have recorded a liability of $1.1 million foradverse purchase commitments. In comparison, as of December 31, 2005, we hadoutstanding purchase commitments with our foundry vendors of $51.7 million fordelivery in 2006, with a recorded liability of $1.8 million for adversepurchase commitments.

 

25

----

 

*OperatingCapital Requirements*. We believe our cash balances, togetherwith the funds we expect to generate from operations, will be sufficient tomeet our projected working capital and other cash requirements through at leastthe next twelve months. However, if we fail to execute to our businessstrategies, we could experience declines in our cash balances. We have secureda line of credit for up to $35.0 million from Cathay Bank to meet operatingcapital requirements if needed. This line of credit expires on August 11, 2006.However, there can be no assurance that future events will not require us toseek additional borrowings or capital and, if so required, that such borrowingor capital will be available on acceptable terms. Factors that could affect ourshort-term and long-term cash used or generated from operations and as aresult, our need to seek additional borrowings or capital include:

 

•    the average selling prices of ourproducts;

•    customer demand for our products;

•    the need to secure future waferproduction capacity from our suppliers;

•    the timing of significant ordersand of license and royalty revenue;

•    the ability to manage our inventorylevels according to plan; and

•    unanticipated research anddevelopment expenses associated with new product introductions.

 

Please also see “Part II. Item 1A. “Risk Factors - Our operating resultsfluctuate significantly and an unanticipated decline in revenues may disappointsecurities analyst or investors and result in a decline in our stock price.”

 

In January and February2005, multiple putative shareholder class action complaints were filed againstus and certain of our directors and officers in the United States DistrictCourt for the Northern District of California. Following the filing of theputative class action lawsuits, multiple shareholder derivative complaints werefiled in California Superior Court for the County of Santa Clara, purportedlyon behalf of SST against certain of our directors and officers. In the event ofunfavorable outcome of the suits, we may be required to pay damages. For moreinformation, please also see “Part II. Item 1A. “Risk Factors – If we becomeengaged in securities class action suits and derivative suits, we may becomesubject to consuming and costly litigation and divert management resources andcould impact our stock price.”

 

From time to time, we arealso involved in other legal actions arising in the ordinary course of business.We have accrued certain costs associated with defending these matters. Therecan be no assurance that the shareholder class action complaints, theshareholder derivative complaints or other third party assertions will beresolved without costly litigation, in a manner that is not adverse to ourfinancial position, results of operations or cash flows or without requiringroyalty payments in the future which may adversely impact gross margins. Noestimate can be made of the possible loss or possible range of loss associatedwith the resolution of these contingencies. As a result, no losses have beenaccrued in our financial statements as of March 31, 2006.

 

**RecentAccounting Pronouncements**

 

In September 2005,the FASB ratified Emerging Issues Task Force Issue No. 04-13, “*Accountingfor Purchases and Sales of Inventory with the Same Counterparty”,*or**EITF 04-13. EITF 04-13discusses whether inventory purchase and sales transactions with the samecounterparty that are entered into in contemplation of one another should becombined and treated as a nonmonetary exchange and addresses (a) underwhat circumstances should two or more transactions with the same counterparty(counterparties) be viewed as a single nonmonetary transaction within thescope of APB Opinion No. 29, “*Accounting for Nonmonetary Transactions*”,**or**APB 29,and Financial Accounting Standard No. 153, *“Exchanges of Nonmonetary Assets, an Amendment of APB 29”,*or SFAS 153, and (b) ifnonmonetary transactions within the scope of APB 29 and FAS 153involve inventory, are there any circumstances under which the transactionsshould be recognized at fair value. The pronouncement is effective for newinventory arrangements entered into, or modifications or renewals of existinginventory arrangements occurring in interim or annual reporting periodsbeginning after March 15, 2006. We do not expect that this pronouncementwill have a material effect on our consolidated financial statements.

 

26

----

 

**Item 3. Quantitative andQualitative Disclosures about Market Risk**

 

We are exposed to risksassociated with foreign exchange rate fluctuations due to our internationalmanufacturing and sales activities. These exposures may change over time asbusiness practices evolve and could negatively impact our operating results andfinancial condition. Currently, we do not hedge these foreign exchange rateexposures. All of our sales are denominated in U.S. dollars. An increase in thevalue of the U.S. dollar relative to foreign currencies could make our productsmore expensive and therefore reduce the demand for our products. Such a declinein the demand could reduce revenues and/or result in operating losses. Inaddition, a downturn in the economies of China, Japan or Taiwan could impairthe value of our equity investments in companies with operations in thesecountries. If we consider the value of these companies to be impaired, we willwrite off, or expense, some or all of our investments. In 2005, we wrote downour investment in ACET by $2.2 million since ACET’s board of directors approvedthe issuance of a new round of equity funding at a lower per share price thanour carrying value. In the first quarter of 2006, we determined that our investmentin Nanotech, Inc. had become impaired as Nanotech defaulted on its loanpayments to certain of its business partners and began preparations toliquidate itself. As a result, we wrote our $3.3 million investment down tozero as well as an outstanding loan for $225 thousand. We believe the chancesof recovering this investment are remote and cannot be estimated.

 

At any time, fluctuations in interest rates could affect interest earningson our cash, cash equivalents and available-for-sale investments, or the fairvalue of our investment portfolio. A 10% move in interest rates as of March 31,2006 would have an immaterial effect on our financial position, results ofoperations and cash flows. Currently, we do not hedge these interest rateexposures. As of March 31, 2006, the carrying value of our available-for-saleinvestments approximated fair value. The table below presents the carryingvalue and related weighted average interest rates for our unrestricted andrestricted cash, cash equivalents and available-for-sale investments as of March31, 2006 (in thousands):

 
| ** **                                              | ** ** | **Carrying** | ** ** | **Interest** | ** ** |
|---------------------------------------------------------|------------|--------------|------------|--------------|------------|
| ** **                                              | ** ** | **Value**    | ** ** | **Rate**     | ** ** |
|                                                    |       |         |       |         |       |
| Short-term  available-for-sale investments - fixed rate |       | $            | 12,164     |         | 3.3        | % |
| Cash and cash  equivalents - variable rate              |       | 95,100       |       | 2.8          | %          |
|                                                    |       | $            | 107,264    |         | 2.9        | % |

 

27

----

 

**Item 4. Controls and Procedures**

 

**Disclosure Controls and Procedures**

 

We maintaindisclosure controls and procedures that are designed to ensure that informationrequired to be disclosed in our reports filed or submitted pursuant to theSecurities Exchange Act of 1934, as amended, or the Exchange Act, is recorded,processed, summarized and reported within the time periods specified in theSecurities and Exchange Commission’s rules and forms. Disclosure controls andprocedures also are designed to ensure that such information is accumulated andcommunicated to our management, including our Chief Executive Officer and ChiefFinancial Officer, as appropriate, to allow timely decisions regarding requireddisclosure. A control system, no matter how well designed and operated, canprovide only reasonable, not absolute, assurance that the control system’sobjectives will be met.

