**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

----

**FORM 10-Q**
| **(Mark One)**                                                                                      |   |   |
|-----------------------------------------------------------------------------------------------------|--------|--------|
| **x****QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934.**  |
| ** **                                                                                          |
| **For the quarterly period ended June 30, 2006**                                                    |   |   |
| ** **                                                                                          |   |   |
| **OR**                                                                                              |   |   |
| ** **                                                                                          |   |   |
| **o****TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934.** |

 

**For thetransition period from             to             .**

 

**CommissionFile Number 0-26944**

****

**SILICONSTORAGE TECHNOLOGY, INC.**

(Exact name of Registrant asSpecified 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 mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.  Yes x  No o

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):

LargeAccelerated filer o                                   Acceleratedfiler x                                             Non-acceleratedfiler o

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act). Yes o No x

Number of shares outstanding of our Common Stock, no parvalue, as of the latest practicable date, July 31, 2006:   103,198,374.

 

----

 

**SILICON STORAGE TECHNOLOGY,INC.**

**FORM 10-Q: QUARTER ENDED JUNE30, 2006TABLE OF CONTENTS**
| **Part I - FINANCIAL  INFORMATION** |                                                                                         |   |   |   |
|-------------------------------------|----------------------------------------------------------------------------------------------|--------|--------|--------|
| ** **                          |                                                                                         |   |   |   |
| Item 1.                             | Condensed  Consolidated Financial Statements (Unaudited):                                    |   |   |
|                                | Condensed Consolidated  Statements of Operations                                             |   | 3      |
|                                | Condensed  Consolidated Balance Sheets                                                       |   | 4      |
|                                | Condensed  Consolidated Statements of Cash Flows                                             |   | 5      |
|                                | Notes  to Condensed Consolidated Financial Statements                                        |   | 6      |
|                                |                                                                                         |   |   |
| Item 2.                             | Management’s  Discussion and Analysis of Financial Condition and Results of Operations. |   | 20     |
|                                |                                                                                         |   |   |
| Item 3.                             | Quantitative  and Qualitative Disclosures About Market Risk                                  |   | 29     |
|                                |                                                                                         |   |   |
| Item 4.                             | Controls  and Procedures.                                                                    |   | 30     |
|                                |                                                                                         |   |   |   |
| **Part II  - OTHER INFORMATION**    |                                                                                         |   |   |   |
|                                |                                                                                         |   |   |   |
| Item 1.                             | Legal  Proceedings                                                                           |   | 31     |
|                                |                                                                                         |   |   |
| Item 1A.                            | Risk  Factors                                                                                |   | 32     |
|                                |                                                                                         |   |   |
| Item 4.                             | Submission  of Matters to a Vote of Security Holders                                         |   | 42     |
|                                |                                                                                         |   |   |
| Item 6.                             | Exhibits                                                                                     |   | 43     |
|                                |                                                                                         |   |   |   |
| Signatures                          |                                                                                         |   |   | 44     |
|                                     |                                                                                              |        |        |        |  |

 

2

----

 

**PART I - FINANCIAL INFORMATION**

**Item 1.   Condensed Consolidated Financial Statements(Unaudited)**

**SILICONSTORAGE TECHNOLOGY, INC. AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTSOF OPERATIONS**

**(Unaudited)(in thousands, except per share data)**
| ** **                                                                            | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                            | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                                                            | ** ** | **2005**                         | ** ** | **2006**                       | ** ** | **2005** | ** ** | **2006** | ** ** |
|                                                                                  |       |                             |       |                           |       |   |   |   |   |
| Net revenues:                                                                         |       |                             |       |                           |       |   |   |   |   |
| Product revenues  - unrelated parties                                                 |       | $                                | 36,872     |                           | $          | 40,775 |   | $ | 74,493 |   | $ | 78,807 |   |
| Product revenues  - related parties                                                   |       | 48,010                           |       | 58,163                         |       | 89,659 |   | 120,434 |   |
| Technology  licensing                                                                 |       | 8,388                            |       | 8,791                          |       | 15,331 |   | 17,641 |   |
| Technology  licensing - related parties                                               |       | 29                               |       | —                         |       | 131 |   | 1,378 |   |
| Total net  revenues                                                                   |       | 93,299                           |       | 107,729                        |       | 179,614 |   | 218,260 |   |
| Cost of revenues:                                                                     |       |                             |       |                           |       |   |   |   |   |
| Cost of revenues  - unrelated parties                                                 |       | 33,268                           |       | 29,259                         |       | 65,709 |   | 57,074 |   |
| Cost of revenues  - related parties                                                   |       | 48,769                           |       | 51,096                         |       | 90,050 |   | 99,899 |   |
| Total cost of  revenues                                                               |       | 82,037                           |       | 80,355                         |       | 155,759 |   | 156,973 |   |
| Gross profit                                                                          |       | 11,262                           |       | 27,374                         |       | 23,855 |   | 61,287 |   |
| Operating expenses:                                                                   |       |                             |       |                           |       |   |   |   |   |
| Research and  development                                                             |       | 13,086                           |       | 13,093                         |       | 25,051 |   | 28,260 |   |
| Sales and  marketing                                                                  |       | 7,006                            |       | 7,042                          |       | 14,346 |   | 15,203 |   |
| General and  administrative                                                           |       | 7,123                            |       | 5,769                          |       | 13,825 |   | 11,806 |   |
| Other operating  expenses                                                             |       | 2,911                            |       | —                         |       | 2,911 |   | — |   |
| Total operating  expenses                                                             |       | 30,126                           |       | 25,904                         |       | 56,133 |   | 55,269 |   |
| Income (loss) from  operations                                                        |       | (18,864                          | )          | 1,470                          |       | (32,278 | ) | 6,018 |   |
| Other income (expense),  net                                                          |       | 1,014                            |       | 1,056                          |       | 1,215 |   | 1,495 |   |
| Interest expense                                                                      |       | (37                              | )          | (57                            | )          | (58 | ) | (136 | ) |
| 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 |       | (17,887                          | )          | 2,469                          |       | (31,121 | ) | 16,060 |   |
| Provision for income  taxes                                                           |       | 1,693                            |       | 1,014                          |       | 2,440 |   | 3,315 |   |
| Minority interest                                                                     |       | 7                                |       | —                         |       | (77 | ) | — |   |
| Net income (loss)                                                                     |       | $                                | (19,587    | )                              | $          | 1,455 |   | $ | (33,484 | ) | $ | 12,745 |   |
| Net income (loss) per  share - basic                                                  |       | $                                | (0.19      | )                              | $          | 0.01 |   | $ | (0.33 | ) | $ | 0.12 |   |
| Shares used in per  share calculation - basic                                         |       | 102,201                          |       | 103,178                        |       | 100,010 |   | 103,159 |   |
| Net income (loss) per  share - diluted                                                |       | $                                | (0.19      | )                              | $          | 0.01 |   | $ | (0.33 | ) | $ | 0.12 |   |
| Shares used in per share calculation - diluted                                        |       | 102,201                          |       | 104,529                        |       | 100,010 |   | 104,634 |   |

 

The accompanying notes are anintegral part of these unaudited condensed consolidated financial statements.

3

----

 

**SILICONSTORAGE TECHNOLOGY, INC. AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(Unaudited)(in thousands)**
| ** **                                                                                                                                     | ** ** | **December 31,** | ** ** | **June 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-------------------|------------|
| ** **                                                                                                                                     | ** ** | **2005**              | ** ** | **2006**          | ** ** |
| **ASSETS**                                                                                                                                     | ** ** | ** **            | ** ** | ** **        | ** ** |
| ** **                                                                                                                                     | ** ** | ** **            | ** ** | ** **        | ** ** |
| Current assets:                                                                                                                                |       |                  |       |              |       |
| Cash and cash equivalents                                                                                                                      |       | $                     | 77,382     |              | $          | 87,798 |   |
| Short-term available-for-sale investments                                                                                                      |       | 1,008                 |       | 28,371            |       |
| Trade accounts receivable-unrelated parties, net of  allowance for doubtful accounts of $758 at December 31, 2005 and $1,082 at  June 30, 2006 |       | 21,378                |       | 21,356            |       |
| Trade accounts receivable-related parties                                                                                                      |       | 55,858                |       | 37,969            |       |
| Inventories                                                                                                                                    |       | 108,343               |       | 94,433            |       |
| Other current assets                                                                                                                           |       | 13,109                |       | 13,194            |       |
| Total current assets                                                                                                                           |       | 277,078               |       | 283,121           |       |
|                                                                                                                                           |       |                  |       |              |       |
| Property and  equipment, net                                                                                                                   |       | 19,415                |       | 17,675            |       |
| Long-term  available-for-sale investments                                                                                                      |       | 39,057                |       | 22,500            |       |
| Equity  investments, GSMC                                                                                                                      |       | 83,150                |       | 83,150            |       |
| Equity  investments, others                                                                                                                    |       | 12,962                |       | 12,636            |       |
| Goodwill                                                                                                                                       |       | 29,637                |       | 29,637            |       |
| Intangible  assets, net                                                                                                                        |       | 11,816                |       | 11,545            |       |
| Other assets                                                                                                                                   |       | 4,722                 |       | 7,098             |       |
| Total assets                                                                                                                                   |       | $                     | 477,837    |              | $          | 467,362 |   |
|                                                                                                                                           |       |                  |       |              |       |
| **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                |       | 32,340            |       |
| Trade accounts payable-related parties                                                                                                         |       | 21,867                |       | 21,791            |       |
| Accrued expenses and other liabilities                                                                                                         |       | 17,318                |       | 21,552            |       |
| Deferred revenue                                                                                                                               |       | 4,493                 |       | 4,090             |       |
| Total current liabilities                                                                                                                      |       | 95,377                |       | 82,991            |       |
|                                                                                                                                           |       |                  |       |              |       |
| Other  liabilities                                                                                                                             |       | 2,627                 |       | 1,880             |       |
| Total liabilities                                                                                                                              |       | 98,004                |       | 84,871            |       |
|                                                                                                                                           |       |                  |       |              |       |
| 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 103,193 shares at June 30, 2006                    |       | 377,027               |       | 382,203           |       |
| Accumulated  other comprehensive income                                                                                                        |       | 31,780                |       | 16,517            |       |
| Accumulated  deficit                                                                                                                           |       | (28,974               | )          | (16,229           | )          |
| Total shareholders’ equity                                                                                                                |       | 379,833               |       | 382,491           |       |
| Total  liabilities and shareholders’ equity                                                                                               |       | $                     | 477,837    |              | $          | 467,362 |   |

 

The accompanying notes are an integral part of these unaudited condensedconsolidated financial statements.

4

----

 

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

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)(in thousands)**
| ** **                                                                                                 | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                                                 | ** ** | **June 30,**              | ** ** |
| ** **                                                                                                 | ** ** | **2005**                       | ** ** | **2006** | ** ** |
| Cash flows from  operating activities:                                                                     |       |                           |       |   |   |
| Net income (loss)                                                                                          |       | $                              | (33,484    | ) | $ | 12,745 |   |
| Adjustments to reconcile net income (loss) to net  cash provided by (used in) operating activities:        |       |                           |       |   |   |
| Depreciation and amortization                                                                              |       | 4,671                          |       | 4,982 |   |
| Purchased in process research and development                                                              |       | 1,661                          |       | — |   |
| Stock-based compensation expense                                                                           |       | —                         |       | 3,802 |   |
| Provision (credits) for doubtful accounts receivable                                                       |       | 57                             |       | 323 |   |
| Provision for sales returns                                                                                |       | 1,689                          |       | 421 |   |
| Provision for excess and obsolete inventories,  write-down of inventories and adverse purchase commitments |       | 23,678                         |       | 8,446 |   |
| Loss in equity interest                                                                                    |       | 260                            |       | 28 |   |
| Impairment loss on equity investment                                                                       |       | —                         |       | 3,523 |   |
| Gain on sale of equity investments                                                                         |       | —                         |       | (12,206 | ) |
| (Gain) loss on disposal of equipment                                                                       |       | 30                             |       | (6 | ) |
| Minority interest                                                                                          |       | (77                            | )          | — |   |
| Changes in operating assets and liabilities:                                                               |       |                           |       |   |   |
| Trade accounts receivable-unrelated parties                                                                |       | 4,802                          |       | (739 | ) |
| Trade accounts receivable-related parties                                                                  |       | 4,138                          |       | 17,906 |   |
| Inventories                                                                                                |       | (33,245                        | )          | 5,017 |   |
| Other current and non-current assets                                                                       |       | 3,196                          |       | (2,681 | ) |
| Trade accounts payable-unrelated parties                                                                   |       | (17,445                        | )          | (15,880 | ) |
| Trade accounts payable-related parties                                                                     |       | (4,017                         | )          | (76 | ) |
| Accrued expenses and other liabilities                                                                     |       | (4,040                         | )          | 4,082 |   |
| Deferred revenue                                                                                           |       | 572                            |       | (403 | ) |
| Net cash provided by (used in) operating activities                                                        |       | (47,554                        | )          | 29,284 |   |
|                                                                                                       |       |                           |       |   |   |
| Cash flows from  investing activities:                                                                     |       |                           |       |   |   |
| Acquisitions, net of cash                                                                                  |       | (7,818                         | )          | — |   |
| Investments in equity securities                                                                           |       | (333                           | )          | (3,000 | ) |
| Purchase of property and equipment                                                                         |       | (2,617                         | )          | (2,359 | ) |
| Proceeds from sale of equipment                                                                            |       | —                         |       | 9 |   |
| Purchase of intellectual property license                                                                  |       | —                         |       | (317 | ) |
| Purchases of available-for-sale investments                                                                |       | (20,305                        | )          | (33,699 | ) |
| Sales and maturities of available-for-sale and  equity investments                                         |       | 85,687                         |       | 19,820 |   |
| Net cash provided by (used in) investing activities                                                        |       | 54,614                         |       | (19,546 | ) |
|                                                                                                       |       |                           |       |   |   |
| Cash flows from  financing activities:                                                                     |       |                           |       |   |   |
| Debt repayments                                                                                            |       | (214                           | )          | (94 | ) |
| Borrowing against line of credit                                                                           |       | 3,000                          |       | — |   |
| Issuance of shares of common stock                                                                         |       | 1,668                          |       | 1,374 |   |
| Capital lease payments                                                                                     |       | —                         |       | (602 | ) |
| Net cash provided by financing activities                                                                  |       | 4,454                          |       | 678 |   |
| Net increase in  cash and cash equivalents                                                                 |       | 11,514                         |       | 10,416 |   |
| Cash and cash  equivalents at beginning of period                                                          |       | 35,365                         |       | 77,382 |   |
| Cash and cash  equivalents at end of period                                                                |       | $                              | 46,879     |   | $ | 87,798 |   |

 

The accompanying notes are anintegral part of these unaudited condensed consolidated financial statements.

5

----

 

**SILICONSTORAGE TECHNOLOGY, INC. AND SUBSIDIARIES**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED):**

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

In the opinion of management, the accompanyingunaudited condensed interim consolidated financial statements contain alladjustments, all of which are normal and recurring in nature, necessary tofairly state our financial position, results of operations and cash flows.  The results of operations for the interimperiods presented are not necessarily indicative of the results that may beexpected for any future interim periods or for the full fiscal year.  These interim financial statements should beread in conjunction with the consolidated financial statements in our AnnualReport on Form 10-K for the year ended December 31, 2005.

The year-end balance sheet at December 31, 2005was derived from audited financial statements, but does not include alldisclosures required by U.S. generally accepted accounting principles.  Please refer to the audited financialstatements in our Annual Report 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 financialstatements and the reported amounts of revenues and expenses during thereporting period.  Actual results coulddiffer from those estimates. 

*StockBased Compensation*

Effective January 1, 2006, we adopted the fair value recognitionprovisions of Financial Accounting Standards Board, or FASB, Statement ofFinancial Accounting Standards, or SFAS No. 123(R), *“Share-Based Payments*,” using the modifiedprospective application method. Under this transition method, compensation costrecognized in the three and six months ended June 30, 2006, includes theapplicable amounts of: (a) compensation cost of all stock-based paymentsgranted prior to, but not yet vested as of January 1, 2006 (based on thegrant-date fair value estimated in accordance with the original provisions ofSFAS No. 123 and previously presented in the pro forma footnotedisclosures), and (b) compensation cost for all stock-based paymentsgranted subsequent to January 1, 2006 (based on the grant-date fair valueestimated 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). 