 

Ourmanagement, with the participation of the Chief Executive Officer and ChiefFinancial Officer, conducted an evaluation of the effectiveness of ourdisclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e)and 15d-15(e)) as of March 31, 2006. Based on their evaluation, the ChiefExecutive Officer and the Chief Financial Officer have concluded that ourdisclosure controls and procedures were effective at the reasonable assurancelevel as of March 31, 2006.

 

**Changes in Internal Control Over Financial Reporting**

 

There have been nochanges in our internal control over financial reporting during the quarterended March 31, 2006 that have materially affected or are reasonably likely tomaterially affect our internal control over financial reporting, as defined inRule 13a-15(f) under the Exchange Act.

 

28

----

 

**PART II -OTHER INFORMATION**

 

**Item 1. Legal Proceedings**

 

In January and February2005, multiple putative shareholder class action complaints were filed againstSST and certain directors and officers, in the United States District Court forthe Northern District of California, following our announcement of anticipatedfinancial results for the fourth quarter of 2004. On March 24, 2005, theputative class actions were consolidated under the caption *In re Silicon Storage Technology, Inc., SecuritiesLitigation,* Case No. C 05 00295 PJH (N.D. Cal.). On May 3, 2005, theHonorable Phyllis J. Hamilton appointed the “Louisiana Funds Group,” consistingof the Louisiana School Employees’ Retirement System and the Louisiana DistrictAttorneys’ Retirement System, to serve as lead plaintiff and the law firms ofPomeranz Haudek Block Grossman & Gross LLP and Berman DeValerio PeaseTabacco Burt & Pucillo to serve as lead counsel and liason counsel,respectively, for the class. The lead plaintiff filed a Consolidated AmendedClass Action Complaint on July 15, 2005. The complaint seeks unspecifieddamages on alleged violations of federal securities laws during the period fromApril 21, 2004 to December 20, 2004. We moved to dismiss the complaint onSeptember 16, 2005. Plaintiff served an opposition to the motion to dismiss onNovember 4, 2005. Our reply in further support of the motion to dismiss wasfiled on December 19, 2005. On January 18, 2006, the Court heard arguments onthe motion to dismiss. On March 10, 2006, the Court granted our motion todismiss the consolidated amended complaint, with leave to file an amendedcomplaint. Plaintiffs filed a second amended complaint on May 1, 2006. Weintend to take all appropriate action in response to these lawsuits. The impactrelated to the outcome of these matters is undeterminable at this time.

 

In January and February2005, following the filing of the putative class actions, multiple shareholderderivative complaints were filed in California Superior Court for the County ofSanta Clara, purportedly on behalf of SST against certain of our directors andofficers. The factual allegations of these complaints are substantiallyidentical to those contained in the putative shareholder class actions filed infederal court. The derivative complaints assert claims for, among other things,breach of fiduciary duty and violations of the California Corporations Code. Thesederivative actions have been consolidated under the caption *In Re Silicon Storage Technology, Inc. Derivative Litigation*,Lead Case No. 1:05CV034387 (Cal. Super. Ct., Santa Clara Co.). On April 28,2005, the derivative action was stayed by court order. We intend to take allappropriate action in response to these lawsuits. The impact related to theoutcome of these matters is undeterminable at this time.

 

From time to time, we arealso involved in other legal actions arising in the ordinary course of business.We have accrued certain costs associated with defending these matters. Therecan be no assurance that the shareholder class action complaints, theshareholder derivative complaints or other third party assertions will beresolved without costly litigation, in a manner that is not adverse to ourfinancial position, results of operations or cash flows or without requiringroyalty payments in the future which may adversely impact gross margins. Noestimate can be made of the possible loss or possible range of loss associatedwith the resolution of these contingencies. As a result, no losses have beenaccrued in our financial statements as of March 31, 2006.

 

29

----

 

**Item 1A. *Risk Factors***

 

**Risks Related to Our Business**

 

**Our operating results fluctuatematerially, and an unanticipated decline in revenues may disappoint securitiesanalysts or investors and result in a decline in our stock price.**

 

Although we wereprofitable for the first quarter of 2006, the last quarter of 2005 and the yearended December 31, 2004, we incurred net losses for the years ended December31, 2005 and 2003. Our operating results have fluctuated significantly and ourpast financial performance should not be used to predict future operatingresults. Our recent quarterly and annual operating results have fluctuated, andmay continue to fluctuate, due to the following factors, all of which aredifficult to forecast and many of which are out of our control:

 

•                  theavailability, timely delivery and cost of wafers or other manufacturing andassembly services from our suppliers;

•                  competitivepricing pressures and related changes in selling prices;

•                  fluctuationsin manufacturing yields and significant yield losses;

•                  newproduct announcements and introductions of competing products by us or ourcompetitors;

•                  productobsolescence;

•                  lowerof cost or market, obsolescence or other inventory adjustments;

•                  changesin demand for, or in the mix of, our products;

•                  thegain or loss of significant customers;

•                  marketacceptance of products utilizing our SuperFlash® technology;

•                  changesin the channels through which our products are distributed and the timelinessof receipt of distributor resale information;

•                  exchangerate fluctuations;

•                  generaleconomic, political and environmental-related conditions, such as naturaldisasters;

•                  changesin our allowance for doubtful accounts;

•                  valuationallowances on deferred tax assets based on changes in estimated future taxableincome;

•                  difficultiesin forecasting, planning and management of inventory levels;

•                  unanticipatedresearch and development expenses associated with new product introductions;and

•                  thetiming of significant orders and of license and royalty revenue.

 

As recent experienceconfirms, a downturn in the market for goods that incorporate our products canalso harm our operating results.

 

**Our operating expenses arerelatively fixed, and we order materials in advance of anticipated customer demand.Therefore, we have limited ability to reduce expenses quickly in response toany revenue shortfalls.**

 

Our operating expensesare relatively fixed, and we therefore have limited ability to reduce expensesquickly in response to any revenue shortfalls. Consequently, our operatingresults will be harmed if our revenues do not meet our projections. We mayexperience revenue shortfalls for the following reasons:

 

•                  suddendrops in consumer demand which may cause customers to cancel backlog, push outshipment schedules, or reduce new orders, possibly due to a slowing economy orinventory corrections among our customers;

•                  significantdeclines in selling prices that occur because of competitive price pressureduring an over-supply market environment;

•                  suddenshortages of raw materials for fabrication, test or assembly capacityconstraints that lead our suppliers to allocate available supplies or capacityto other customers which, in turn, harm our ability to meet our salesobligations; and

•                  thereduction, rescheduling or cancellation of customer orders.

 

In addition, political or economic events beyond our control can suddenlyresult in increased operating costs. In addition, we are now required to recordcompensation expense on stock option grants and purchases under our employeestock purchase plan which substantially increases our operating costs andimpacts our earnings (loss) per share.

** **

**We incurred significant inventoryvaluation and adverse purchase commitment adjustments in 2003, 2004 and 2005and we may incur additional significant inventory valuation adjustments in thefuture.**

 

30

----

 

We typically plan ourproduction and inventory levels based on internal forecasts of customer demand,which are highly unpredictable and can fluctuate materially. The value of ourinventory is dependent on our estimate of future average selling prices, and,if our projected average selling prices are over estimated, we may be requiredto adjust our inventory value to reflect the lower of cost or market. As ofMarch 31, 2006, we had $104.5 million of net inventory on hand, a decrease of$3.8 million, or 3.5%, from December 31, 2005. Total valuation adjustments toinventory and adverse purchase commitments were $37.3 million in 2005 and $1.7million in the first quarter of 2006. Due to the large number of units in ourinventory, even a small change in average selling prices could result in asignificant adjustment and could harm our financial results. Some of ourcustomers have requested that we ship them product that has a finished goodsdate of manufacture that is less than one year old. As of March 31, 2006, ourallowance for excess and obsolete inventories includes an allowance for our onhand finished goods inventory with a date of manufacture of greater than twoyears old and for certain products with a date of manufacture of greater thanone year old. In the event that this becomes a common requirement, it may benecessary for us to provide for an additional allowance for our on handfinished goods inventory with a date of manufacture of greater than one yearold, which could result in a significant adjustment and could harm ourfinancial results.

 

**Cancellations or rescheduling ofbacklog may result in lower future revenue and harm our business.**

 

Due to possible customerchanges in delivery schedules and cancellations of orders, our backlog at anyparticular date is not necessarily indicative of actual sales for anysucceeding period. A reduction of backlog during any particular period, or thefailure of our backlog to result in future revenue, could harm our business inthe future. We experienced a decrease in the average selling prices of ourproducts as a result of the industry-wide oversupply and excessive inventory inthe market in the second half of 2004 and the first half of 2005. Although we sawstrengthening of market demand in the second half of 2005, demand weakened forsome of our products in the first quarter of 2006. Our business could befurther harmed by industry-wide prolonged downturns in the future.

 

**Our business may suffer due torisks associated with international sales and operations.**

 

During 2004 , 2005 andthe first three months of 2006, our export product and licensing revenuesaccounted for 92.7%, 95.1% and 94.1% of our net revenues, respectively. Ourinternational business activities are subject to a number of risks, each ofwhich could impose unexpected costs on us that would harm our operatingresults. These risks include:

 

•                  difficultiesin complying with regulatory requirements and standards;

•                  tariffsand other trade barriers;

•                  costsand risks of localizing products for foreign countries;

•                  relianceon third parties to distribute our products;

•                  extendedaccounts receivable payment cycles;

•                  potentiallyadverse tax consequences;

•                  limitson repatriation of earnings; and

•                  burdensof complying with a wide variety of foreign laws.

 

In addition, we have made equity investments in companies with operationsin several Asian countries. The value of our investments is subject to theeconomic and political conditions particular to their industry, their countriesand to foreign exchange rates and to the global economy. If we determine that achange in the recorded value of an investment is other than temporary, we willadjust the value of the investment. Such an expense could have a negativeimpact on our operating results.

 

We derived 86.0%, 87.6%and 86.2% of our net product revenues from Asia during 2004, 2005 and the firstquarter of 2006, respectively. Additionally, substantially all of our wafersuppliers and packaging and testing subcontractors are located in Asia. Anykind of economic, political or environmental instability in this region of theworld can have a severe negative impact on our operating results due to thelarge concentration of our production and sales activities in this region. Ifcountries where we do business experience severe currency fluctuation andeconomic deflation, it can negatively impact our revenues and also negativelyimpact our ability to collect payments from customers. In this event, the lackof capital in the financial sectors of these countries may make it difficultfor our customers to open letters of credit or other financial instruments thatare guaranteed by foreign banks. Finally, the economic situation can exacerbatea decline in selling prices for our products as our competitors reduce productprices to generate needed cash.

 

31

----

 

It should also be notedthat we are greatly impacted by the political, economic and military conditionsin Taiwan. Taiwan and China are continuously engaged in political disputes andboth countries have continued to conduct military exercises in or near theother’s territorial waters and airspace. Such disputes may continue and evenescalate, resulting in an economic embargo, a disruption in shipping or evenmilitary hostilities. Any of these events can delay production or shipment ofour products. Any kind of activity of this nature or even rumors of suchactivity can harm our operations, revenues, operating results, and stock price.

 

**Terrorist attacks and threats,and government responses thereto, could harm our business.**

 

Terrorist attacks in theUnited States or abroad against American interests or citizens, U.S.retaliation for these attacks, threats of additional terrorist activity and thewar in Iraq have caused our customer base to become more cautious. Anyescalation in these events or similar future events may disrupt our operationsor those of our customers, distributors and suppliers, affect the availabilityof materials needed to manufacture our products, or affect the means totransport those materials to manufacturing facilities and finished products tocustomers. In addition, these events have had and may continue to have anadverse impact on the U.S. and world economy in general and consumer spendingin particular, which could harm our business.