#### *RecentAccounting 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 new inventoryarrangements entered into, or modifications or renewals of existing inventoryarrangements occurring in interim or annual reporting periods beginning afterMarch 15, 2006. This pronouncement did not have a material effect on ourconsolidated financial statements.

In June 2006, the FASB issued FASB Interpretation No.48, or FIN 48, “*Accounting for Uncertainty in Income Taxes*”.  FIN 48 provides interpretive guidance forrecognition and measurement of tax positions taken or expected to be taken in atax return.  This interpretation iseffective for fiscal years beginning after December 15, 2006.  We are reviewing the impact of FIN 48, but donot expect the adoption of FIN 48 to have a material impact on our consolidatedfinancial statements.

6

----

 

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

We have computed andpresented net income (loss) per share under two methods, basic anddiluted.  Basic net income (loss) pershare is computed by dividing net income (loss) by the weighted average numberof common shares outstanding for the period. Diluted net income (loss) per share is computed by dividing net income(loss) by the sum of the weighted average number of common shares outstandingand potential common shares (when dilutive). A reconciliation of the numerator and the denominator of basic anddiluted net income (loss) per share is as follows (in thousands, except pershare amounts):
|                                                | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                     | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                     | ** ** | **2005**                         | ** ** | **2006**                       | ** ** | **2005** | ** ** | **2006** | ** ** |
| Numerator -basic                               |       |                             |       |                           |       |   |   |   |   |
| Net income (loss)                              |       | $                                | (19,587    | )                              | $          | 1,455 |   | $ | (33,484 | ) | $ | 12,745 |   |
|                                           |       |                             |       |                           |       |   |   |   |   |
| Denominator -  basic                           |       |                             |       |                           |       |   |   |   |   |
| Weighted average common stock outstanding      |       | 102,201                          |       | 103,178                        |       | 100,010 |   | 103,159 |   |
|                                           |       |                             |       |                           |       |   |   |   |   |
| Basic net income  (loss) per share             |       | $                                | (0.19      | )                              | $          | 0.01 |   | $ | (0.33 | ) | $ | 0.12 |   |
|                                           |       |                             |       |                           |       |   |   |   |   |
| Denominator -  diluted                         |       |                             |       |                           |       |   |   |   |   |
| Weighted average common stock outstanding      |       | 102,201                          |       | 103,178                        |       | 100,010 |   | 103,159 |   |
| Dilutive potential of common stock equivalents |       | -                                |       | 1,351                          |       | - |   | 1,475 |   |
| Options                                        |       | 102,201                          |       | 104,529                        |       | 100,010 |   | 104,634 |   |
|                                           |       |                             |       |                           |       |   |   |   |   |
| Diluted net income  (loss) per share           |       | $                                | (0.19      | )                              | $          | 0.01 |   | $ | (0.33 | ) | $ | 0.12 |   |

 

Stock options to purchase11,137,000 and 11,138,000 shares of common stock were outstanding for the threeand six months ended June 30, 2005, with a weighted average exercise price of$7.71 for both periods. These stock options were not included in thecomputation of diluted net loss per share for the three and six months endedJune 30, 2005 because we had a net loss for these periods. Stock options topurchase 8,450,580 and 8,492,481 shares with weighted average per share pricesof $9.09 and $9.10, respectively, were outstanding and not included in thecomputation of diluted net income per share for the three and six months ended June30, 2006, respectively, as they were anti-dilutive under the treasury stockmethod..

**3*.             StockCompensation: ***

Effective January1, 2006, we adopted SFAS No. 123(R), “*Share-Based Payments*.”This  statement  requires us to  expense  the fair value of grants of  variousstock-based  compensation  programs over the vesting  period of theawards.  We elected to adopt the “modifiedprospective application” transition method which does not require therestatement of previously issued financial statements.

***EmployeeStock Purchase Plan:***

Our 1995 Employee Stock Purchase Plan, or the PurchasePlan, as amended, has 6.0 million shares reserved for issuance.  Through July 31, 2005, the Purchase Planprovided for eligible employees to purchase shares of common stock at a priceequal to 85% of the fair market value of our common stock on the date of theoption grant, or, if lower, 85% of the fair market value of our common stocksix months after the option grant, by withholding up to 10 percent of theirannual base earnings.  Since July 31,2005, the Purchase Plan provides for eligible employees to purchase shares ofcommon stock at a price equal to 90% of the fair value of our common stock sixmonths after the option date by withholding up to 10% of their annual baseearnings.  At June 30, 2005, 880 thousandshares were available for purchase under the Purchase Plan.  Shares issued under the Purchase Plan for thesix months ended June 30, 2005 and 2006 were 386 thousand 244 thousand,respectively.

***EquityIncentive Plan:***

Our 1995 Equity Incentive Plan, or the EquityIncentive Plan, as amended, has 31.8 million shares of common stock reservedfor issuance upon the exercise of stock options to our employees, directors,consultants and affiliates.  Under theEquity Incentive Plan, the Board of Directors has the authority to determine towhom options will be granted, the number of shares under option, the optionterm and the exercise price. The options generally are exercisable beginningone year from date of grant and generally thereafter over periods ranging fromfour to five years from the date of grant. The term of any options issued maynot exceed ten years from the date of grant.

***Directors’Stock Option Plan:***

Each of our non-employee directors receives stockoption grants under our 1995 Non-Employee Directors’ Stock Option Plan, or theDirectors’ Plan. In April 2005, the Board of Directors amended the Directors’Plan. Pursuant to the Directors’ Plan, upon each non-employee director’sinitial election or appointment to the Board, such new non-employee directorreceives an initial stock option grant for 45,000 shares of common stock. Eachinitial stock option grant vests as to 25% of the shares subject to the granton the anniversary of the grant date. Previously, each such initial stockoption was fully vested and exercisable upon grant. In addition, eachnon-employee director will receive a fully vested annual stock option grant for12,000 shares of common stock. Previously, each non-employee director receiveda fully vested annual stock option grant for 18,000 shares of common stock. Theoptions expire ten years after the date of grant. As of June 30, 2006, theDirectors’ Plan had 169 thousand shares available for issuance.

Compensationexpense is recognized as follows: We amortize deferred stock-based compensationon the graded vesting method over the vesting periods of the stock options,generally four years. The graded vesting method provides for vesting ofportions of the overall awards at interim dates and results in acceleratedvesting as compared to the straight-line method.

The Employee StockPurchase Plan, or the Purchase Plan, provides for eligible employees topurchase shares of common stock at a price equal to 90% of the fair value ofour common stock on the last day of each six-months offering period.  The compensation is the difference betweenthe fair value and purchase price on the date of purchase.

The amount of recognizedcompensation expense is adjusted based upon an estimated forfeiture rate whichis derived from historical data.

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

7

----

 
|                                                 | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                      | ** ** | **June 30, 2006**      | ** ** | **June 30, 2006**    | ** ** |
| Cost of goods  sold                             |       | $                                | 153        |                           | $          | 310 |   |
| Research and  development                       |       | 792                              |       | 1,772                          |       |
| Sales and  marketing                            |       | 237                              |       | 497                            |       |
| General and  administrative                     |       | 583                              |       | 1,223                          |       |
| Effect on  pre-tax income                       |       | 1,765                            |       | 3,802                          |       |
| Tax effect of  stock-based compensation expense |       | —                           |       | —                         |       |
| Effect on net  income                           |       | $                                | 1,765      |                           | $          | 3,802 |   |
|                                            |       |                             |       |                           |       |
| Effect on net  income per share:                |       |                             |       |                           |       |
| Basic                                           |       | $                                | 0.02       |                           | $          | 0.04 |   |
| Diluted                                         |       | $                                | 0.02       |                           | $          | 0.04 |   |

 

There were nocompensation costs capitalized for either of the above periods for the threeand six months ended June 30, 2006.

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 three andsix months ended June 30, 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 with amaximum contractual term of ten years. The fair value of these options isestimated using the Black-Scholes option pricing model which incorporates theassumptions noted in the table below. The risk-free interest rate for periodswithin the expected life of the option is based on the U.S. Treasury bond ratein effect at the time of grant. .We do not pay dividends and do not expect todo so in the future. Expected volatilities are based on the historicalperformance of our common stock. The expected term of the options granted is6.0 years calculated using the simplified method allowed under SAB 107. 

The fair values of grantsin the stated period were computed using the following assumptions for ourstock option plans:
|                          | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **               | ** ** | **June 30, 2006**      | ** ** | **June 30, 2006**    | ** ** |
| Risk-free  interest rate |       | 4.8%                             |       | 4.3%-4.8%                      |       |
| Dividend yield           |       | 0.0%                             |       | 0.0%                           |       |
| Expected volatility      |       | 82.6%                            |       | 77.0%-82.6%                    |       |
| Expected life            |       | 6.0 years                        |       | 6.0 years                      |       |

8

----

 

The following is asummary of all option activity for the three and six months ended June 30, 2006(number of shares in thousands):
|                                               | ** ** | ** **         | ** ** | ** **         | ** ** | ** **   | ** ** | ** **        | ** ** | ** **                | ** ** |
|-----------------------------------------------|------------|--------------------|------------|--------------------|------------|--------------|------------|-------------------|------------|---------------------------|------------|
| ** **                                    | ** ** | ** **         | ** ** | ** **         | ** ** | ** **   | ** ** | **Weighted**      | ** ** | ** **                | ** ** |
| ** **                                    | ** ** | ** **         | ** ** | ** **         | ** ** | ** **   | ** ** | **Average**       | ** ** | **Aggregate**             | ** ** |
| ** **                                    | ** ** | **Shares**         | ** ** | **Number of** | ** ** | **Weighted** | ** ** | **Remaining**     | ** ** | **Intrinsic Value**  | ** ** |
| ** **                                    | ** ** | **Available**      | ** ** | **Shares**         | ** ** | **Average**  | ** ** | **Term (in** | ** ** | **at June 30,** | ** ** |
| ** **                                    | ** ** | **for Grant** | ** ** | **Outstanding**    | ** ** | **Price**    | ** ** | **years)**        | ** ** | **2006**                  | ** ** |
| Outstanding at  December 31, 2005             |       | 3,162              |       | 11,687             |       | $            | 7.33       |              |       |                      |       |   |
| Granted                                       |       | (116               | )          | 116                |       | $            | 4.72       |              |       |                      |       |   |
| Exercised                                     |       | —             |       | (82                | )          | $            | 2.57       |              |       |                      |       |   |
| Forfeited                                     |       | 195                |       | (195               | )          | $            | 5.89       |              |       |                      |       |   |
| Expired                                       |       | 45                 |       | (45                | )          | $            | 14.00      |              |       |                      |       |   |
| Outstanding at  March 31, 2006                |       | 3,286              |       | 11,481             |       | $            | 7.30       |              | 6.13       |                      | $          | 6,782 |   |
| Granted                                       |       | (270               | )          | 270                |       | $            | 3.95       |              |       |                      |       |   |
| Exercised                                     |       | —             |       | (40                | )          | $            | 2.56       |              |       |                      |       |   |
| Forfeited                                     |       | 349                |       | (349               | )          | $            | 6.64       |              |       |                      |       |   |
| Outstanding at  June 30, 2006                 |       | 3,365              |       | 11,362             |       | $            | 7.26       |              | 5.97       |                      | $          | 5,545 |   |
|                                          |       |               |       |               |       |         |       |              |       |                      |       |
| Vested and  Expected to Vest at June 30, 2006 |       |               |       | 11,162             |       | $            | 7.28       |              | 5.89       |                      | $          | 5,523 |   |
|                                          |       |               |       |               |       |         |       |              |       |                      |       |
| Options Exercisable at  June 30, 2006         |       |               |       | 7,471              |       | $            | 7.87       |              | 4.60       |                      | $          | 5,119 |   |

 

A summary of our stockoptions outstanding at June 30, 2006 as follows (number of shares in thousands):
|                     | ** ** | **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       |                    | 1,118      |   | 1.71 |   | $ | 0.99 |   | 1,118 |   | $ | 0.99 |   |
| $ 1.54         | -          | $                       | 2.83       |                    | 1,118      |   | 4.79 |   | $ | 2.73 |   | 875 |   | $ | 2.29 |   |
| $ 3.07         | -          | $                       | 4.35       |                    | 1,139      |   | 7.15 |   | $ | 3.71 |   | 781 |   | $ | 3.68 |   |
| $ 4.38         | -          | $                       | 4.75       |                    | 1,104      |   | 6.37 |   | $ | 4.54 |   | 798 |   | $ | 4.52 |   |
| $ 4.82         | -          | $                       | 5.05       |                    | 1,211      |   | 8.27 |   | $ | 4.93 |   | 197 |   | $ | 4.96 |   |
| $ 5.07         | -          | $                       | 6.48       |                    | 1,081      |   | 8.04 |   | $ | 6.05 |   | 231 |   | $ | 5.80 |   |
| $ 6.66         | -          | $                       | 8.40       |                    | 1,136      |   | 7.74 |   | $ | 7.57 |   | 538 |   | $ | 7.71 |   |
| $ 8.61         | -          | $                       | 9.85       |                    | 1,232      |   | 5.64 |   | $ | 9.25 |   | 926 |   | $ | 9.24 |   |
| $ 9.92         | -          | $                       | 17.79      |                    | 1,178      |   | 5.67 |   | $ | 12.47 |   | 962 |   | $ | 12.42 |   |
| $ 18.60        | -          | $                       | 29.44      |                    | 1,045      |   | 4.03 |   | $ | 21.29 |   | 1,045 |   | $ | 21.29 |   |
| $ 0.44         | -          | $                       | 29.44      |                    | 11,362     |   | 5.97 |   | $ | 7.26 |   | 7,471 |   | $ | 7.87 |   |

 
| ** **                                                                                                             | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                                                             | ** ** | **June 30, 2006**      | ** ** | **June 30, 2006**    | ** ** |
|                                                                                                                   |       |                             |       |                           |       |
| Weighted average  grant date fair value of options granted                                                             |       | $                                | 2.80       |                           | $          | 3.09 |   |
| Total fair value  of shares vested                                                                                     |       | 1,802,000                        |       | 3,543,000                      |       |
| Total intrinsic  value of options exercised                                                                            |       | $                                | 70,000     |                           | $          | 275,000 |   |
| Total cash received  from employees as a result of employee stock option excercises and employee  stock plan purchases |       | $                                | 103,000    |                           | $          | 1,374,000 |   |

 

9

----

 

We settle stock optionexercises with newly issued shares of common stock. We do not have any equityinstruments outstanding other than the options described above as of June 30, 2006.

Total unrecognizedcompensation expense from stock options was $9.8 million excluding estimatedforfeitures, which is expected to be recognized over a weighted-average periodof 1.42 years as follows, in thousands:
|                              | ** ** | **Compensation**               | ** ** |
|------------------------------|------------|--------------------------------|------------|
| ** **                   | ** ** | **Expense excluding**     | ** ** |
| ** **                   | ** ** | **Estimated Forfeitures** | ** ** |
| 2006 (remaining  six months) |       | $                              | 3,426      |   |
| 2007                         |       | 4,121                          |       |
| 2008                         |       | 1,768                          |       |
| 2009                         |       | 483                            |       |
| 2010                         |       | 35                             |       |
| Total                        |       | $                              | 9,833      |   |

 

*Pro Forma Information under SFAS123 for the period prior to 2006*

For the three and six monthsended June 30, 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:
|                                                                                                                                               | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                                                                                    | ** ** | **June 30, 2005**      | ** ** | **June 30, 2005**    | ** ** |
| Net loss as  reported                                                                                                                         |       | $                                | (19,587    | )                              | $          | (33,484 | ) |
| Add: Stock-based  employee compensation expense in reported net income, net of related tax  effects                                           |       | —                           |       | —                         |       |
| Deduct: total  stock-based employee compensation expense determined under fair value based  method for all awards, net of related tax effects |       | (2,039                           | )          | (4,473                         | )          |
| Pro forma net  loss                                                                                                                           |       | $                                | (21,626    | )                              | $          | (37,957 | ) |
|                                                                                                                                          |       |                             |       |                           |       |
| Basic loss per  share                                                                                                                         |       |                             |       |                           |       |
| As reported:                                                                                                                                  |       | $                                | (0.19      | )                              | $          | (0.33 | ) |
| Pro forma:                                                                                                                                    |       | $                                | (0.21      | )                              | $          | (0.38 | ) |
| Diluted net loss  per share                                                                                                                   |       |                             |       |                           |       |
| As reported:                                                                                                                                  |       | $                                | (0.19      | )                              | $          | (0.33 | ) |
| Pro forma:                                                                                                                                    |       | $                                | (0.21      | )                              | $          | (0.38 | ) |

 

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.  Substantially all of our cash and cash equivalentsare in the custody of three major financial institutions.