 

**We do not typically enter intolong-term contracts with our customers, and the loss of a major customer couldharm our business.**

 

We do not typically enterinto long-term contracts with our customers. In addition, we cannot be certainas to future order levels from our customers. In the past, when we have enteredinto a long-term contract, the contract has generally been terminable at theconvenience of the customer.

 

**We depend on stockingrepresentatives and distributors to generate a majority of our revenues.**

 

We rely on stockingrepresentatives and distributors to establish and maintain customerrelationships and to sell our products. These stocking representatives anddistributors could discontinue their relationship with us or discontinueselling our products at any time. The majority of our stocking representativesare located in Asia. The loss of our relationship with any stockingrepresentative or distributor could harm our operating results by impairing ourability to sell our products to our end customers.

 

**We depend on Silicon ProfessionalTechnology Ltd., or SPT, our logistics center, to support many of our customersin Asia.**

 

We out-source our endcustomer service logistics in Asia to SPT, which supports our customers inTaiwan, China and other Southeast Asia countries. SPT provides forecasting,planning, warehousing, delivery, billing, collection and other logisticfunctions for us in these regions. SPT is a wholly owned subsidiary ofProfessional Computer Technology, or PCT, which is one of our stockingrepresentatives in Taiwan. During 2004, 2005 and the first three months of2006, SPT serviced end customer shipments accounted for 52.9%, 58.5% and 60.9%of our net product revenues recognized, respectively. As of December 31, 2004,2005, and March 31, 2006, SPT accounted for 55.1%, 69.6%, and 53.6%respectively, of our net accounts receivable. For further description of ourrelationships with PCT and SPT, please refer to “Item 7. Management’sDiscussion and Analysis of Financial Condition and Results of Operation -Related Party Transactions” in our Annual Report on Form 10-K for the yearended December 31, 2005.

 

We do not have anylong-term contracts with SPT, PCT or Silicon Professional Alliance Corporation,or SPAC, another subsidiary of PCT. SPT, PCT or SPAC may cease providingservices to us at any time. If SPT, PCT or SPAC were to terminate theirrelationship with us we would experience a delay in reestablishing warehousing,logistics and distribution functions, and it could impair our ability tocollect accounts receivable from SPT and may harm our business.

 

**We depend on a limited number offoreign foundries to manufacture our products, and these foundries may not beable to satisfy our manufacturing requirements, which could cause our revenuesto decline.**

 

We outsourcesubstantially all of our manufacturing and testing activities. We currently buyall of our wafers and sorted die from a limited number of suppliers. Themajority of our products are manufactured by five foundries, TSMC in Taiwan,Seiko-Epson and Yasu in Japan and Grace and Shanghai Hua Hong NEC ElectronicCompany Limited, or HHNEC, in China. We have invested $83.2 million in GSMC, aCayman Islands company, which owns a wafer foundry subsidiary, Grace, inShanghai, China. We anticipate that these foundries, together with Sanyo in

 

32

----

 

Japan, Samsung in Koreaand Vanguard and Powerchip Semiconductor Corporation, or PSC, in Taiwan willmanufacture substantially all of our products in 2006. If these suppliers failto satisfy our requirements on a timely basis at competitive prices we couldsuffer manufacturing delays, a possible loss of revenues or higher thananticipated costs of revenues, any of which could harm our operating results.

 

Our revenues may beimpacted by our ability to obtain adequate wafer supplies from our foundries. Thefoundries with which we currently have arrangements, together with anyadditional foundry at which capacity might be obtained, may not be willing orable to satisfy all of our manufacturing requirements on a timely basis atfavorable prices. In addition, we have encountered delays in qualifying newproducts and in ramping-up new product production and we could experience thesedelays in the future. During the first quarter of 2006, we experiencedfabrication issues with one of our wafer foundries and capacity constraints forcertain package types at one of our backend suppliers. We are also subject tothe risks of service disruptions, raw material shortages and price****increases by our foundries. Such disruptions, shortages andprice increases could harm our operating results.

 

**Manufacturing capacity has in thepast been difficult to secure and if capacity constraints arise in the futureour revenues may decline.**

 

In order to grow, we needto increase our present manufacturing capacity. We currently believe that theexisting capacity plus additional future capacity from Grace, HHNEC andVanguard available to us will be sufficient through 2006. However, events thatwe have not foreseen could arise which would limit our capacity. Similar to our$83.2 million investment in GSMC, we may determine that it is necessary toinvest substantial capital in order to secure appropriate production capacitycommitments. If we cannot secure additional manufacturing capacity onacceptable terms, our ability to grow will be impaired and our operatingresults will be harmed.

 

**Our cost of revenues may increaseif we are required to purchase manufacturing capacity in the****future.**

 

To obtain additionalmanufacturing capacity, we may be required to make deposits, equipment purchases,loans, joint ventures, equity investments or technology licenses in or withwafer fabrication companies. These transactions could involve a commitment ofsubstantial amounts of our capital and technology licenses in return forproduction capacity. We may be required to seek additional debt or equityfinancing if we need substantial capital in order to secure this capacity andwe cannot assure you that we will be able to obtain such financing.

 

**If our foundries fail to achieveacceptable wafer manufacturing yields, we will experience higher costs ofrevenues and reduced product availability.**

 

The fabrication of ourproducts requires wafers to be produced in a highly controlled and ultra-cleanenvironment. Semiconductor companies that supply our wafers have, from time totime, experienced problems achieving acceptable wafer manufacturing yields. Semiconductormanufacturing yields are a function of both our design technology and thefoundry’s manufacturing process technology. Low yields may result from marginaldesign or manufacturing process drift. Yield problems may not be identifieduntil the wafers are well into the production process, which often makes themdifficult, time consuming and costly to correct. Furthermore, we rely onindependent foundries for our wafers which increases the effort and timerequired to identify, communicate and resolve manufacturing yield problems. Ifour foundries fail to achieve acceptable manufacturing yields, we willexperience higher costs of revenues and reduced product availability, whichcould harm our operating results.

 

**If our foundries discontinue themanufacturing processes needed to meet our demands, or fail**toupgrade the technologies needed to manufacture our products, we may faceproduction delays and lower revenues.**

 

Our wafer and productrequirements typically represent a small portion of the total production of thefoundries that manufacture our products. As a result, we are subject to therisk that a foundry will cease production on an older or lower-volumemanufacturing process that it uses to produce our parts. Additionally, wecannot be certain our foundries will continue to devote resources to advancethe process technologies on which the manufacturing of our products is based. Eitherone of these events could increase our costs and harm our ability to deliverour products on time.

 

**Our dependence on third-partysubcontractors to assemble and test our products subjects us to a number ofrisks, including an inadequate supply of products and higher costs ofmaterials.**

 

33

----

 

We depend on independentsubcontractors to assemble and test our products. Our reliance on thesesubcontractors involves the following significant risks:

 

•                  reducedcontrol over delivery schedules and quality;

•                  thepotential lack of adequate capacity during periods of strong demand;

•                  difficultiesselecting and integrating new subcontractors;

•                  limitedwarranties on products supplied to us;

•                  potentialincreases in prices due to capacity shortages and other factors; and

•                  potentialmisappropriation of our intellectual property.

 

These risks may lead toincreased costs, delayed product delivery or loss of competitive advantage,which would harm our profitability and customer relationships.

 

**Because our flash memory productstypically have lengthy sales cycles, we may experience substantial delaysbetween incurring expenses related to research and development and thegeneration of revenues.**

 

Due to the flash memoryproduct cycle we usually require more than nine months to realize volumeshipments after we first contact a customer. We first work with customers toachieve a design win*,*which maytake three months or longer. Our customers then complete the design, testingand evaluation process and begin to ramp up production, a period whichtypically lasts an additional six months or longer. As a result, a significantperiod of time may elapse between our research and development efforts and ourrealization of revenue, if any, from volume purchasing of our products by ourcustomers.

 

**We face intense competition fromcompanies with significantly greater financial, technical and marketingresources that could harm sales of our products.**

 

We compete with majordomestic and international semiconductor companies, many of which havesubstantially greater financial, technical, marketing, distribution, and otherresources than we do. Many of our competitors have their own facilities for theproduction of semiconductor memory components and have recently addedsignificant capacity for such production. As noted under the section entitledCompetition in our Annual Report on Form 10-K for the year ended December 31,2005, our low density memory products, medium density memory products, and highdensity memory products (if we are successful in developing these products)face substantial competition. In addition, we may in the future experiencedirect competition from our foundry partners. We have licensed to our foundrypartners the right to fabricate products based on our technology and circuitdesign, and to sell such products worldwide, subject to our receipt of royaltypayments. Competition may also come from alternative technologies such asferroelectric random access memory devices, or FRAM, or other developingtechnologies.

 

**Our markets are subject to rapidtechnological change and, therefore, our success depends on our ability todevelop and introduce new products.**

 

The markets for ourproducts are characterized by:

 

•                  rapidlychanging technologies;

•                  evolvingand competing industry standards;

•                  changingcustomer needs;

•                  frequentnew product introductions and enhancements;

•                  increasedintegration with other functions; and

•                  rapidproduct obsolescence.

 

To develop new productsfor our target markets, we must develop, gain access to and use leadingtechnologies in a cost-effective and timely manner and continue to expand ourtechnical and design expertise. In addition, we must have our products designedinto our customers’ future products and maintain close working relationshipswith key customers in order to develop new products that meet their changingneeds. In addition, products for communications applications are based oncontinually evolving industry standards. Our ability to compete will depend onour ability to identify and ensure compliance with these industry standards. Asa result, we could be required to invest significant time and effort and incursignificant expense to redesign our products and ensure compliance withrelevant standards. We believe that products for these applications willencounter intense competition and be highly price sensitive. While we arecurrently developing and introducing new products for these applications, wecannot assure you that these products will reach the market on time, willsatisfactorily address customer needs, will be sold in high volume, or will besold at profitable margins.

 

34

----

 

We cannot assure you thatwe will be able to identify new product opportunities successfully, develop andbring to market new products, achieve design wins or respond effectively to newtechnological changes or product announcements by our competitors. In addition,we may not be successful in developing or using new technologies or in developingnew products or product enhancements that achieve market acceptance. Ourpursuit of necessary technological advances may require substantial time andexpense. Failure in any of these areas could harm our operating results.

 

**Our future success depends inpart on the continued service of our key design engineering, sales, marketingand executive personnel and our ability to identify, recruit and retainadditional personnel.**

 

We are highly dependenton Bing Yeh, our President and Chief Executive Officer, as well as the otherprincipal members of our management team and engineering staff. There isintense competition for qualified personnel in the semiconductor industry, inparticular the highly skilled design, applications and test engineers involvedin the development of flash memory technology. Competition is especiallyintense in Silicon Valley, where our corporate headquarters is located. We maynot be able to continue to attract and retain engineers or other qualifiedpersonnel necessary for the development of our business or to replace engineersor other qualified personnel who may leave our employ in the future. Ouranticipated growth is expected to place increased demands on our resources andwill likely require the addition of new management and engineering personneland the development of additional expertise by existing management personnel. Thefailure to recruit and retain key design engineers or other technical andmanagement personnel could harm our business.

 

**Our ability to competesuccessfully depends, in part, on our ability to protect our intellectualproperty rights.**

 

We rely on a combinationof patent, trade secrets, copyrights, mask work rights, nondisclosureagreements and other contractual provisions and technical measures to protectour intellectual property rights. Policing unauthorized use of our products,however, is difficult, especially in foreign countries. Litigation may continueto be necessary in the future to enforce our intellectual property rights, toprotect our trade secrets, to determine the validity and scope of theproprietary rights of others, or to defend against claims of infringement orinvalidity. Litigation could result in substantial costs and diversion ofresources and could harm our business, operating results and financialcondition regardless of the outcome of the litigation. We hold 178 patents inthe United States relating to certain aspects of our products and processes,with expiration dates ranging from 2010 to 2025 and have filed for severalmore. In addition, we hold several patents in Europe, Japan, Korea, Taiwan, andChina. We cannot assure you that any pending patent application will be granted.Our operating results could be harmed by the failure to protect ourintellectual property.