Short and long-term investments, which are comprised of federal, stateand municipal government obligations, foreign and public corporate debtsecurities and marketable equity securities, are classified asavailable-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 of debt securities is adjusted for amortization of premiums andaccretion of discounts to maturity, both of which are included in interestincome. Realized gains and losses are recorded on the specific identificationmethod. In the first quarter of 2006, we sold 4.0 million common

10

----

 

shares of our investmentin Powertech Technology, Incorporated, or PTI, for a pre-tax gain ofapproximately $12.2 million. We owned approximately 5.5 million shares of PTIat June 30, 2006. 

KingYuan Electronics Company Limited, or KYE, Insyde Software Corporation, orInsyde, PTI, and Professional Computer Technology Limited, or PCT, areTaiwanese companies that are listed on the Taiwan Stock Exchange.  Equity investments in these companies havebeen 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 available for resale within one year at thebalance sheet date are recorded at fair market value, with unrealized gains andlosses, net of tax, reported in Shareholders’ Equity as Other ComprehensiveIncome.  If a decline in value is judgedto 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. 

In the first quarter of 2006,we determined our investment in Nanotech Corporation, or Nanotech, a privatelyheld Cayman Island company, had become impaired as Nanotech defaulted on loanpayments to certain of its business partners and is now in the process ofdiscontinuing operations. Consequently, our remaining investment of $3.3 millionalong with a loan of $225 thousand were written down to a net realizable valueof zero. 

The fair values of available-for-sale investments as of June 30, 2006were as follows (in thousands):
|                                                           | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair**  | ** ** |
|-----------------------------------------------------------|------------|---------------|------------|----------------|------------|----------------|------------|-----------|------------|
| ** **                                                | ** ** | **Cost**      | ** ** | **Gain**       | ** ** | **Loss**       | ** ** | **Value** | ** ** |
| Corporate bonds  and notes                                |       | $             | 15,621     |           | $          | 13             | ** ** | **$**     | **—** |   | $ | 15,634 |   |
| Government bonds  and notes                               |       | 52,216        |       | —         |       | (19            | )          | 52,197    |       |
| Foreign listed  equity securities                         |       | 5,999         |       | 16,501         |       | —         |       | 22,500    |       |
| Total bonds,  notes and equity securities                 |       | $             | 73,836     |           | $          | 16,514         |       | $         | (19        | ) | $ | 90,331 |   |
|                                                      |       |          |       |           |       |           |       |      |       |
| Less amounts  classified as cash equivalents              |       |          |       |           |       |           |       | (39,460   | )          |
| Total short and  long-term available-for-sale investments |       |          |       |           |       |           |       | $         | 50,871     |   |

 

Contractual maturity dates of our available-for-saleinvestments for debt securities are all in 2006.  All of these securities are classified ascurrent as they are expected to be realized in cash or sold or consumed duringthe normal operating cycle of our business.

The unrealized gains and losses as of June 30,2006 are recorded in accumulated other comprehensive income, net of tax.

The fair values of available-for-sale investments as of December 31,2005 were as follows (in thousands):
|                                                           | ** ** | **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              |       |          |       |           |       |           |       | (4,690    | )          |
| Total short and  long-term available-for-sale investments |       |          |       |           |       |           |       | $         | 40,065     |   |

 

The unrealized gains and losses as of December 31,2005 are recorded in accumulated other comprehensive income, net of tax.

Market values weredetermined for each individual security in our investment portfolio.  The declines in value of the government bondsand notes primarily relate to changes in the interest rates and are consideredtemporary in nature.  With respect to ourforeign listed equity securities, our policy is to review our equity holdingson a regular basis to evaluate whether or not such securities have experiencedan other than temporary decline in fair value. Our policy

11

----

 

includes, but is notlimited to, reviewing each company’s cash position, earnings and revenueoutlook, stock price performance over the past six months, liquidity,management and ownership.  If we believethat an other-than-temporary decline in value exists, it is our policy to writedown these investments to the market value and record the related write-down inour consolidated statement of operations. 

Investments in privately held enterprises andcertain restricted stocks are accounted for using either the cost or equitymethod of accounting.  As of June 30,2006, the carrying value of these investments was $95.8 million, which includesan investment of $83.2 million in Grace Semiconductor ManufacturingCorporation, or GSMC, which represents a 10% interest.  As of December 31, 2005, the carrying valueof these investments was $96.1 million. 

**5.             Selected BalanceSheet Detail**

Details of selected balance sheet accounts are asfollows (in thousands):

Inventories comprise:
|                                                      | ** ** | **December 31,** | ** ** | **June 30,** | ** ** |
|------------------------------------------------------|------------|-----------------------|------------|-------------------|------------|
| ** **                                           | ** ** | **2005**              | ** ** | **2006**          | ** ** |
| Raw materials                                        |       | $                     | 65,404     |              | $          | 59,754 |   |
| Work in process                                      |       | 6,491                 |       | 5,278             |       |
| Finished goods                                       |       | 29,450                |       | 23,840            |       |
| Finished goods  inventories held at logistics center |       | 6,998                 |       | 5,561             |       |
|                                                 |       | $                     | 108,343    |              | $          | 94,433 |   |

 

Inventories are stated at the 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 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.  If weover estimate future market demand, we may end up with excess inventory levelsthat cannot be sold within a normal operating cycle and we may be required to recorda provision for excess inventory.  Ourinventories include high technology parts and components that are specializedin nature or subject to rapid technological obsolescence.  Some of our customers have requested that weship them product that has a finished goods date of manufacture less than oneyear old.  In the event that this becomesa common requirement, it may be necessary for us to provide for an additionalallowance for our on-hand finished goods inventory with a date of manufactureof greater than one year old, which could result in a material adjustment andcould harm our financial results.  Wereview on-hand inventory including inventory held at the logistic center forpotential excess, obsolescence and lower of cost or market exposure and recordprovisions accordingly.  Due to the largenumber of units in our inventory, even a small change in average selling pricescould result in a significant adjustment and have a material impact on ourfinancial position and results of operations. 

Our allowance for excess and obsolete inventories includes an allowancefor 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 addition, our allowanceincludes an allowance for die, work-in-process and finished goods that exceedour estimated forecast for the next twelve to twenty four months.  For the obsolete inventory analysis, wereview inventory items in detail and consider date code, customer baserequirements, known product defects, planned or recent product revisions, endof life plans and diminished market demand. For excess inventory analysis, we review inventory items in detail andconsider our customer base requirements and market demand.  While we have programs to minimizeinventories on hand and we consider technological obsolescence when estimatingallowances for potentially excess and obsolete inventories and those requiredto reduce recorded amounts to market values, it is reasonably possible thatsuch estimates could change in the near term. Such changes in estimates could have a material impact on our financialposition and results of operations.

Accrued expenses and other liabilities comprise (in thousands):

12

----

 
| ** **                              | ** ** | **December 31,** | ** ** | **June 30,** | ** ** |
|-----------------------------------------|------------|-----------------------|------------|-------------------|------------|
| ** **                              | ** ** | **2005**              | ** ** | **2006**          | ** ** |
| Accrued  compensation and related items |       | $                     | 5,934      |              | $          | 6,880 |   |
| Accrued adverse  purchase commitments   |       | 1,752                 |       | 1,306             |       |
| Accrued  commission                     |       | 2,762                 |       | 2,671             |       |
| Accrued income  tax payable             |       | 1,319                 |       | 4,076             |       |
| Accrued warranty                        |       | 803                   |       | 910               |       |
| Other accrued  liabilities              |       | 4,748                 |       | 5,709             |       |
|                                    |       | $                     | 17,318     |              | $          | 21,552 |   |

 

Changes in the warranty reserves during the three months ended June 30,2005 and 2006 were as follows (in thousands):
| ** **                                  | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                  | ** ** | **2005**                                          | ** ** | **2006** | ** ** |
| Beginning  balance                          |       | $                                                 | 3,826      |   | $ | 803 |   |
| Provisions for  warranty                    |       | 1,418                                             |       | 1,736 |   |
| Change in  estimate of prior period accrual |       | (500                                              | )          | — |   |
| Consumption of  reserves                    |       | (2,662                                            | )          | (1,629 | ) |
| Ending balance                              |       | $                                                 | 2,082      |   | $ | 910 |   |

 

Our products are generally subject to warranty and we provide for theestimated future costs of repair, replacement or customer accommodation uponshipment of the product in our condensed consolidated statements ofoperations.  Our warranty accrual isestimated based on historical claims compared to historical revenues. For newproducts, we use our historical percentage for the appropriate class ofproduct.  The higher warranty reserve asof June 30, 2005 compared to June 30, 2006 related mainly to the rescreeningwork related to two specific customers. The work was completed during 2005 so there is no comparable reserve asof June 30, 2006.

**6.             Commitments**

Our technology license agreements generally include an indemnificationclause that indemnifies the licensee against liability and damages (includinglegal defense costs) arising from any claims of patent, copyright, trademark ortrade secret infringement by our proprietary technology.  The terms of these guarantees approximate theterms of the technology license agreements, which typically range from five toten years.  Our current licenseagreements expire from 2006 through 2014. The maximum possible amount of future payments we could be required tomake, if such indemnifications were required on all of these agreements, is $41.7million. We have not recorded any liabilities as of June 30, 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 indemnities to various lessorsin connection with facility leases for certain claims arising from suchfacility or lease and indemnities to our directors and officers to the maximumextent permitted under the laws of California. In addition, we have contractual commitments to some customers, whichcould require us to incur costs to repair an epidemic defect with respect toour products outside the normal warranty period if such defect were tooccur.  The duration of theseindemnities, commitments and guarantees varies. The majority of these indemnities, commitments and guarantees do notprovide for any limitation of the maximum potential future payments that wecould be obligated to make.  We have notrecorded any liability for these indemnities, commitments and guarantees in theaccompanying condensed consolidated balance sheets. We do, however, accrue forlosses for any known contingent liability, including those that may arise fromindemnification provisions, when future payment is probable and the amount isreasonably 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, the putative

13

----

 

class actions wereconsolidated under the caption *In re SiliconStorage Technology, Inc., Securities Litigation,* Case No. C 05 00295PJH (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 leadplaintiff filed a Consolidated Amended Class 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.  Wemoved to dismiss the complaint on September 16, 2005.  Plaintiff served an opposition to the motionto dismiss on November 4, 2005.  Ourreply in further support of the motion to dismiss was filed on December 19,2005.  On January 18, 2006, the Courtheard arguments on the motion to 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  responded with a motion to dismiss on June 19,2006. We intend to take all appropriate action in response to theselawsuits.  The impact related to theoutcome 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 ofthese complaints are substantially identical to those contained in the putativeshareholder class actions filed in federal court.  The derivative complaints assert claims for,among other things, breach of fiduciary duty and violations of the CaliforniaCorporations Code.  These derivativeactions have been consolidated under the caption *In ReSilicon Storage Technology, Inc. Derivative Litigation*, Lead CaseNo. 1:05CV034387 (Cal. Super. Ct., Santa Clara Co.).  On April 28, 2005, the derivative action wasstayed by court order.  We intend to takeall appropriate action in response to these lawsuits.  The impact related to the outcome of thesematters is undeterminable at this time.

On July 13, 2006,a shareholder derivative complaint was filed in the United States DistrictCourt for the Northern District of California by Mike Brien under the caption *Brien v. Yeh, et al*., Case No. C06-04310 JF (N.D. Cal.). OnJuly 18, 2006, a shareholder derivative complaint was filed in the UnitedStates District Court for the Northern District of California by BehradBazargani under the caption *Bazargani v. Yeh, et al*.,Case No. C06-04388 HRL (N.D. Cal.). Both complaints were brought purportedly onbehalf of us against certain of our current and former officers and directorsand allege among other things, that the named officers and directors: (a)breached their fiduciary duties as they colluded with each other to backdatestock options, (b) violated Rule 10b-5 of the Securities Exchange Act of 1934through their alleged actions, and (c) were unjustly enriched by their receiptand retention of such stock options. We intend to take all appropriate actionin responding to the complaints.

Fromtime to time, we are also involved in other legal actions arising in theordinary course of business.  We haveaccrued certain costs associated with defending these matters.  There can be no assurance that theshareholder class action complaints, the shareholder derivative complaints orother third party assertions will be resolved without costly litigation, in amanner that is not adverse to our financial position, results of operations orcash flows or without requiring royalty payments in the future which mayadversely impact gross margins. No estimate can be made of the possible loss orpossible range of loss associated with the resolution of these contingencies.  As aresult, no losses have been accrued in our financial statements as of June 30,2006.

**8.             Line of Credit**

OnAugust 11, 2005, we entered into a 1-year loan and security agreement withCathay Bank for a $35.0 million revolving line of credit, all of which wasavailable to us as of June 30, 2006. The line of credit will be used forworking capital but there are no restrictions in the agreement as to how thefunds may be used.  The interest rate forthe line of credit is 1% below the prime rate reported from time to time by theWall Street Journal, Western Edition (8.25% at June 30, 2006). The line ofcredit is collateralized by substantially all of the assets of SST other thanintellectual property.  The agreementcontains certain financial covenants, including the levels of qualifyingaccounts receivable and inventories, which could limit the availability offunds under the agreement. There were noborrowings under this line as of June 30, 2006.

On July 16, 2004, we entered into a 2-year loan agreementwith Cathay Bank, a U.S. bank, for a $3.0 million revolving line ofcredit.  The interest rate for the lineof credit is 3.475% per annum.  The lineof credit is collateralized by a $3.0 million certificate of deposit which isincluded in non-current other assets. The loan agreement was extended in July 2006 and now matures inSeptember 2006. It carries an interest rate of 2.6% per annum. As of December31, 2005, and June 30, 2006, we had borrowed $3.0 million under our line ofcredit.

14

----

 

**9.             Goodwilland Intangible Assets:**

Our acquisitions in prior years included the acquisition of $16.5million of finite-lived intangible assets. Certain of our acquisitions alsoincluded an aggregate of $29.6 million of goodwill. The goodwill is not being amortizedbut is tested for impairment annually, as well as when an event or circumstanceoccurs indicating a possible impairment in value. Of our $1.5 million ofintellectual property assets, $1.2 million was acquired prior to fiscal2006 and included in property, plant and equipment.

As of June 30, 2006, our intangible assets consisted of thefollowing (in thousands):
|                         | ** ** | ** ** | ** ** | **Accumulated**  | ** ** | ** ** | ** ** |
|-------------------------|------------|------------|------------|------------------|------------|------------|------------|
| ** **              | ** ** | **Cost**   | ** ** | **Amortization** | ** ** | **Net**    | ** ** |
| Existing  technology    |       | $          | 11,791     |             | $          | 4,122      |       | $ | 7,669 |   |
| Intellectual property   |       | 1,517      |       | —           |       | 1,517      |       |
| Trade name              |       | 1,198      |       | 433              |       | 765        |       |
| Customer  relationships |       | 1,857      |       | 777              |       | 1,080      |       |
| Backlog                 |       | 811        |       | 811              |       | —     |       |
| Non-Compete  Agreements |       | 810        |       | 296              |       | 514        |       |
|                    |       | $          | 17,984     |             | $          | 6,439      |       | $ | 11,545 |   |

 

As of December 31, 2005, our intangible assets consisted of thefollowing (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 are being amortized on a straight-line methodover their estimated useful lives. Existing technologies have been assigneduseful lives of between four and five years, with a weighted average life ofapproximately 4.6 years. Non-compete agreements have been assigned useful livesbetween two and four years, with a weighted average of 3.6 years. Intellectualproperty has been assigned an estimated life of five years and will beginamortization as it is put into service. Trade names, customer relationships andbacklogs have been assigned useful lives of five years, three years and oneyear, respectively. Amortization expense for intangible assets for the sixmonths ended June 30, 2006 was $1.8 million.

Estimated future intangible asset amortization expense for the nextfive years is as follows (in thousands):
| Fiscal Year           | ** ** | **Amortization of   Intangible Assets** | ** ** |
|----------------------------|------------|--------------------------------------------------------|------------|
| 2006 remaining  six months |       | $                                                      | 1,782      |   |
| 2007                       |       | 3,675                                                  |       |
| 2008                       |       | 3,376                                                  |       |
| 2009                       |       | 1,938                                                  |       |
| 2010 and after             |       | 774                                                    |       |
|                       |       | $                                                      | 11,545     |   |

 

There was no change in the carrying amount of goodwill for the sixmonths ended June 30, 2006 from December 31, 2005.

15

----

 

**10.          Segment Reporting**

A keyobjective of ours is to diversify our product offerings from primarily flash toa multi-product line company and to be a leading worldwide supplier of low tomedium density NOR flash memory devices, a leading supplier of othersemiconductor products in the consumer electronics market and a leadinglicensor of embedded flash technology. As a result, the operating results thatthe company’s chief operating decision maker reviews to make decisions aboutresource allocations and to assess performance have changed. EffectiveJanuary 1, 2006, we have re-evaluated our operating segments to bring themin line with our key objectives and focus. The new segments include MemoryProducts, Non-Memory Products and Technology Licensing.

OurMemory Product segment, which is comprised of NOR flash memory products,includes the Multi-Purpose Flash, or MPF, family, the Multi-Purpose Flash Plus,or MPF+, family, the Concurrent SuperFlash, or CSF, family, the Firmware Hub,or FWH, family, the Serial Flash family, the ComboMemory family, the Many-TimeProgrammable, or MTP, family, and the Small Sector Flash, or SSF, family.

OurNon-Memory Products segment includes other semiconductor products includingflash microcontrollers, smart card integrated circuit, or ICs, and modules,radio frequency, or RF, ICs and modules and NAND controller products andmodules.

TechnologyLicensing includes both license fees and royalties generated from the licensingof our SuperFlash technology to semiconductor manufacturers for use in embeddedflash applications.

We donot allocate operating expenses, interest and other income/expense, interestexpense, impairment of equity investments or 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.

Priorperiod segment information has been reclassified to conform to the currentperiod’s presentation.

Thefollowing table shows our revenues and gross profit (loss) for each segment (inthousands):
|                       | ** ** | **Three Months Ended** | ** ** | **Three Months Ended** | ** ** |
|-----------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **            | ** ** | **June 30, 2005**      | ** ** | **June 30, 2006**      | ** ** |
| ** **            | ** ** | ** **                       | ** ** | **Gross**                        | ** ** | ** ** | ** ** | **Gross** | ** ** |
| ** **            | ** ** | **Revenues**                     | ** ** | **Profit**                       | ** ** | **Revenues** | ** ** | **Profit** | ** ** |
|                  |       |                             |       |                             |       |   |   |   |   |
| Memory                |       | $                                | 74,942     |                             | $          | 3,122 |   | $ | 82,970 |   | $ | 14,036 |   |
| Non-Memory            |       | 9,940                            |       | (277                             | )          | 15,968 |   | 4,547 |   |
| Technology  Licensing |       | 8,417                            |       | 8,417                            |       | 8,791 |   | 8,791 |   |
|                  |       | $                                | 93,299     |                             | $          | 11,262 |   | $ | 107,729 |   | $ | 27,374 |   |

 
|                       | ** ** | **Six Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------|------------|--------------------------------|------------|--------------------------------|------------|
| ** **            | ** ** | **June 30, 2005**    | ** ** | **June 30, 2006**    | ** ** |
| ** **            | ** ** | ** **                     | ** ** | **Gross**                      | ** ** | ** ** | ** ** | **Gross** | ** ** |
| ** **            | ** ** | **Revenues**                   | ** ** | **Profit**                     | ** ** | **Revenues** | ** ** | **Profit** | ** ** |
|                  |       |                           |       |                           |       |   |   |   |   |
| Memory                |       | $                              | 142,934    |                           | $          | 4,073 |   | $ | 163,008 |   | $ | 31,972 |   |
| Non-Memory            |       | 21,218                         |       | 4,320                          |       | 36,233 |   | 10,296 |   |
| Technology  Licensing |       | 15,462                         |       | 15,462                         |       | 19,019 |   | 19,019 |   |
|                  |       | $                              | 179,614    |                           | $          | 23,855 |   | $ | 218,260 |   | $ | 61,287 |   |

 

16

----

 

**11.          Comprehensive Income (Loss)**

Thecomponents of comprehensive income (loss), net of tax, are as follows (inthousands):
| ** **                                             | ** ** | **For the Three Months Ended** | ** ** | **For the Six Months Ended** | ** ** |
|--------------------------------------------------------|------------|----------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                             | ** ** | **June 30, 2005**                        | ** ** | **June 30, 2006**                      | ** ** | **June 30, 2005** | ** ** | **June 30, 2006** | ** ** |
|                                                   |       |                                               |       |                                             |       |   |   |   |   |
| Net income (loss)                                      |       | $                                                  | (19,587    | )                                                | $          | 1,455 |   | $ | (33,484 | ) | $ | 12,745 |   |
|                                                   |       |                                               |       |                                             |       |   |   |   |   |
| Other comprehensive  income:                           |       |                                               |       |                                             |       |   |   |   |   |
| Change in unrealized  gains on investments, net of tax |       | 5,889                                              |       | (2,653                                           | )          | 9,790 |   | (15,279 | ) |
| Change in cumulative  translation adjustment           |       | (104                                               | )          | 5                                                |       | (35 | ) | 16 |   |
| Total comprehensive  income                            |       | $                                                  | (13,802    | )                                                | $          | (1,193 | ) | $ | (23,729 | ) | $ | (2,518 | ) |

 

Thecomponents of accumulated other comprehensive income are as follows (inthousands):
|                                                        | ** ** | **Balances as of**    | ** ** |
|--------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                             | ** ** | **December 31, 2005** | ** ** | **June 30, 2006** | ** ** |
| Components of  accumulated other comprehensive income: |       |                            |       |   |   |
|                                                   |       |                            |       |   |   |
| Net unrealized  gains on investments, net of tax       |       | $                               | 31,774     |   | $ | 16,495 |   |
| Cumulative  translation adjustment                     |       | 6                               |       | 22 |   |
|                                                   |       | $                               | 31,780     |   | $ | 16,517 |   |

 

17

----

 

**12.          Related Party Transactions andBalances**

The following table is a summary ofour related party revenues and purchases for the three and six months monthsended June 30, 2005 and 2006, and our related party accounts receivableand accounts payable and accruals as of December 31, 2005 andJune 30, 2006 (in thousands):
|                                                           | ** ** | **Three Months Ended** | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                                | ** ** | **June 30, 2005**      | ** ** | **June 30, 2006**      | ** ** |
| ** **                                                | ** ** | **Revenues**                     | ** ** | **Purchases**                    | ** ** | **Revenues** | ** ** | **Purchases** | ** ** |
|                                                      |       |                             |       |                             |       |   |   |   |   |
| Silicon Technology Co.,  Ltd                              |       | $                                | 1,139      |                             | $          | — |   | $ | 260 |   | $ | — |   |
| Apacer  Technology, Inc. & related entities |       | 518                              |       | —                           |       | 714 |   | — |   |
| Silicon Professional  Technology Ltd                      |       | 46,353                           |       | —                           |       | 57,189 |   | — |   |
| Grace Semiconductor  Manufacturing Corp                   |       | 29                               |       | 11,431                           |       | — |   | 14,319 |   |
| King Yuan Electronics  Company, Limited                   |       | —                           |       | 7,654                            |       | — |   | 7,029 |   |
| Powertech Technology,  Incorporated                       |       | —                           |       | 3,125                            |       | — |   | 3,113 |   |
|                                                      |       | $                                | 48,039     |                             | $          | 22,210 |   | $ | 58,163 |   | $ | 24,461 |   |

 
|                                                           | ** ** | **Six Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------------------|------------|--------------------------------|------------|--------------------------------|------------|
| ** **                                                | ** ** | **June 30, 2005**    | ** ** | **June 30, 2006**    | ** ** |
| ** **                                                | ** ** | **Revenues**                   | ** ** | **Purchases**                  | ** ** | **Revenues** | ** ** | **Purchases** | ** ** |
|                                                      |       |                           |       |                           |       |   |   |   |   |
| Silicon Technology Co.,  Ltd                              |       | $                              | 1,838      |                           | $          | — |   | $ | 486 |   | $ | — |   |
| Apacer  Technology, Inc. & related entities |       | 842                            |       | —                         |       | 1,680 |   | — |   |
| Silicon Professional  Technology Ltd                      |       | 86,979                         |       | —                         |       | 118,268 |   | — |   |
| Grace Semiconductor  Manufacturing Corp                   |       | 131                            |       | 34,772                         |       | 1,378 |   | 24,142 |   |
| King Yuan Electronics  Company, Limited                   |       | —                         |       | 16,822                         |       | — |   | 15,033 |   |
| Powertech Technology,  Incorporated                       |       | —                         |       | 6,827                          |       | — |   | 6,904 |   |
|                                                      |       | $                              | 89,790     |                           | $          | 58,421 |   | $ | 121,812 |   | $ | 46,079 |   |

 
|                                                           | ** ** | **December 31, 2005** | ** ** | **June 30, 2006** | ** ** |
|-----------------------------------------------------------|------------|---------------------------------|------------|-----------------------------|------------|
| ** **                                                | ** ** | **Trade**                       | ** ** | **Accounts**                | ** ** | **Trade** | ** ** | **Accounts** | ** ** |
| ** **                                                | ** ** | **Accounts**                    | ** ** | **Payable and**        | ** ** | **Accounts** | ** ** | **Payable and** | ** ** |
| ** **                                                | ** ** | **Receivable**                  | ** ** | **Accruals**                | ** ** | **Receivable** | ** ** | **Accruals** | ** ** |
|                                                      |       |                            |       |                        |       |   |   |   |   |
| Silicon  Technology Co., Ltd                              |       | $                               | 370        |                        | $          | — |   | $ | 127 |   | $ | — |   |
| Apacer  Technology, Inc. & related entities |       | 237                             |       | —                      |       | 319 |   | — |   |
| Professional  Computer Technology Limited                 |       | —                          |       | 123                         |       | — |   | 127 |   |
| Silicon  Professional Technology Ltd                      |       | 53,785                          |       | 846                         |       | 37,455 |   | 869 |   |
| Grace Semiconductor  Manufacturing Corp                   |       | 1,466                           |       | 4,949                       |       | 68 |   | 9,391 |   |
| King Yuan  Electronics Company, Limited                   |       | —                          |       | 10,004                      |       | — |   | 7,162 |   |
| Powertech  Technology, Incorporated                       |       | —                          |       | 5,945                       |       | — |   | 4,242 |   |
|                                                      |       | $                               | 55,858     |                        | $          | 21,867 |   | $ | 37,969 |   | $ | 21,791 |   |

 

Professional Computer Technology Limited, or PCT, earnscommissions for point-of-sales transactions to customers. PCT’s commissions arepaid at 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.

18

----

 

**13.          Income Taxes**

We maintained a fullvaluation allowance on our net deferred tax assets as of June 30, 2006.The valuation allowance was determined in accordance with the provisions ofStatement of Financial Accounting Standards No. 109, or SFAS No. 109,“*Accounting for Income Taxes*,” whichrequires an assessment of both positive and negative evidence when determiningwhether it is more likely than not that deferred tax assets are recoverable;such assessment is required on a jurisdiction by jurisdiction basis. Cumulativelosses incurred in the U.S. in recent years represented sufficient negativeevidence under SFAS No. 109 such that a full valuation allowance wasrecorded against U.S. deferred tax assets. We intend to maintain a fullvaluation allowance in the U.S. deferred tax assets until sufficient positiveevidence exists to support reversal of the valuation allowance. Our taxprovision for the three and six months ended June 30, 2006 was $1.0million and $3.3 million, respectively, which consists primarily of foreignwithholding taxes and tentative U.S. minimum tax.

19

----

 

**Item 2. Management’s Discussion and Analysis ofFinancial 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 theyear ended December 31, 2005, as filed with the Securities and ExchangeCommission.*

*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.Please also see Part II, Item 1A. “Risk Factors.”*

###### **Overview**

We area leading supplier of NOR flash memory semiconductor devices for the digitalconsumer, networking, wireless communications and Internet computing markets.NOR flash memory is a form of non-volatile memory that allows electronicsystems to retain information when the system is turned off. NOR flash memoryis now used in hundreds of millions of consumer electronics and computingproducts annually.

Weproduce and sell many products based on our SuperFlash design and manufacturingprocess technology. Our products are incorporated into products sold by manywell-known companies including Apple, Asustek, BenQ, Cisco, Dell, FirstInternational Computer, or FIC, Gigabyte, Huawei, Infineon, Intel, IBM,Inventec, Legend Lenovo, LG Electronics, Freescale Semiconductor, Inc, NEC,Nintendo, Panasonic, Philips, Quanta, Samsung, Sanyo, Seagate, Sony, SonyEricsson, Texas Instruments and VTech.

Wealso produce and sell other semiconductor products including flashmicrocontrollers, smartcard ICs and modules, radio frequency, or RF, ICs andmodules and memory controllers.

One of our key initiatives is the active development of our non-memorybusiness. Our objective is to transformSST from a pure-play in flash to a multi-product line company. We continue toexecute on our plan to derive, by mid-2008, 30% of our revenue from non-memoryproducts, which includes embedded controllers, NAND controller based products,smart card ICs and radio frequency ICs 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 the transition in our objectives,the operating results that our chief executive officer reviews to makedecisions about resource allocations and to assess our performance havechanged. Effective January 1, 2006, we have re-evaluated our operatingsegments to bring them in line with our key objectives and focus. The newsegments include Memory Products, Non-Memory Products and Technology Licensing.For other information related to our segments, see “Note 10 – Segment Reporting”to our Notes to the Consolidated Financial Statements.

Thesecond quarter of 2006 ended a relatively weak first half of 2006, although we expect to seestrengthening demand in the second half of the year. Sales in the Internetcomputing and digital consumer applications during the second quarter wereseasonally low. Revenue from the networking and wireless communicationsapplications, however, was strong. Revenues from wireless communicationssurpassed that of Internet computing and became our second largest applicationin the second quarter

Looking at our application categories, unitshipments to the Internet computing application were negatively affected.Shipments decreased 2.5% in the second quarter due to weak demand for desktopPCs, notebook PC and graphic card applications. However, we had record unitshipments to the server and LCD monitor applications. Unit shipments to thedigital consumer category decreased 11.1% in the second quarter due to softnessin the DVD player, DVD ROM drive, MP3 player, and digital TV applications.Shipments to the digital camera, DVD RW drive, set-top box and video gameapplications remained strong. We expect shipments to the digital consumermarket to improve during the third quarter as we approach the holiday season.Units shipped to the wireless communications market increased by 11.5% in thesecond quarter due to record unit shipments to the GPS module and cell phoneapplications, as well as the renewed strength in Bluetooth and cordless phoneapplications. Further, due to higher average selling price from ComboMemoryproducts for the cell phone market, revenue from the

20

----

 

wirelesscommunications market improved more than 25% and became our second highestrevenue source during the second quarter. We expect the GPS and low cost cellphone applications to continue to be a growth driver for the wirelesscommunications market. The demand in the networking segment rebounded stronglyand increased 62.2% in units shipped and 39.6% in revenue sequentially from thefirst quarter due to the strong shipments to the DSL modem, Wireless LAN andnetworking equipment applications. Overall, unit shipments in the secondquarter of 2006 increased by 0.9% compared with the prior quarter.

In the area of memory technologies, we arecontinuing to reduce manufacturing costs through the transition to smallerprocess technologies that generally carry a lower cost per die. Substantiallyall of our new wafer starts are now in 0.25 micron and 0.18 micron geometries.We are in the process of developing 0.13 micron and 0.12 micron processtechnologies.