 

**We are engaged in securitiesclass action suits and derivative suits, which may become time consuming,costly and divert management resources and could impact our stock price.**

 

Securities class actionlaw suits are often brought against companies, particularly technology companies,following periods of volatility in the market price of their securities. Irrespectiveof the validity or the successful assertion of such claims, we could incursignificant costs and management resources in defending against such claims.  In January and February 2005, multipleputative shareholder class action complaints were filed against SST and certaindirectors and officers, in the United States District Court for the NorthernDistrict of California, following our announcement of anticipated financialresults for the fourth quarter of 2004. On March 24, 2005, the putative classactions were consolidated under the caption *Inre Silicon Storage Technology, Inc., Securities Litigation,* Case No.C 05 00295 PJH (N.D. Cal.). On May 3, 2005, the Honorable Phyllis J. Hamiltonappointed the “Louisiana Funds Group,” consisting of the Louisiana SchoolEmployees’ Retirement System and the Louisiana District Attorneys’ RetirementSystem, to serve as lead plaintiff and the law firms of Pomeranz Haudek Block Grossman& Gross LLP and Berman DeValerio Pease Tabacco Burt & Pucillo to serveas lead counsel and liason counsel, respectively, for the class. The leadplaintiff filed a Consolidated Amended Class Action Complaint on July 15, 2005.The complaint seeks unspecified damages on alleged violations of federalsecurities laws during the period from April 21, 2004 to December 20, 2004. Wemoved to dismiss the complaint on September 16, 2005. Plaintiff served anopposition to the motion to dismiss on November 4, 2005. Our reply in furthersupport of the motion to dismiss was filed on December 19, 2005. On January 18,2006, the Court heard arguments on the motion to dismiss. On March 10,2006, the Court granted our motion to dismiss the consolidated amendedcomplaint, with leave to file an amended complaint. Plaintiffs filed a secondamended complaint on May 1, 2006. We intend to take all appropriate action inresponse to these lawsuits. The impact related to the outcome of these mattersis undeterminable at this time.

 

35

----

 

In January and February2005, following the filing of the putative class actions, multiple shareholderderivative complaints were filed in California Superior Court for the County ofSanta Clara, purportedly on behalf of SST against certain of our directors andofficers. The factual allegations of these complaints are substantiallyidentical to those contained in the putative shareholder class actions filed infederal court. The derivative complaints assert claims for, among other things,breach of fiduciary duty and violations of the California Corporations Code. Thesederivative actions have been consolidated under the caption *In Re Silicon Storage Technology, Inc. Derivative Litigation*,Lead Case No. 1:05CV034387 (Cal. Super. Ct., Santa Clara Co.). On April 28,2005, the derivative action was stayed by court order. We intend to take allappropriate action in response to these lawsuits.

 

*Public announcements may hurt ourstock price.*During the course of these lawsuits there may bepublic announcements of the results of hearings, motions, and other interimproceedings or developments in the litigation. If securities analysts orinvestors perceive these results to be negative, it could harm the market priceof our stock.

 

*Our litigation may be expensive,may be protracted and confidential information may be compromised.*Wehave incurred certain costs associated with defending these matters, and at anytime, additional claims may be filed against us, which could increase the risk,expense and duration of the litigation. Further, because of the amount ofdiscovery required in connection with this type of litigation, there is a riskthat some of our confidential information could be compromised by disclosure. Formore information with respect to our litigation, please also see “Part II, Item1- Legal Proceedings.”

 

**If we are accused of infringingthe intellectual property rights of other parties we may become subject to timeconsuming and costly litigation. If we lose, we could suffer a significantimpact on our business and be forced to pay damages.**

 

Third parties may assertthat our products infringe their proprietary rights, or may assert claims forindemnification resulting from infringement claims against us. Any such claimsmay cause us to delay or cancel shipment of our products or pay damages thatcould harm our business, financial condition and results of operations. Inaddition, irrespective of the validity or the successful assertion of suchclaims, we could incur significant costs in defending against such claims.

 

In the past, we were suedby Atmel Corporation and Intel Corporation, among others, regarding patentinfringement. Significant management time and financial resources were devotedto defending these lawsuits. We settled with Intel in May 1999 and with Atmelin June 2005.

 

In addition to the Atmeland Intel actions, we receive from time to time, letters or communications fromother companies stating that such companies have patent rights that involve ourproducts. Since the design of most of our products is based on SuperFlashtechnology, any legal finding that the use of our SuperFlash technologyinfringes the patent of another company would have a significantly negativeeffect on our entire product line and operating results. Furthermore, if such afinding were made, there can be no assurance that we could license the othercompany’s technology on commercially reasonable terms or that we couldsuccessfully operate without such technology. Moreover, if we are found toinfringe, we could be required to pay damages to the owner of the protectedtechnology and could be prohibited from making, using, selling, or importinginto the United States any products that infringe the protected technology. Inaddition, the management attention consumed by and legal cost associated withany litigation could harm our operating results. During the course of theselawsuits there may be public announcements of the results of hearings, motions,and other interim proceedings or developments in the litigation. If securitiesanalysts or investors perceive these results to be negative, it could harm themarket price of our stock.

 

**If an earthquake or other naturaldisaster strikes our manufacturing facility or those of our suppliers, we wouldbe unable to manufacture our products for a substantial amount of time and wewould experience lost revenues.**

 

Our corporate headquarters are located in Californianear major earthquake faults. In addition, some of our suppliers are locatednear fault lines. In the event of a major earthquake or other natural disasternear our headquarters, our operations could be harmed. Similarly, a majorearthquake or other natural disaster such as typhoon near one or more of ourmajor suppliers, like the earthquakes in September 1999 and March 2002 or thetyphoons in September 2001 and July 2005 that occurred in Taiwan, couldpotentially disrupt the operations of those suppliers, which could then limitthe supply of our products and harm our business.

 

36

----

 

**A virus or viral outbreak in Asiacould harm our business.**

 

We derive substantially all of our revenues from Asiaand our logistics center is located in Taiwan. A virus or viral outbreak inAsia, such as the SARS outbreak in early 2003 or the current threat of theAvian flu, could harm the operations of our suppliers, distributors, logisticscenter and those of our end customers, which could harm our business.

 

**Prolonged electrical poweroutages, energy shortages, or increased costs of energy could harm ourbusiness.**

 

Our design and processresearch and development facilities and our corporate offices are located inCalifornia, which is susceptible to power outages and shortages as well asincreased energy costs. To limit this exposure, all corporate computer systemsat our main California facilities are on battery back-up. ****In addition, all of our engineering and back-upservers and selected corporate servers are on generator back-up****.While the majority of our production facilities are not located in California,more extensive power shortages in the state could delay our design and processresearch and development as well as increase our operating costs.