Thesemiconductor industry has historically been cyclical, characterized byperiodic changes in business conditions caused by product supply and demand imbalance.When the industry experiences downturns, they often occur in connection with,or in anticipation 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 first sixmonths of 2006 although pricing remained stable. Our business could be furtherharmed by industry-wide prolonged downturns in the future.

Ourproduct sales are made primarily using short-term cancelable purchase orders.The quantities actually purchased by the customer, as well as shipmentschedules, are frequently revised to reflect changes in the customer’s needsand in our supply of product. Accordingly, our backlog of open purchase ordersat any given time is not a meaningful indicator of future sales. Changes in theamount of our backlog do not necessarily reflect a corresponding change in thelevel of actual or potential sales.

Wederived 86.0%, 87.6% and 87.4% of our net product revenues during 2004, 2005and the six months ended June 30, 2006, respectively, from productshipments to Asia. Additionally, substantially all of our wafer suppliers andpackaging and testing subcontractors are located in Asia.

Ourtop ten end customers, excluding stocking representatives and distributors,accounted for 29.1%, 27.2% and 21.7% of our net product revenues in 2004, 2005and the six months ended June 30, 2006, respectively.

Nosingle end customer, which we define as original equipment manufacturers, orOEMs, original design manufacturers, or ODMs, contract electronicmanufacturers, or CEMs, or end users, represented 10.0% or more of our netproduct revenues during 2004, 2005 or the six months ended June 30, 2006.

Weout-source our end customer service logistics in Asia to Silicon ProfessionalTechnology Ltd., or SPT, which supports our customers in Taiwan, China andother Southeast Asia countries. SPT provides forecasting, planning, warehousing,delivery, billing, collection and other logistic functions for us in theseregions. SPT is a wholly-owned subsidiary of Professional Computer TechnologyLimited, or PCT, one of our stocking representatives in Taiwan. Please see adescription of our relationship with PCT under “Item 7. Management’s Discussionand Analysis of Financial Condition and Results of Operations - Related PartyTransactions” in our Annual Report on Form 10-K for the year endedDecember 31, 2005. Products shipped to SPT are accounted for as ourinventory held at our logistics center, and revenue is recognized when theproducts have been delivered and are considered as a sale to our end customersby SPT. For 2004 and 2005 and the six months ended June 30, 2006, SPTserviced end customer sales accounting for 52.9%, 58.5% and 59.4%,respectively, of our net product revenues recognized. As of December 31,2005 and June 30, 2006, SPT represented 69.6% and 63.1% of our netaccounts receivable, respectively.

Weship products to, and have accounts receivable from, OEMs, ODMs, CEMs, stockingrepresentatives, distributors and our logistics center. Our stockingrepresentatives, distributors and logistics center reship our products to ourend customers, including OEMs, ODMs, CEMs and end users. Shipments, by us orour logistics center, to our top three stocking representatives for reshipmentaccounted for 34.0%, 40.3% and 46.8% of our product shipments in 2004, 2005 andthe six months ended June 30, 2006, respectively. In addition, the topthree stocking representatives solicited sales, for which they received acommission, for 25.1%, 18.3% and 10.2% of our shipments to end users in 2004,2005 and the six months ended June 30, 2006, respectively.

21

----

 

**CriticalAccounting Estimates**

EffectiveJanuary 1, 2006, we adopted the fair value recognition provisions ofFinancial Accounting Standards Board, or FASB, Statement of FinancialAccounting Standards, or SFAS, No. 123(R), *“Share-Based Payments*,” using the modified prospectiveapplication method. Under this transition method, compensation cost recognizedin the quarter ended June 30, 2006 includes the applicable amounts of:(a) compensation cost of all stock-based payments granted prior to, but notyet vested as of, January 1, 2006 (based on the grant-date fair valueestimated in accordance with the original provisions of SFAS No. 123 andpreviously presented in the pro forma footnote disclosures), and(b) compensation cost for all stock-based payments granted subsequent toJanuary 1, 2006 (based on the grant-date fair value estimated inaccordance with the new provisions of SFAS No. 123(R)). Results for priorperiods have not been restated to reflect our adoption of SFAS No. 123(R).

Forother information related to our revenue recognition and other criticalaccounting estimates, please refer to the “Critical Accounting Estimates”section of “Management’s Discussion and Analysis of Financial Conditionand Results of Operations” contained in our Annual Report on Form 10-K forthe year ended December 31, 2005.

**Resultsof Operations: Three and Six Months Ended June 30, 2006**

**NetRevenues (in thousands)**
|                       | ** ** | **Three Months Ended** | ** ** | ** **         | ** ** | ** **        | ** ** |
|-----------------------|------------|----------------------------------|------------|--------------------|------------|-------------------|------------|
| ** **            | ** ** | **June 30,**                | ** ** | **March 31,** | ** ** | **June 30,** | ** ** | **2Q06-Over-** | ** ** | **2Q06-Over-** | ** ** |
| ** **            | ** ** | **2005**                         | ** ** | **2006**           | ** ** | **2006**          | ** ** | **2Q05 Change** | ** ** | **1Q06 Change** | ** ** |
| Memory Revenue        |       | $                                | 74,942     |               | $          | 80,038            |       | $ | 82,970 |   | $ | 8,028 |   | 10.7 | % | $ | 2,932 |   | 3.7 | % |
| Non-Memory  Revenue   |       | $                                | 9,940      |               | $          | 20,265            |       | $ | 15,968 |   | $ | 6,028 |   | 60.6 | % | $ | (4,297 | ) | (21.2 | )% |
| Product revenues      |       | $                                | 84,882     |               | $          | 100,303           |       | $ | 98,938 |   | $ | 14,056 |   | 16.6 | % | $ | (1,365 | ) | (1.4 | )% |
| Technology  licensing |       | $                                | 8,417      |               | $          | 10,228            |       | $ | 8,791 |   | $ | 374 |   | 4.4 | % | $ | (1,437 | ) | (14.0 | )% |
| Total net revenues    |       | $                                | 93,299     |               | $          | 110,531           |       | $ | 107,729 |   | $ | 14,430 |   | 15.5 | % | $ | (2,802 | ) | (2.5 | )% |

 
|                       | ** ** | **Six Months Ended** | ** ** | ** **        | ** ** |
|-----------------------|------------|--------------------------------|------------|-------------------|------------|
| ** **            | ** ** | **June 30,**              | ** ** | **June 30,** | ** ** | **2Q06-Over-** | ** ** |
| ** **            | ** ** | **2005**                       | ** ** | **2006**          | ** ** | **2Q05 Change** | ** ** |
| Memory Revenue        |       | $                              | 142,934    |              | $          | 163,008 |   | $ | 20,074 |   | 14.0 | % |
| Non-Memory  Revenue   |       | $                              | 21,218     |              | $          | 36,233 |   | $ | 15,015 |   | 70.8 | % |
| Product revenues      |       | $                              | 164,152    |              | $          | 199,241 |   | $ | 35,089 |   | 21.4 | % |
| Technology  licensing |       | $                              | 15,462     |              | $          | 19,019 |   | $ | 3,557 |   | 23.0 | % |
| Total net revenues    |       | $                              | 179,614    |              | $          | 218,260 |   | $ | 38,646 |   | 21.5 | % |

 

Netrevenues decreased 2.5% in the second quarter of 2006 from the first quarter of2006 primarily due to a 21.2% decrease in non-memory product revenue and lowertechnology license revenue due mainly to the timing of up-front license fees.Average selling prices of our products for the second quarter of 2006 decreased 2.8% from the first quarter of 2006due to product mix as well as pricing pressures on serial flash and higherdensity products. Net revenues for the second quarter of 2006 increased15.5% compared to the second quarter of 2005 due to a 13.7% increase in unitshipments, a 3.5% increase in blended average selling prices and increasedroyalty revenue. For the six months ended June 30, 2006, net revenuesincreased 21.5% as compared to the same period in the prior year due to a 19.3%increase in total units shipped and higher technology license revenue.

Thefollowing discussions are based on our reportable segments described in Note 10of the Notes to the Unaudited Condensed Consolidated Financial Statements.

*MemoryProducts*

Memory revenue increased 3.7% in the secondquarter of 2006 from the first quarter of 2006 primarily due to a 1.5% increasein unit shipments. Weaker demand for several consumer electronic and computerapplications led to the modest results. Memory revenue increased in the secondquarter of 2006 compared to the second quarter of 2005 primarily due to an 8.2%increase in unit shipments and a 2.5% increase in average selling prices. Theincreases came largely from increases in unit shipments of serial flashdevices, multi-purpose flash plus and ComboMemory

22

----

 

products. For the six months ended June 30,2006 compared to the same period in 2005, memory revenue increased due a 14.7%increase in unit shipments led primarily by increased activity of serial flashdevices and ComboMemory products.

*Non-MemoryProducts*

Non-memoryrevenue declined in the second quarter of 2006 from the first quarter of 2006primarily due to a 1.5% decrease in unit shipments and an 11.5% decrease in ouraverage selling price. Product mix and pricing pressures on some of oursmartcard ICs led to the declines. Non-memory revenue increased in the secondquarter of 2006 compared to the second quarter of 2005 primarily due to a 45.5%increase in unit shipments and a 17.0% increase in average selling prices dueto product mix. The increases came largely from increases in unit shipments ofNAND controllers and communications products. For the six months endedJune 30, 2006 compared to the same period in 2005, non-memory revenueincreased due to a 43.1% increase in unit shipments driven by NAND controllersand communications products.

*TechnologyLicensing Revenue*

Technologylicense revenue includes a combination of up-front fees and royalties.Technology licensing revenue for the second quarter of 2006 declined from thefirst quarter of 2006 as a result of lower upfront fees as well as somefluctuation in royalties. Technology licensing revenue for the second quarterof 2006 increased slightly compared to the second quarter of 2005 due to timingof fees. For the six months ended June 30, 2006 technology licenserevenues, compared to the same period in 2005, increased 22.8% primarily due tolicense fees on new and existing licenses. We anticipate revenues fromtechnology licensing may fluctuate significantly in the future.

###### **Gross Profit (in thousands)**

 
| ** **                         | ** ** | **Three Months Ended** | ** ** | ** **         | ** ** | ** **        | ** ** |
|------------------------------------|------------|----------------------------------|------------|--------------------|------------|-------------------|------------|
| ** **                         | ** ** | **June 30,**                | ** ** | **March 31,** | ** ** | **June 30,** | ** ** | **2Q06-Over-** | ** ** | **2Q06-Over-** | ** ** |
| ** **                         | ** ** | **2005**                         | ** ** | **2006**           | ** ** | **2006**          | ** ** | **2Q05 Change** | ** ** | **1Q06 Change** | ** ** |
| Memory gross profit                |       | $                                | 3,122      |               | $          | 17,936            |       | $ | 14,036 |   | $ | 10,914 |   | 349.6 | % | $ | (3,900 | ) | (21.7 | )% |
| Memory gross  margin               |       | 4.2                              | %          | 22.4               | %          | 16.9              | %          |   |   |   |   |   |   |   |   |
| Non-Memory gross profit            |       | $                                | (277       | )                  | $          | 5,749             |       | $ | 4,547 |   | $ | 4,824 |   | (1741.5 | )% | $ | (1,202 | ) | (20.9 | )% |
| Non-Memory gross  margin           |       | -2.8                             | %          | 28.4               | %          | 28.5              | %          |   |   |   |   |   |   |   |   |
| Product gross profit               |       | $                                | 2,845      |               | $          | 23,685            |       | $ | 18,583 |   | $ | 15,738 |   | 553.2 | % | $ | (5,102 | ) | (21.5 | )% |
| Product gross  margin              |       | 3.4                              | %          | 23.6               | %          | 18.8              | %          |   |   |   |   |   |   |   |   |
| Technology licensing  gross profit |       | 8,417                            |       | 10,228             |       | 8,791             |       | 374 |   | 4.4 | % | (1,437 | ) | (14.0 | )% |
| Technology  licensing gross margin |       | 100.0                            | %          | 100.0              | %          | 100.0             | %          |   |   |   |   |   |   |   |   |
| Total gross profit                 |       | $                                | 11,262     |               | $          | 33,913            |       | $ | 27,374 |   | $ | 16,112 |   | 143.1 | % | $ | (6,539 | ) | (19.3 | )% |
| Total gross margin                 |       | 12.1                             | %          | 30.7               | %          | 25.4              | %          |   |   |   |   |   |   |   |   |

 
|                                    | ** ** | **Six Months Ended** | ** ** | ** **        | ** ** | ** **           | ** ** |
|------------------------------------|------------|--------------------------------|------------|-------------------|------------|----------------------|------------|
| ** **                         | ** ** | **June 30,**              | ** ** | **June 30,** | ** ** | **2Q06-Over-**       | ** ** |
| ** **                         | ** ** | **2005**                       | ** ** | **2006**          | ** ** | **2Q05 Change** | ** ** |
| Memory gross  profit               |       | $                              | 4,073      |              | $          | 31,972               |       | $ | 27,899 |   | 685.0 | % |
| Memory gross margin                |       | 2.8                            | %          | 19.6              | %          |                 |       |   |   |
| Non-Memory gross  profit           |       | $                              | 4,320      |              | $          | 10,296               |       | $ | 5,976 |   | 138.3 | % |
| Non-Memory gross margin            |       | 20.4                           | %          | 28.4              | %          |                 |       |   |   |
| Product gross  profit              |       | $                              | 8,393      |              | $          | 42,268               |       | $ | 33,875 |   | 403.6 | % |
| Product gross margin               |       | 5.1                            | %          | 21.2              | %          |                 |       |   |   |
| Technology  licensing gross profit |       | $                              | 15,462     |              | $          | 19,019               |       | $ | 3,557 |   | 23.0 | % |
| Technology licensing gross margin  |       | 100.0                          | %          | 100.0             | %          |                 |       |   |   |
| Total gross  profit                |       | $                              | 23,855     |              | $          | 61,287               |       | $ | 37,432 |   | 156.9 | % |
| Total gross  margin                |       | 13.3                           | %          | 28.1              | %          |                 |       |   |   |

 

Grossmargin declined in the second quarter of 2006 compared to the first quarter of2006 as we shipped morehigher-density products that carry a relatively lower margin reducing ouroverall gross margin. Our blended average selling prices, which take intoaccount both product mix and selling prices decreased by 2.8% in the secondquarter, mainly due to product mix and the increased competition in the serialflash market. Gross profit more than doubled for the second quarter of2006 compared to the same period in 2005 due to a $6.2 million lower inventoryprovision

23

----

 

and a13.7% increase in the number of units shipped. For the year to date endedJune 30, 2006, compared to 2005, gross profit grew substantially as ourinventory provision was $15.2 million less and we shipped 48.4 million moreunits.

Forother factors that could affect our gross profit, please also see “Part II,Item 1A.”Risk Factors - We incurred material inventory valuation adjustments in2003, 2004 and 2005, and we may incur additional material inventory valuationadjustments in the future.”

*ProductGross Profit*

*Memoryproducts*

Grossprofit for memory products decreased in the second quarter of 2006 compared tothe first quarter of 2006 largely due to a decrease in the average sellingprices of memory products and the decline of gross margin percentage from theshipment of lower margin devices than the first quarter. Compared to the secondquarter of 2005, gross profit grew on a 1.5% increase in average selling pricescoupled with an 8.2% increase in units shipped. For the six months endedJune 30, 2006 gross profit grew substantially over 2005 due to a 14.7%increase in unit shipments as well as a lower provision for inventory andadverse purchase commitments in the current year.

*Non-memoryproducts*

Grossprofit for non-memory products decreased in the second quarter of 2006 comparedto the first quarter of 2006 due to lower revenue as a result of decreasedshipments and product mix. In comparison to the second quarter of 2005, unit shipmentsincreased 45.5% and our average selling price increased 17.0% due to productmix. For the six months ended June 30, 2006 in comparison to 2005, grossprofit rose on higher shipments in the current year. We expect some revenuefluctuation in non-memory business until at least late 2007 as we expect togrow and diversify our revenue and customer base.