 

**Our growth has in the past placeda significant strain on our management systems and resources and if we fail tomanage our growth, our ability to market or sell our products or develop newproducts may be harmed.**

 

Our business has in thepast experienced rapid growth which strained our internal systems and futuregrowth will require us to continuously develop sophisticated informationmanagement systems in order to manage our business effectively. We haveimplemented a supply-chain management system and a vendor electronic datainterface system. There is no guarantee that these measures, in themselves,will be adequate to address any growth, or that we will be able to foresee in atimely manner other infrastructure needs before they arise. Our success dependson the ability of our executive officers to effectively manage our growth. Ifwe are unable to manage our growth effectively, our results of operations willbe harmed. If we fail to successfully implement new management informationsystems, our business may suffer severe inefficiencies that may harm theresults of our operations.

 

**Future changes in financial accounting standardsor practices or existing taxation rules or practices may cause adverseunexpected revenue fluctuations and affect our reported results of operations.**

 

A change inaccounting standards or practices or a change in existing taxation rules orpractices can have a significant effect on our reported results and may evenaffect reporting of transactions completed before the change is effective. Newaccounting pronouncements and taxation rules and varying interpretations ofaccounting pronouncements and taxation practice have occurred and may occur inthe future. Changes to existing rules or the questioning of current practicesmay adversely affect our reported financial results or the way we conduct ourbusiness. For example, we adopted SFAS No. 123(R) in the first quarter of 2006which requires us to record charges to earnings for the stock options we grantand purchases of our common stock under our employee stock purchase plan.

 

**Evolving regulation of corporategovernance and public disclosure may result in additional expenses andcontinuing uncertainty.**

 

Changing laws,regulations and standards relating to corporate governance and publicdisclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations andNASDAQ National Market rules are creating uncertainty for public companies. Wecontinually evaluate and monitor developments with respect to new and proposedrules and cannot predict or estimate the amount of the additional costs we mayincur or the timing of such costs. These new or changed laws, regulations andstandards are subject to varying interpretations, in many cases due to theirlack of specificity, and as a result, their application in practice may evolveover time as new guidance is provided by regulatory and governing bodies. Thiscould result in continuing uncertainty regarding compliance matters and highercosts necessitated by ongoing revisions to disclosure and governance practices.We are committed to maintaining high standards of corporate governance andpublic disclosure. As a result, we have invested resources to comply withevolving laws, regulations and standards, and this investment has resulted inincreased general and administrative expenses and a diversion of managementtime and attention from revenue-generating activities to compliance activities.If our efforts to comply with new or changed laws, regulations and standardsdiffer from the activities intended by regulatory or governing bodies due toambiguities related to practice, regulatory authorities may initiate legalproceedings against us and we may be harmed.

 

37

----

 

**We, and our independentregistered public accounting firm, determined that we had a material weaknessin our internal controls over financial reporting in 2004. In the future, suchevents could cause our current and potential stockholders to lose confidence inour financial reporting, which would harm our business and the trading price ofour stock.**

 

Under Section 404 of theSarbanes-Oxley Act of 2002, we are required to evaluate and determine theeffectiveness of our internal controls over financial reporting. We dedicated asignificant amount of time and resources to ensure compliance with this legislationsince its inception and will continue to do so for future fiscal periods. Wemay encounter problems or delays in completing the review and evaluation, theimplementation of improvements and the receipt of a positive attestation, orany attestation at all, by our independent regional accounting firm.Additionally, management’s assessment of our internal controls over financialreporting may identify deficiencies that need to be addressed in our internalcontrols over financial reporting or other matters that may raise concerns forinvestors.

 

As of December 31, 2004,we did not maintain effective control over accounting for and review of thevaluation of inventory, the income tax provision and related balance sheetaccounts and licensing revenue because we lacked a sufficient complement ofpersonnel with a level of accounting expertise that is commensurate with ourfinancial reporting requirements. Because of this material weakness, ourmanagement concluded that, as of December 31, 2004, we did not maintaineffective internal control over financial reporting based on those criteria. Asa result, PricewaterhouseCoopers LLP, issued an adverse opinion with respect toour internal controls over financial reporting and their report is included inour Form 10-K for the year ended December 31, 2004. As of December 31, 2005,these material weaknesses had been remediated. For further information, seeItem 9A – “Controls and Procedures” of our Annual Report on Form 10-K for theyear ended December 31, 2005.

 

Should we, or ourindependent registered public accounting firm, determine in future fiscalperiods that we have additional material weaknesses in our internal controlsover financial reporting, the reliability of our financial reports may beimpacted, and our results of operations or financial condition may be harmedand the price of our common stock may decline.

 

**Acquisitions could result inoperating difficulties, dilution and other harmful consequences.**

 

Over the past two yearswe have acquired Emosyn, LLC a fabless semiconductor manufacturer specializingin the design and marketing of smart card ICs for subscriber identificationmodule card applications, G-Plus, Inc., a semiconductor manufacturerspecializing in the design and marketing of radio frequency ICs and monolithicmicrowave ICs and Actrans Systems Inc., a fabless semiconductor company thatdesigns flash memory and EEPROMs. We expect to continue to evaluate andconsider a wide array of potential strategic transactions, including businesscombinations, acquisitions and dispositions of businesses, technologies,services, products and other assets, including interests in our existingsubsidiaries and joint ventures. At any given time we may be engaged indiscussions or negotiations with respect to one or more of such transactions.Any of such transactions could be material to our financial condition andresults of operations. There is no assurance that any such discussions ornegotiations will result in the consummation of any transaction. The process ofintegrating any acquired business may create unforeseen operating difficultiesand expenditures and is itself risky. The areas where we may face difficultiesinclude:

 

•                        diversionof management time, as well as a shift of focus from operating the businessesto issues of integration and future products;

 

•                        decliningemployee morale and retention issues resulting from changes in compensation,reporting relationships, future prospects, or the direction of the business;

 

•                        theneed to integrate each company’s accounting, management information, humanresource and other administrative systems to permit effective management, andthe lack of control if such integration is delayed or not implemented;

 

•                        theneed to implement controls, procedures and policies appropriate for a publiccompany at companies that prior to acquisition had lacked such controls,procedures and policies; and in some cases, the need to transition operationsonto our platforms and

 

•                        insome cases, the need to transition operations onto our technology platforms.

 

38

----

 

Internationalacquisitions involve additional risks, including those related to integrationof operations across different cultures and languages, currency risks, and theparticular economic, political, and regulatory risks associated with specificcountries. Moreover, we may not realize the anticipated benefits of any or allof our acquisitions. As a result of future acquisitions or mergers, we mightneed to issue additional equity securities, spend our cash, or incur debt,contingent liabilities, or amortization expenses related to intangible assets,any of which could reduce our profitability and harm our business.