OperatingExpenses (in thousands)

*Research and development*
| ** **                | ** ** | **Three Months Ended** | ** ** | ** **         | ** ** | ** **        | ** ** | ** **           | ** ** | ** **           | ** ** |
|---------------------------|------------|----------------------------------|------------|--------------------|------------|-------------------|------------|----------------------|------------|----------------------|------------|
| ** **                | ** ** | **June 30,**                | ** ** | **March 31,** | ** ** | **June 30,** | ** ** | **2Q06-Over-**       | ** ** | **2Q06-Over-**       | ** ** |
| ** **                | ** ** | **2005**                         | ** ** | **2006**           | ** ** | **2006**          | ** ** | **2Q05 Change** | ** ** | **1Q06 Change** | ** ** |
| Research and  development |       | $                                | 13,086     |               | $          | 15,167            |       | $                    | 13,093     |                 | $          | 7 |   | 0.1 | % | $ | (2,074 | ) | (13.7 | )% |
| Percent of revenue        |       | 14.0                             | %          | 13.7               | %          | 12.2              | %          |                 |       |                 |       |   |   |   |   |
|                           |            |                                  |            |                    |            |                   |            |                      |            |                      |            |  |  |  |  |  |  |  |  |  |

 
|                           | ** ** | **Six Months Ended** | ** ** | ** **        | ** ** | ** **           | ** ** |
|---------------------------|------------|--------------------------------|------------|-------------------|------------|----------------------|------------|
| ** **                | ** ** | **June 30,**              | ** ** | **June 30,** | ** ** | **2Q06-Over-**       | ** ** |
| ** **                | ** ** | **2005**                       | ** ** | **2006**          | ** ** | **2Q05 Change** | ** ** |
| Research and  development |       | $                              | 25,051     |              | $          | 28,260               |       | $ | 3,209 |   | 12.8 | % |
| Percent of  revenue       |       | 13.9                           | %          | 12.9              | %          |                 |       |   |   |
|                           |            |                                |            |                   |            |                      |            |  |  |  |  |  |

 

Research and development expenses include costsassociated with the development of new products, enhancements to existingproducts, quality assurance activities and occupancy costs. These costs consistprimarily of employee salaries, stock-based compensation expense and otherbenefit-related costs and the cost of materials such as wafers and masks.

In comparison to the first quarter of 2006, researchand development spending decreased due to the timing of $824 thousand of waferand evaluations parts expenses. In addition, headcount related benefit costsdecreased $838 thousand primarily due to the reversal of profit sharingaccruals as a result of reduced profitability in the second quarter of 2006.Research and development expenses were flat in the second quarter of 2006compared to the second quarter of 2005 primarily from stock-based compensationexpense of $791 thousand in the second quarter of 2006 as a result of theimplementation of SFAS No. 123(R) in 2006 was partially offset by reducedwafer and evaluation parts costs due to timing of engineering projects. For thesix months ended June 30, 2006 compared to the same period in 2005,increased research and development spending of $3.2 million was primarily dueto stock-based compensation expense of $1.8 million as a result of theimplementation of SFAS No. 123(R) in 2006, as well as increases in waferand evaluation parts, depreciation expense and increased patent fees,previously recorded in Sales and Marketing. We expect that research anddevelopment expenses will fluctuate based on the timing of engineering projectsfor new product introductions and the development of new technologies tosupport future growth.

24

----

 

*Sales andmarketing*
| ** **          | ** ** | **Three Months Ended** | ** ** | ** **         | ** ** | ** **        | ** ** | ** **           | ** ** | ** **           | ** ** |
|---------------------|------------|----------------------------------|------------|--------------------|------------|-------------------|------------|----------------------|------------|----------------------|------------|
| ** **          | ** ** | **June 30,**                | ** ** | **March 31,** | ** ** | **June 30,** | ** ** | **2Q06-Over-**       | ** ** | **2Q06-Over-**       | ** ** |
| ** **          | ** ** | **2005**                         | ** ** | **2006**           | ** ** | **2006**          | ** ** | **2Q05 Change** | ** ** | **1Q06 Change** | ** ** |
| Sales and marketing |       | $                                | 7,006      |               | $          | 8,161             |       | $                    | 7,042      |                 | $          | 36 |   | 0.5 | % | $ | (1,119 | ) | (13.7 | )% |
| Percent of revenue  |       | 7.5                              | %          | 7.4                | %          | 6.5               | %          |                 |       |                 |       |   |   |   |   |
|                     |            |                                  |            |                    |            |                   |            |                      |            |                      |            |  |  |  |  |  |  |  |  |  |

 
|                      | ** ** | **Six Months Ended** | ** ** | ** **        | ** ** | ** **           | ** ** |
|----------------------|------------|--------------------------------|------------|-------------------|------------|----------------------|------------|
| ** **           | ** ** | **June 30,**              | ** ** | **June 30,** | ** ** | **2Q06-Over-**       | ** ** |
| ** **           | ** ** | **2005**                       | ** ** | **2006**          | ** ** | **2Q05 Change** | ** ** |
| Sales and  marketing |       | $                              | 14,346     |              | $          | 15,203               |       | $ | 857 |   | 6.0 | % |
| Percent of  revenue  |       | 8.0                            | %          | 7.0               | %          |                 |       |   |   |
|                      |            |                                |            |                   |            |                      |            |  |  |  |  |  |

 

Salesand marketing expenses consist primarily of commissions, employee salaries,stock-based compensation expense and other benefit-related costs, as well astravel and entertainment expenses.

Salesand marketing expense decreased in the second quarter of 2006 compared to thefirst quarter of 2006 due to lower profit sharing and bonus accruals of $350thousand from reduced profitability in the second quarter of 2006. Commissionexpense also decreased $704 thousand. Sales and marketing expenses increasedslightly in the second quarter of 2006 compared to the second quarter of 2005primarily due to stock-based compensation expense of $237 thousand as a resultof the implementation of SFAS 123(R) in 2006 offset by decreased patent fees,now recorded in research and development. On a year-to-date basis, 2006spending was greater than the same period of 2005 primarily due to stock-basedcompensation expense of $497 thousand as a result of the implementation of SFAS123(R) in 2006. We expect that sales and marketing expenses may increase inabsolute dollars. In addition, fluctuations in revenues will cause fluctuationsin sales and marketing expenses due to our commission expenses.

*Generaland administrative*
| ** **                  | ** ** | **Three Months Ended** | ** ** | ** **         | ** ** | ** **        | ** ** | ** **           | ** ** | ** **           | ** ** |
|-----------------------------|------------|----------------------------------|------------|--------------------|------------|-------------------|------------|----------------------|------------|----------------------|------------|
| ** **                  | ** ** | **June 30,**                | ** ** | **March 31,** | ** ** | **June 30,** | ** ** | **2Q06-Over-**       | ** ** | **2Q06-Over-**       | ** ** |
| ** **                  | ** ** | **2005**                         | ** ** | **2006**           | ** ** | **2006**          | ** ** | **2Q05 Change** | ** ** | **1Q06 Change** | ** ** |
| General and  administrative |       | $                                | 7,123      |               | $          | 6,037             |       | $                    | 5,769      |                 | $          | (1,354 | ) | (19.0 | )% | $ | (268 | ) | (4.4 | )% |
| Percent of revenue          |       | 7.6                              | %          | 5.5                | %          | 5.4               | %          |                 |       |                 |       |   |   |   |   |
|                             |            |                                  |            |                    |            |                   |            |                      |            |                      |            |  |  |  |  |  |  |  |  |  |

 
|                             | ** ** | **Six Months Ended** | ** ** | ** **        | ** ** | ** **           | ** ** |
|-----------------------------|------------|--------------------------------|------------|-------------------|------------|----------------------|------------|
| ** **                  | ** ** | **June 30,**              | ** ** | **June 30,** | ** ** | **2Q06-Over-**       | ** ** |
| ** **                  | ** ** | **2005**                       | ** ** | **2006**          | ** ** | **2Q05 Change** | ** ** |
| General and  administrative |       | $                              | 13,825     |              | $          | 11,806               |       | $ | (2,019 | ) | (14.6 | )% |
| Percent of  revenue         |       | 7.7                            | %          | 5.4               | %          |                 |       |   |   |
|                             |            |                                |            |                   |            |                      |            |  |  |  |  |  |

 

Generaland administrative expenses mainly consist of salaries, stock-basedcompensation, and other-benefit related costs for administrative, executive andfinance personnel, recruiting costs, professional services and legal fees andallowances for doubtful accounts.

Generaland administrative expenses decreased in the second quarter of 2006 compared tothe first quarter of 2006 primarily due to the reversal of profit sharingaccruals of $175 thousand from reduced profitability in the second quarter of2006. In comparison to the second quarter of 2005, expenses decreased in thesecond quarter of 2006 due to lower external tax fees of $1.0 million relatedto contingency work associated with a tax refund project and outside servicesof $608 thousand primarily related to lower Sarbanes-Oxley compliance costspartially offset by the addition of stock compensation expense of $583 from theimplementation of SFAS 123(R). For the six months ended June 30, 2006compared to the same period in 2005, lower general and administrative expenseswere due to decreased external tax fees of $1.3 million, primarily due tocontingent work associated with a tax refund project and outside services of$1.6 million due to lower Sarbanes-Oxley compliance costs were partially offsetby stock-based compensation expense of $1.2 million as a result of theimplementation of SFAS No. 123(R) in 2006. In addition to the increasedexpense related to SFAS No. 123(R), we anticipate that general andadministrative expenses may increase in absolute dollars as we scale ourfacilities, infrastructure and headcount to support our overall expectedgrowth.

25

----

 

*Otheroperating expenses*
| ** **                | ** ** | **Three Months Ended** | ** ** | ** **         | ** ** | ** **        | ** ** | ** **           | ** ** | ** **           | ** ** |
|---------------------------|------------|----------------------------------|------------|--------------------|------------|-------------------|------------|----------------------|------------|----------------------|------------|
| ** **                | ** ** | **June 30,**                | ** ** | **March 31,** | ** ** | **June 30,** | ** ** | **2Q06-Over-**       | ** ** | **2Q06-Over-**       | ** ** |
| ** **                | ** ** | **2005**                         | ** ** | **2006**           | ** ** | **2006**          | ** ** | **2Q05 Change** | ** ** | **1Q06 Change** | ** ** |
| Other operating  expenses |       | $                                | 2,911      |               | $          | —            |       | $                    | —     |                 | $          | (2,911 | ) | (100.0 | )% | $ | — |   | 0.0 | % |
| Percent of revenue        |       | 3.1                              | %          | 0.0                | %          | 0.0               | %          |                 |       |                 |       |   |   |   |   |
|                           |            |                                  |            |                    |            |                   |            |                      |            |                      |            |  |  |  |  |  |  |  |  |  |

 
|                          | ** ** | **Six Months Ended** | ** ** | ** **        | ** ** | ** **           | ** ** |
|--------------------------|------------|--------------------------------|------------|-------------------|------------|----------------------|------------|
| ** **               | ** ** | **June 30,**              | ** ** | **June 30,** | ** ** | **2Q06-Over-**       | ** ** |
| ** **               | ** ** | **2005**                       | ** ** | **2006**          | ** ** | **2Q05 Change** | ** ** |
| Other operating expenses |       | $                              | 2,911      |              | $          | —               |       | $ | (2,911 | ) | (100.0 | )% |
| Percent of  revenue      |       | 1.6                            | %          | 0.0               | %          |                 |       |   |   |
|                          |            |                                |            |                   |            |                      |            |  |  |  |  |  |

During the second quarterof 2005, we recorded other operating expense of $2.9 million related toin-process research and development in conjunction with the acquisitions ofActrans Systems Inc. and the acquisition of the remaining minority interest inEmosyn and the settlement of our patent litigation case with Atmel. We incurredno other operating expenses during the first or second quarter of 2006.

*Other income and expense, net*
| ** **                  | ** ** | **Three Months Ended** | ** ** | ** **         | ** ** | ** **        | ** ** | ** **      | ** ** | ** **      | ** ** |
|-----------------------------|------------|------------------------|------------|--------------------|------------|-------------------|------------|-----------------|------------|-----------------|------------|
| ** **                  | ** ** | **June 30,**      | ** ** | **March 31,** | ** ** | **June 30,** | ** ** | **2Q06-Over-**  | ** ** | **2Q06-Over-**  | ** ** |
| ** **                  | ** ** | **2005**               | ** ** | **2006**           | ** ** | **2006**          | ** ** | **2Q05 Change** | ** ** | **1Q06 Change** | ** ** |
| Other income (expense), net |       | $                      | 1,014      |               | $          | 439               |       | $               | 1,056      |            | $          | 42 |   | 4.1 | % | $ | 617 |   | 140.5 | % |
| Percent of revenue          |       | 1.1                    | %          | 0.4                | %          | 1.0               | %          |            |       |            |       |   |   |   |   |
|                             |            |                        |            |                    |            |                   |            |                 |            |                 |            |  |  |  |  |  |  |  |  |  |

 
|                             | ** ** | **Six Months Ended** | ** ** | ** **        | ** ** | ** **      | ** ** |
|-----------------------------|------------|----------------------|------------|-------------------|------------|-----------------|------------|
| ** **                  | ** ** | **June 30,**    | ** ** | **June 30,** | ** ** | **2Q06-Over-**  | ** ** |
| ** **                  | ** ** | **2005**             | ** ** | **2006**          | ** ** | **2Q05 Change** | ** ** |
| Other income (expense), net |       | $                    | 1,215      |              | $          | 1,495           |       | $ | 280 |   | 23.0 | % |
| Percent of revenue          |       | 0.7                  | %          | 0.7               | %          |            |       |   |   |
|                             |            |                      |            |                   |            |                 |            |  |  |  |  |  |

Other income and expense for the periods presented included mainlyinterest and dividend income on our cash and investments. Other income (expense)increased during the three months ended June 30, 2006 in comparison to theprior quarter and the second quarter of 2005 due to higher levels of investedcash and higher short-term interest rates. We expect other income and expensewill fluctuate as a result of changes in cash balances and the timing fordividends on our investments.

*Interestexpense*
| ** **         | ** ** | **Three Months Ended** | ** ** | ** **         | ** ** | ** **        | ** ** | ** **      | ** ** | ** **      | ** ** |
|--------------------|------------|------------------------|------------|--------------------|------------|-------------------|------------|-----------------|------------|-----------------|------------|
| ** **         | ** ** | **June 30,**      | ** ** | **March 31,** | ** ** | **June 30,** | ** ** | **2Q06-Over-**  | ** ** | **2Q06-Over-**  | ** ** |
| ** **         | ** ** | **2005**               | ** ** | **2006**           | ** ** | **2006**          | ** ** | **2Q05 Change** | ** ** | **1Q06 Change** | ** ** |
| Interest expense   |       | $                      | 37         |               | $          | 79                |       | $               | 57         |            | $          | 20 |   | 54.1 | % | $ | (22 | ) | (27.8 | )% |
| Percent of revenue |       | 0.0                    | %          | 0.1                | %          | 0.1               | %          |            |       |            |       |   |   |   |   |
|                    |            |                        |            |                    |            |                   |            |                 |            |                 |            |  |  |  |  |  |  |  |  |  |

 
|                    | ** ** | **Six Months Ended** | ** ** | ** **        | ** ** | ** **      | ** ** |
|--------------------|------------|----------------------|------------|-------------------|------------|-----------------|------------|
| ** **         | ** ** | **June 30,**    | ** ** | **June 30,** | ** ** | **2Q06-Over-**  | ** ** |
| ** **         | ** ** | **2005**             | ** ** | **2006**          | ** ** | **2Q05 Change** | ** ** |
| Interest expense   |       | $                    | 58         |              | $          | 136             |       | $ | 78 |   | 134.5 | % |
| Percent of revenue |       | 0.0                  | %          | 0.1               | %          |            |       |   |   |
|                    |            |                      |            |                   |            |                 |            |  |  |  |  |  |

Interest expense remainedrelatively low as we do not have significant outstanding debt. Interest expensein the second quarter of 2006 decreased compared to the first quarter of 2006as we continued paying down our outstanding debt. For the six months endedJune 30, 2006 in comparison to the prior year interest expense was higherdue to our borrowings being outstanding for a longer period of time. As ofJune 30, 2006, we had no borrowings against our $35.0 million line ofcredit with Cathay Bank and had $3.0 million in borrowings against our $3.0million line revolving line of credit with Cathay Bank. If we borrow againstour credit lines in the future, interest expense will increase as a result ofthe borrowings.

26

----

 

*Equity investments*

Duringthe first quarter of 2006, we realized a pre-tax gain of $12.2 million from thesale of 4.0 million shares of our investment in Powertech Technology, Inc.or PTI. As of June 30, 2006, we owned 5.5 million shares of PTI.

Alsoduring the first quarter of 2006, we determined that our investment inNanotech, 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 reasonably estimated.

**Provision for Income Taxes**

Wemaintained a full valuation allowance on our net deferred tax assets as ofJune 30, 2006. The valuation allowance was determined in accordance withthe provisions of Statement of Financial Accounting Standards No. 109, orSFAS 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 years representedsufficient negative evidence under SFAS No. 109 such that a full valuationallowance was recorded against U.S. deferred tax assets. We intend to maintaina full valuation allowance in the U.S. deferred tax assets until sufficientpositive evidence exists to support reversal of the valuation allowance.

Ourtax provision for the three and six months ended June 30, 2006 was $1.0million and $3.3 million, respectively, which consists primarily of foreignwithholding taxes and tentative U.S. minimum tax.

**Liquidityand Capital Resources (in thousands)**
|                                                     | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------------|------------|--------------------------------|------------|
| ** **                                          | ** ** | **June 30,**              | ** ** | **June 30,** | ** ** |
| **Cash provided by (used in):** | ** ** | **2005**                       | ** ** | **2006** | ** ** |
| Operating activities                                |       | $                              | (47,554    | ) | $ | 29,284 |   |
| Investing activities                                |       | $                              | 54,614     |   | $ | (19,546 | ) |
| Financing Activities                                |       | $                              | 4,454      |   | $ | 678 |   |

*Operatingactivities.*The major contributing factors to our sources anduses of operating cash during the six months is our net income of $12.7 millionand the reduction of related party receivables of $17.9 million as a result ofpayments from our international customers. This was offset by decreasedaccounts payable from both related and unrelated parties of $16.0 million. Netincome was also affected by non-cash items in the first six months 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 $3.8million, depreciation and amortization expense of $5.0 million, a $3.5 millioncharge for the impairment of our in investment in Nanotech, Inc. and $8.4million charge to our inventory provision. Our operating activities used cashof $47.6 million for the six months ended June 30, 2005. Our net loss of$33.5 million for the six months ended June 30, 2005, included non-cashcharges of $23.7 million for provision against inventory, $4.7 million ofdepreciation and amortization, $1.7 million for purchasing in process researchand development and $1.7 million for provision of sales returns. In addition toour net loss, the primary usage of cash related to an increase in inventory of$33.2 million, decreased accounts payable from related and unrelated parties of$21.5 million and a decrease in accrued expenses and other liabilities of $4.0million.

*Investingactivities.*The primary use of cash from investing activitieswas $33.7 million in cash for the purchase for other available-for-saleinstruments as well as the $2.4 million in purchases of fixed assets to supportour operations came from the net sales offset by cash provided by the maturitiesand purchases of available-for-sale investments, primarily from the sales ofPTI shares that provided cash of $19.8 million. Our investing activitiesprovided cash of $54.6 million for the first six months of 2005. Cash providedby investing activities in the first half of 2005 was primarily attributable to$65.4 million of cash from the net sales and maturities of available-for-saleinvestments, offset by $7.8 million net cash used in the acquisition of Actransand the minority interest of Emosyn, $2.6 million in capital expenditures and$333 thousand in equity investments.

27

----

 

*Financingactivities.*Cash from financing activities in the six monthsof 2006 primarily related to the issuance of common stock under our employeestock purchase plan and the exercise of employee stock options of $1.4 millionoffset by capital lease payments of $602 thousand. Our financing activitiesprovided cash of $4.5 million during the first six months of 2005. Cashgenerated from financing activities in the first half of 2005 primarily relatedto the borrowing against the line of credit of $3.0 million and the issuance ofcommon stock under the employee stock purchase plan and the exercise ofemployee stock options totaling $1.7 million.

Principalsources of liquidity at June 30, 2006 consisted of $116.2 million of cash,cash equivalents and short-term available-for-sale investments. In addition, inAugust 2005, we entered into a 1-year loan and security agreement withCathay Bank, for a $35.0 million revolving line of credit. For more informationregarding the line of credit, refer to Note 8 of the Notes to the UnauditedCondensed Consolidated Financial Statements

As ofJune 30, 2006, other than as described below, there were no materialchanges in long-term debt obligations, capital lease obligations, operatinglease obligations, purchase obligations or any other long-term liabilitiesreflected on our condensed consolidated balance sheet as compared toDecember 31, 2005.

*PurchaseCommitments.*As of June 30, 2006, we had outstandingpurchase commitments with our foundry vendors of $45.4 million for delivery in2006. We have recorded a liability of $1.3 million for adverse purchasecommitments. In comparison, as of December 31, 2005, we had outstandingpurchase commitments with our foundry vendors of $51.7 million for delivery in2006, with a recorded liability of $1.8 million for adverse purchasecommitments.

*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. There can be no assurance that future events will not require us to seekadditional borrowings or capital and, if so required, that such borrowing orcapital 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 averageselling prices of our products;

·                  customer demandfor our products;

·                  the need tosecure future wafer production capacity from our suppliers;

·                  the timing ofsignificant orders and of license and royalty revenue;

·                  the ability to manageour inventory levels according to plan; and

·                  unanticipatedresearch and development expenses associated with new product introductions.

Please also see “Part II. Item 1A. “RiskFactors - Our operating results fluctuate significantly and an unanticipateddecline in revenues may disappoint securities analyst or investors and resultin a decline in our stock price.”

InJanuary and February 2005, multiple putative shareholder class actioncomplaints were filed against us and certain of our directors and officers inthe United States District Court for the Northern District of California.Following the filing of the putative class action lawsuits, multipleshareholder derivative complaints were filed in California Superior Court forthe County of Santa Clara, purportedly on behalf of SST against certain of ourdirectors and officers. In addition, in July 2006, multiple shareholderderivative complaints were filed against us and certain of our directors andofficers in the United States District Court for the Northern District ofCalifornia. In the event of unfavorable outcome of the suits, we may berequired to pay damages. For more information, please also see “Part II.Item 1A. “Risk Factors – We are engaged in securities class action suits andderivative suits, which may become time consuming, costly and divert managementresources and could impact our stock price.”

Fromtime to time, we are also involved in other legal actions arising in theordinary course of business. We have accrued certain costs associated withdefending these matters. There can be no assurance that the shareholder classaction complaints, the shareholder derivative complaints or other third partyassertions will be resolved without costly litigation, in a manner that is notadverse to our financial position, results of operations or cash flows orwithout requiring royalty payments in the future which may adversely impactgross margins. No estimate can be made of the possible loss or possible rangeof loss associated with the resolution of these contingencies. As a result, nolosses have been accrued in our financial statements as of June 30, 2006.

28

----

 

**RecentAccounting Pronouncements**

InSeptember 2005, the FASB ratified Emerging Issues Task Force IssueNo. 04-13, “*Accounting for Purchases and Sales of Inventory withthe Same Counterparty”,*or**EITF 04-13.EITF 04-13 discusses whether inventory purchase and sales transactionswith the same counterparty that are entered into in contemplation of oneanother should be combined and treated as a nonmonetary exchange and addresses(a) under what circumstances should two or more transactions with the samecounterparty (counterparties) be viewed as a single nonmonetarytransaction within the scope of APB Opinion No. 29, “*Accountingfor Nonmonetary Transactions*”,**or**APB 29, and FinancialAccounting Standard No. 153, *“Exchangesof 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. This pronouncement did not have a materialeffect on our consolidated financial statements.

In June 2006, theFASB issued FASB Interpretation No. 48, or FIN 48, “*Accountingfor Uncertainty in Income Taxes*”. FIN 48 provides interpretiveguidance for recognition and measurement of tax positions taken or expected tobe taken in a tax return. This interpretation is effective for fiscal yearsbeginning after December 15, 2006. We are reviewing the impact of FIN 48but we do not expect the adoption of FIN 48 to have a material impact on ourconsolidated financial statements.

**Item 3. Quantitative and Qualitative Disclosuresabout Market Risk**

We areexposed to risks associated with foreign exchange rate fluctuations due to ourinternational manufacturing and sales activities. These exposures may changeover time as business practices evolve and could negatively impact ouroperating results and financial condition. Currently, we do not hedge theseforeign exchange rate exposures. All of our sales are denominated in U.S.dollars. An increase in the value of the U.S. dollar relative to foreigncurrencies could make our products more expensive and therefore reduce thedemand for our products. Such a decline in the demand could reduce revenuesand/or result in operating losses. In addition, a downturn in the economies ofChina, Japan or Taiwan could impair the value of our equity investments incompanies with operations in these countries. If we consider the value of thesecompanies to be impaired, we will write off, or expense, some or all of ourinvestments. In 2005, we wrote down our investment in ACET by $2.2 millionsince ACET’s board of directors approved the issuance of a new round of equityfunding at a lower per share price than our carrying value. In the firstquarter of 2006, we determined that our investment in Nanotech, Inc. hadbecome impaired as Nanotech defaulted on its loan payments to certain of itsbusiness partners and began preparations to liquidate itself. As a result, wewrote our $3.3 million investment down to zero as well as an outstanding loanfor $225 thousand. We believe the chances of recovering this investment areremote and cannot be estimated.

At any time, fluctuations in interest rates couldaffect interest earnings on our cash, cash equivalents and available-for-saleinvestments, or the fair value of our investment portfolio. A 10% move ininterest rates as of June 30, 2006 would have an immaterial effect on ourfinancial position, results of operations and cash flows. Currently, we do nothedge these interest rate exposures. As of June 30, 2006, the carryingvalue of our available-for-sale investments approximated fair value. The tablebelow presents the carrying value and related weighted average interest ratesfor our unrestricted and restricted cash, cash equivalents andavailable-for-sale investments as of June 30, 2006 (in thousands):
| ** **                                              | ** ** | **Carrying** | ** ** | **Interest** | ** ** |
|---------------------------------------------------------|------------|--------------|------------|--------------|------------|
| ** **                                              | ** ** | **Value**    | ** ** | **Rate**     | ** ** |
| Cash and cash  equivalents - variable rate              |       | $            | 87,798     |         | 3.7        | % |
| Short-term avaialble-for-sale  investments - fixed rate |       | 28,371       |       | 4.8          | %          |
|                                                    |       | $            | 116,169    |         | 4.0        | % |

 

29

----

 

### **Item 4.Controls and Procedures**

**Disclosure Controls and Procedures**

We maintain disclosure controls and procedures that aredesigned to ensure that information required to be disclosed in our reportsfiled or submitted pursuant to the Securities Exchange Act of 1934, as amended,or the Exchange Act, is recorded, processed, summarized and reported within thetime periods specified in the Securities and Exchange Commission’s rules andforms. Disclosure controls and procedures also are designed to ensure that suchinformation is accumulated and communicated to our management, including ourChief Executive Officer and Chief Financial Officer, as appropriate, to allowtimely decisions regarding required disclosure. A control system, no matter howwell designed and operated, can provide only reasonable, not absolute,assurance that the control system’s objectives will be met.

Our management, with the participation of the ChiefExecutive Officer and Chief Financial Officer, conducted an evaluation of theeffectiveness of our disclosure controls and procedures (as defined in ExchangeAct Rules 13a-15(e) and 15d-15(e)) as of June 30, 2006. Based ontheir evaluation, the Chief Executive Officer and the Chief Financial Officerhave concluded that our disclosure controls and procedures were effective atthe reasonable assurance level as of June 30, 2006.

**Changes in Internal Control Over FinancialReporting**

Therehave been no changes in our internal control over financial reporting duringthe quarter ended June 30, 2006 that have materially affected or arereasonably likely to materially affect our internal control over financialreporting, as defined in Rule 13a-15(f) under the Exchange Act.

30

----

**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, the putative class actionswere consolidated under the caption *In reSilicon Storage Technology, Inc., Securities Litigation,* Case No. C05 00295 PJH (N.D. Cal.).  On May 3,2005, the Honorable Phyllis J. Hamilton appointed the “Louisiana Funds Group,”consisting of the Louisiana School Employees’ Retirement System and theLouisiana District Attorneys’ Retirement System, to serve as lead plaintiff andthe law firms of Pomeranz Haudek Block Grossman & Gross LLP and BermanDeValerio Pease Tabacco Burt & Pucillo to serve as lead counsel and liasoncounsel, respectively, for the class. The lead plaintiff filed a Consolidated Amended Class Action Complainton July 15, 2005.  The complaint seeksunspecified damages on alleged violations of federal securities laws during theperiod from April 21, 2004 to December 20, 2004.  We moved to dismiss the complaint onSeptember 16, 2005.  Plaintiff served anopposition to the motion to dismiss on November 4, 2005.  Our reply in further support of the motion todismiss was filed on December 19, 2005. On January 18, 2006, the Court heardarguments on the motion to dismiss.  OnMarch 10, 2006, the Court granted our motion to dismiss the consolidatedamended complaint, with leave to file an amended complaint. Plaintiffs filed asecond amended complaint on May 1, 2006. We responded with a motion to dismisson June 19, 2006. We intend to take all appropriate action in response to theselawsuits.  The impact related to theoutcome 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 ofthese complaints are substantially identical to those contained in the putativeshareholder class actions filed in federal court.  The derivative complaints assert claims for,among other things, breach of fiduciary duty and violations of the CaliforniaCorporations Code.  These derivativeactions have been consolidated under the caption *In ReSilicon Storage Technology, Inc. Derivative Litigation*, Lead CaseNo. 1:05CV034387 (Cal. Super. Ct., Santa Clara Co.).  On April 28, 2005, the derivative action wasstayed by court order.  We intend to takeall appropriate action in response to these lawsuits.  The impact related to the outcome of thesematters is undeterminable at this time.

On July 13, 2006, ashareholder derivative complaint was filed in the United States District Courtfor the Northern District of California by Mike Brien under the caption *Brien v. Yeh, et al*., Case No. C06-04310 JF (N.D. Cal.). OnJuly 18, 2006, a shareholder derivative complaint was filed in the UnitedStates District Court for the Northern District of California by BehradBazargani under the caption *Bazargani v. Yeh, et al*.,Case No. C06-04388 HRL (N.D. Cal.). Both complaints were brought purportedly onbehalf of us against certain of our current and former officers and directorsand allege among other things, that the named officers and directors: (a)breached their fiduciary duties as they colluded with each other to backdatestock options, (b) violated Rule 10b-5 of the Securities Exchange Act of 1934through their alleged actions, and (c) were unjustly enriched by their receiptand retention of such stock options. We intend to take all appropriate actionin responding to the complaints.

Fromtime to time, we are also involved in other legal actions arising in theordinary course of business.  We haveaccrued certain costs associated with defending these matters.  There can be no assurance that theshareholder class action complaints, the shareholder derivative complaints orother third party assertions will be resolved without costly litigation, in amanner that is not adverse to our financial position, results of operations orcash flows or without requiring royalty payments in the future which mayadversely impact gross margins. No estimate can be made of the possible loss orpossible range of loss associated with the resolution of these contingencies.  As a result,no losses have been accrued in our financial statements as of June 30, 2006.

31

----

 

**Item1A.   *Risk Factors***

**RisksRelated 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 half 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:

·                  the availability, timely delivery andcost of wafers or other manufacturing and assembly services from our suppliers;

·                  competitive pricing pressures andrelated changes in selling prices;

·                  fluctuations in manufacturing yieldsand significant yield losses;

·                  new product announcements andintroductions of competing products by us or our competitors;

·                  product obsolescence;

·                  lower of cost or market, obsolescenceor other inventory adjustments;

·                  changes in demand for, or in the mixof, our products;

·                  the gain or loss of significantcustomers;

·                  market acceptance of productsutilizing our SuperFlash® technology;

·                  changes in the channels through whichour products are distributed and the timeliness of receipt of distributorresale information;

·                  exchange rate fluctuations;

·                  general economic, political andenvironmental-related conditions, such as natural disasters;

·                  changes in our allowance for doubtfulaccounts;

·                  valuation allowances on deferred taxassets based on changes in estimated future taxable income;

·                  difficulties in forecasting, planningand management of inventory levels;

·                  unanticipated research anddevelopment 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 customerdemand. Therefore, we have limited ability to reduce expenses quickly inresponse to any 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:

·                  sudden drops in consumer demand whichmay cause customers to cancel backlog, push out shipment schedules, or reducenew orders, possibly due to a slowing economy or inventory corrections amongour customers;

·                  significant declines in sellingprices that occur because of competitive price pressure during an over-supplymarket environment;

·                  sudden shortages of raw materials forfabrication, test or assembly capacity constraints that lead our suppliers toallocate available supplies or capacity to other customers which, in turn, harmour ability to meet our sales obligations; and

·                  thereduction, rescheduling or cancellation of customer orders.