 

**Risks Related to Our Industry**

 

**Our success is dependent on thegrowth and strength of the flash memory market.**

 

Substantially all of ourproducts, as well as all new products currently under design, are stand-aloneflash memory devices or devices embedded with flash memory. A memory technologyother than SuperFlash may be adopted as an industry standard. Our competitorsare generally in a better financial and marketing position than we are fromwhich to influence industry acceptance of a particular memory technology. Inparticular, a primary source of competition may come from alternativetechnologies such as FRAM devices if such technology is commercialized forhigher density applications. To the extent our competitors are able to promotea technology other than SuperFlash as an industry standard, our business willbe seriously harmed.

 

**The selling prices for ourproducts are extremely volatile and have historically declined during periodsof over capacity or industry downturns.**

 

The semiconductorindustry has historically been cyclical, characterized by periodic changes inbusiness conditions caused by product supply and demand imbalance. When theindustry experiences downturns, they often occur in connection with, or inanticipation of, maturing product cycles and declines in general economicconditions. These downturns are characterized by weak product demand, excessiveinventory and accelerated decline of selling prices. We experienced a decreasein the average selling prices of our products as a result of the industry-wideoversupply and excessive inventory in the market in the second half of 2004 andthe first half of 2005. Although we saw strengthening of market demand in thesecond half of 2005 demand for some of our products weakened in the firstquarter of 2006 although pricing remained stable. Our business could be furtherharmed by industry-wide prolonged downturns in the future.

 

**There is seasonality in ourbusiness and if we fail to continue to introduce new products this seasonalitymay become more pronounced.**

 

Sales of our products inthe consumer electronics applications market are subject to seasonality. As aresult, sales of these products are impacted by seasonal purchasing patternswith higher sales generally occurring in the second half of each year. In thepast we have been able to mitigate such seasonality with the introduction ofnew products throughout the year. If we fail to continue to introduce newproducts, our business may suffer and the seasonality of a portion of our salesmay become more pronounced.

 

39

----

 

**Item 5. Other Events.**

 

*Employee ProfitSharing Plan Amendment*

 

In January 2006, theCompensation Committee of our Board of Directors amended our Employee Profit SharingPlan to change the amount of the profit sharing pool on operating profits,excluding stock-based compensation charges, in excess of 5% of revenues, cappedat a 10% allocation pool for operating profits of 10% or more of revenues. Therewill be no profit sharing pool if pre-tax profits or operating profits are lessthan 5% of revenues. Prior to this amendment, our plan required operatingprofits in excess of 10% of revenues before a profit sharing pool was created. TheEmployee Profit Sharing Pan, as amended is attached to the Quarterly Report onForm 10-Q as exhibit 10.4. For more information, please see the sectionentitled Profit Sharing and Cash Bonuses in our definitive proxy statement forour 2006 Annual Meeting of Shareholders filed with the Securities and ExchangeCommission.

 

*CompensationCommittee Approval of Executive Bonus Targets*

 

In January 2006, theCompensation Committee of our Board of Directors approved a performance basedincentive plan for our president and chief executive officer, Bing Yeh,targeted at 50% of his base pay with the potential to achieve 100% of base pay,and dependant upon achieving certain performance objectives to be establishedby the Compensation Committee. The Compensation Committee is in the process offinalizing the criteria pursuant to the performance based incentive plan which willbe based on our achievement of financial and operating metrics as well asindividual objectives. For more information, please see the section entitledCompensation of the Chief Executive officer in our definitive proxy statementfor our 2006 Annual Meeting of Shareholders filed with the Securities andExchange Commission.

 

40

----

 

**Item 6. Exhibits.**

 

(a)           *Exhibits.*

 

Weincorporate by reference all exhibits filed in connection with our AnnualReport on Form 10-K for the year ended December 31, 2005.

 
| 10.4   | Employee Profit Sharing  Plan.                                                                                                                                                                                                                    |
|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                              |
| 31.1   | Certification of  President and Chief Executive Officer required by Rule 13a- 14(a) of the  Securities Exchange Act of 1934, as amended.                                                                                                          |
|   |                                                                                                                                                                                                                                              |
| 31.2   | Certification of Vice  President Finance and Chief Financial Officer required by Rule 13a- 14(a) of  the Securities Exchange Act of 1934, as amended.                                                                                             |
|   |                                                                                                                                                                                                                                              |
| 32.1   | Certification of  President and Chief Executive Officer, as required by Rule 13a-14(b) of the  Securities Exchange Act of 1934, as amended, and Section 1350 of Chapter 63  of Title 18 of the United States Code (18 U.S.C. 1350).*              |
|   |                                                                                                                                                                                                                                              |
| 32.2   | Certification of Vice  President Finance and Chief Financial Officer, as required by Rule 13a-14(b)  of the Securities Exchange Act of 1934, as amended, and Section 1350 of  Chapter 63 of Title 18 of the United States Code (18 U.S.C. 1350).* |

 

----

* The certifications attached as Exhibit 32.1 andExhibit 32.2 accompany the Quarterly Report on Form 10-Q, are not deemed filedwith the Securities and Exchange Commission and are not to be incorporated byreference into any filing of Silicon Storage Technology, Inc. under theSecurities Act of 1933, as amended, or the Securities Exchange Act of 1934, asamended (whether made before or after the date of the Form 10-Q), irrespectiveof any general incorporation language contained in such filing.

 

41

----

 

**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hascaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized, in the City of Sunnyvale, County of Santa Clara, State ofCalifornia, on the 10th day of May, 2006.

 
|   | SILICON STORAGE TECHNOLOGY, INC. |
|--------|----------------------------------|
|   |                             |
|   |                             |
|   |                             | By: |
|   |                             |   |
|   |                             | /s/ BING YEH |   |
|   |                             | Bing Yeh |
|   |                             | Chairman, President and Chief Executive Officer |
|   |                             | (*Principal Executive Officer*) |
|   |                             |   |
|   |                             |   |
|   |                             | /s/ ARTHUR O. WHIPPLE |   |
|   |                             | Arthur O. Whipple |
|   |                             | Vice President, Finance and Chief Financial Officer |
|   |                             | (*Principal Financial and  Accounting Officer*) |

 

42

----