In addition, political oreconomic events beyond our control can suddenly result in increased operatingcosts.  In addition, we are now requiredto record compensation expense on stock option grants and purchases under ouremployee stock purchase plan which substantially increases our operating costsand impacts our earnings (loss) per share.

32

----

 

**We incurred significant inventoryvaluation and adverse purchase commitment adjustments in 2003, 2004, 2005 andin the first six months of 2006 and we may incur additional significantinventory valuation adjustments in the future.**

We typically planour production and inventory levels based on internal forecasts of customerdemand, which are highly unpredictable and can fluctuate materially. The valueof our inventory 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 of June 30, 2006, we had $94.4 million ofnet inventory on hand, a decrease of $13.9 million, or 12.8%, from December 31,2005.  Total valuation adjustments toinventory and adverse purchase commitments were $37.3 million in 2005 and $8.4million in the first six months of 2006. Due to the large number of units inour inventory, even a small change in average selling prices could result in asignificant adjustment and could harm our financial results.  Some of our customers have requested that weship them product that has a finished goods date of manufacture that is lessthan one year old.  As of June 30, 2006,our allowance for excess and obsolete inventories includes an allowance for ouron hand 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 thisbecomes a common requirement, it may be necessary for us to provide for anadditional allowance for our on hand finished goods inventory with a date ofmanufacture of greater than one year old, which could result in a significantadjustment and could harm our financial results.

**Cancellationsor rescheduling of backlog may result in lower future revenue and harm ourbusiness.**

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 ofbacklog during any particular period, or the failure of our backlog to resultin future revenue, could harm our business in the future. We experienced adecrease in the average selling prices of our products as a result of theindustry-wide oversupply and excessive inventory in the market in the secondhalf of 2004 and the first half of 2005. Although we saw strengthening ofmarket demand in the second half of 2005, demand weakened for some of ourproducts in the first six months of 2006. Our business could be further harmedby industry-wide prolonged downturns in the future.

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

During 2005 and the firstsix months of 2006, our international product and licensing revenues accountedfor 92.7%, 95.1% and 94.0% of our net revenues, respectively.  Our international business activities aresubject to a number of risks, each of which could impose unexpected costs on usthat would harm our operating results. These risks include:

·                  difficulties in complying withregulatory requirements and standards;

·                  tariffs and other trade barriers;

·                  costs and risks of localizingproducts for foreign countries;

·                  reliance on third parties todistribute our products;

·                  extended accounts receivable paymentcycles;

·                  potentially adverse tax consequences;

·                  limits on repatriation of earnings;and

·                  burdensof complying with a wide variety of foreign laws.

In addition, wehave made equity investments in companies with operations in several Asiancountries.  The value of our investmentsis subject to the economic and political conditions particular to theirindustry, their countries and to foreign exchange rates and to the globaleconomy.  If we determine that a changein the recorded value of an investment is other than temporary, we will adjustthe value of the investment.  Such anexpense could have a negative impact on our operating results.

We derived 86.0%, 87.6%and 87.4% of our net product revenues from Asia during 2004, 2005 and the firstsix months of 2006, respectively. Additionally, substantially all of our wafer suppliers and packaging andtesting subcontractors are located in Asia. Any kind of economic, political or environmental instability in thisregion of the world can have a severe negative impact on our operating resultsdue to the large concentration of our production and sales activities in thisregion. If countries where we do business experience severe currencyfluctuation and economic deflation, it can negatively impact our revenues andalso negatively impact our ability to collect payments from customers. In thisevent, the lack of capital in the financial sectors of these countries may makeit difficult for our customers to open letters of credit or other financialinstruments that are guaranteed by foreign banks.  Finally,

33

----

 

the economic situationcan exacerbate a decline in selling prices for our products as our competitorsreduce product prices to generate needed cash.

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 even escalate, resulting in an economicembargo, a disruption in shipping or even military hostilities.  Any of these events can delay production orshipment of our products.  Any kind ofactivity of this nature or even rumors of such activity can harm ouroperations, revenues, operating results, and stock price.

**Terroristattacks 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.  Any escalation in these events or similar futureevents may disrupt our operations or those of our customers, distributors andsuppliers, affect the availability of materials needed to manufacture ourproducts, or affect the means to transport those materials to manufacturingfacilities and finished products to customers. In addition, these events have had and may continue to have an adverseimpact on the U.S. and world economy in general and consumer spending inparticular, 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 certain as to future order levels from ourcustomers.  In the past, when we haveentered into a long-term contract, the contract has generally been terminableat the convenience of the customer.

**We dependon stocking representatives and distributors to generate a majority of ourrevenues.**

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 ourrelationship with any stocking representative or distributor could harm ouroperating results by impairing our ability to sell our products to our endcustomers.

**We dependon Silicon Professional Technology Ltd., or SPT, our logistics center, tosupport many of our customers in 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 logistic functions for usin these regions.  SPT is a wholly ownedsubsidiary of Professional Computer Technology, or PCT, which is one of ourstocking representatives in Taiwan. During 2004, 2005 and the first six months of  2006, SPT serviced end customer shipmentsaccounting for 52.9%, 58.5% and 59.4%, respectively, of our net productrevenues recognized.  As of December 31,2005 and June 30, 2006, SPT accounted for 69.6%, and 63.1% respectively, of ournet accounts receivable.  For furtherdescription of our relationships with PCT and SPT, please refer to “Item 7.Management’s Discussion and Analysis of Financial Condition and Results ofOperation - Related Party Transactions” in our Annual Report on Form 10-K forthe year ended 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 providing services 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 buy all of our wafers and sorteddie from a limited number of suppliers. The majority of our products are manufactured by five foundries,

34

----

 

TSMC in Taiwan,Seiko-Epson and Yasu in Japan and Grace and Shanghai Hua Hong NEC ElectronicCompany Limited, or HHNEC, in China.  Wehave invested $83.2 million in GSMC, a Cayman Islands company, which owns awafer foundry subsidiary, Grace, in Shanghai, China.  We anticipate that these foundries, togetherwith Sanyo in Japan, Samsung in Korea and Vanguard and Powerchip SemiconductorCorporation, or PSC, in Taiwan will manufacture substantially all of ourproducts in 2006.  If these suppliersfail to 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 ourfoundries.  The foundries with which wecurrently have arrangements, together with any additional foundry at whichcapacity might be obtained, may not be willing or able to satisfy all of ourmanufacturing requirements on a timely basis at favorable prices.  In addition, we have encountered delays inqualifying new products and in ramping-up new product production and we couldexperience these delays in the future. During the first quarter of 2006, weexperienced fabrication issues with one of our wafer foundries and capacityconstraints for certain package types at one of our backend suppliers. We arealso subject to the risks of service disruptions, raw material shortages andprice****increases by our foundries.  Such disruptions, shortages and priceincreases 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 that we have not foreseencould arise which would limit our capacity. Similar to our $83.2 million investment in GSMC, we may determine thatit is necessary to invest substantial capital in order to secure appropriateproduction capacity commitments.  If wecannot secure additional manufacturing capacity on acceptable terms, ourability to grow will be impaired and our operating results will be harmed.

**Our costof revenues may increase if we are required to purchase manufacturing capacityin the****future.**

To obtain additionalmanufacturing capacity, we may be required to make deposits, equipmentpurchases, loans, joint ventures, equity investments or technology licenses inor with wafer fabrication companies. These transactions could involve acommitment of substantial amounts of our capital and technology licenses inreturn for production capacity.  We maybe required to seek additional debt or equity financing if we need substantialcapital in order to secure this capacity and we cannot assure you that we willbe 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 manufacturingyields.  Semiconductor manufacturingyields are a function of both our design technology and the foundry’smanufacturing process technology.  Lowyields may result from marginal design or manufacturing process drift.  Yield problems may not be identified untilthe wafers are well into the production process, which often makes themdifficult, time consuming and costly to correct.  Furthermore, we rely on independent foundriesfor our wafers which increases the effort and time required to identify,communicate and resolve manufacturing yield problems.  If our foundries fail to achieve acceptablemanufacturing yields, we will experience higher costs of revenues and reducedproduct availability, which could 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 the risk that a foundry will ceaseproduction on an older or lower-volume manufacturing process that it uses toproduce 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.  Either one of these events could increase ourcosts and harm our ability to deliver our products on time.

35

----

 

**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.**

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

·                  reduced control over deliveryschedules and quality;

·                  the potential lack of adequatecapacity during periods of strong demand;

·                  difficulties selecting andintegrating new subcontractors;

·                  limited warranties on productssupplied to us;

·                  potential increases in prices due tocapacity 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.  Ourcustomers then complete the design, testing and evaluation process and begin toramp up production, a period which typically lasts an additional six months orlonger.  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 ourcompetitors have their own facilities for the production of semiconductormemory components and have recently added significant capacity for suchproduction.  As noted under the sectionentitled Competition in our Annual Report on Form 10-K for the year endedDecember 31, 2005, our low density memory products, medium density memoryproducts, and high density memory products (if we are successful in developingthese products) face substantial competition. In addition, we may in the future experience direct competition from ourfoundry partners.  We have licensed toour foundry partners the right to fabricate products based on our technologyand circuit design, and to sell such products worldwide, subject to our receiptof royalty payments. Competition may also come from alternative technologiessuch as ferroelectric random access memory devices, or FRAM, magneto-resistiverandom access memory, or MRAM, or other developing technologies.

**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:

·                  rapidly changing technologies;

·                  evolving and competing industrystandards;

·                  changing customer needs;

·                  frequent new product introductionsand enhancements;

·                  increased integration with otherfunctions; 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.  Inaddition, we must have our products designed into our customers’ futureproducts and maintain close working relationships with key customers in orderto develop new products that meet their changing needs.  In addition, products for communicationsapplications are based on continually evolving industry standards.  Our ability to compete will

36

----

 

depend on our ability toidentify and ensure compliance with these industry standards.  As a result, we could be required to investsignificant time and effort and incur significant expense to redesign ourproducts and ensure compliance with relevant standards.  We believe that products for theseapplications will encounter intense competition and be highly pricesensitive.  While we are currentlydeveloping and introducing new products for these applications, we cannotassure 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.

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 indeveloping or using new technologies or in developing new products or productenhancements that achieve market acceptance. Our pursuit of necessary technological advances may require substantialtime and expense.  Failure in any ofthese 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 is intense competition for qualifiedpersonnel in the semiconductor industry, in particular the highly skilleddesign, applications and test engineers involved in the development of flashmemory technology.  Competition isespecially intense in Silicon Valley, where our corporate headquarters islocated.  We may not be able to continueto attract and retain engineers or other qualified personnel necessary for thedevelopment of our business or to replace engineers or other qualifiedpersonnel who may leave our employ in the future.  Our anticipated growth is expected to placeincreased demands on our resources and will likely require the addition of newmanagement and engineering personnel and the development of additionalexpertise by existing management personnel. The failure to recruit and retain key design engineers or othertechnical and management personnel could harm our business.

**Ourability to compete successfully depends, in part, on our ability to protect ourintellectual property 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 continue to be necessary in the future to enforce ourintellectual property rights, to protect our trade secrets, to determine thevalidity and scope of the proprietary rights of others, or to defend againstclaims of infringement or invalidity. Litigation could result in substantial costs and diversion of resourcesand could harm our business, operating results and financial conditionregardless of the outcome of the litigation. We hold 190 patents in the United States relating to certain aspects ofour products and processes, with expiration dates ranging from 2010 to 2025 andhave filed for several more. In addition, we hold several patents in Europe,Japan, Korea, Taiwan, and China. We cannot assure you that any pending patentapplication will be granted.  Ouroperating results could be harmed by the failure to protect our intellectualproperty.

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

Securities class actionlaw suits are often brought against companies, particularly technologycompanies, following periods of volatility in the market price of theirsecurities.  Irrespective of the validityor the successful assertion of such claims, we could incur significant costsand management resources in defending against such claims. In January andFebruary 2005, multiple putative shareholder class action complaints were filedagainst SST and certain directors and officers, in the United States DistrictCourt for the Northern District of California, following our announcement ofanticipated financial results for the fourth quarter of 2004.  On March 24, 2005, the putative class actionswere consolidated under the caption *In reSilicon Storage Technology, Inc., Securities Litigation,* Case No. C05 00295 PJH (N.D. Cal.).  On May 3,2005, the Honorable Phyllis J. Hamilton appointed the “Louisiana Funds Group,”consisting of the Louisiana School Employees’ Retirement System and theLouisiana District Attorneys’ Retirement System, to serve as lead plaintiff andthe law firms of Pomeranz Haudek Block Grossman & Gross LLP and BermanDeValerio Pease Tabacco Burt & Pucillo to serve as lead counsel and liasoncounsel, respectively, for the class. The lead plaintiff filed a Consolidated Amended Class Action Complainton July 15, 2005.  The complaint seeksunspecified damages on alleged violations of federal securities laws during theperiod from April 21, 2004 to December 20, 2004.  We moved to dismiss the complaint onSeptember 16, 2005.  Plaintiff

37

----

 

served an opposition tothe motion to dismiss on November 4, 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 motion to dismiss.  On March 10, 2006, the Court granted ourmotion to dismiss the consolidated amended complaint, with leave to file anamended complaint. Pursuant to the Court’s Order, any amended complaint must befiled no later than May 1, 2006. Plaintiffs filed a second amended complaint onMay 1, 2006. We responded with a motion to dismiss on June 19, 2006. We intendto take all appropriate action in response to these lawsuits.  The impact related to the outcome of thesematters 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 ofthese complaints are substantially identical to those contained in the putativeshareholder class actions filed in federal court.  The derivative complaints assert claims for,among other things, breach of fiduciary duty and violations of the CaliforniaCorporations Code.  These derivativeactions have been consolidated under the caption *In ReSilicon Storage Technology, Inc. Derivative Litigation*, Lead CaseNo. 1:05CV034387 (Cal. Super. Ct., Santa Clara Co.).  On April 28, 2005, the derivative action wasstayed by court order.  We intend to takeall appropriate action in response to these lawsuits.

On July 13, 2006, ashareholder derivative complaint was filed in the United States District Courtfor the Northern District of California by Mike Brien under the caption *Brien v. Yeh, et al*., Case No. C06-04310 JF (N.D. Cal.). OnJuly 18, 2006, a shareholder derivative complaint was filed in the UnitedStates District Court for the Northern District of California by BehradBazargani under the caption *Bazargani v. Yeh, et al*.,Case No. C06-04388 HRL (N.D. Cal.). Both complaints were brought purportedly onbehalf of us against certain of our current and former officers and directorsand allege among other things, that the named officers and directors: (a)breached their fiduciary duties as they colluded with each other to backdatestock options, (b) violated Rule 10b-5 of the Securities Exchange Act of 1934through their alleged actions, and (c) were unjustly enriched by their receiptand retention of such stock options. We intend to take all appropriate actionin responding to the complaints.

*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 or investors perceive these results to benegative, it could harm the market price of 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 of discovery required in connection withthis type of litigation, there is a risk that some of our confidentialinformation could be compromised by disclosure. For more information with respect to our litigation, please also see “PartII, Item 1- Legal Proceedings.”

**If we are accused of infringingthe intellectual property rights of other parties we may become subject to timeconsuming and costly litigation.  If welose, we could suffer a significant impact on our business and be forced to paydamages.**

Third parties may assertthat our products infringe their proprietary rights, or may assert claims forindemnification resulting from infringement claims against us.  Any such claims may cause us to delay orcancel shipment of our products or pay damages that could harm our business,financial condition and results of operations. In addition, irrespective of thevalidity or the successful assertion of such claims, we could incur significantcosts in defending against such claims.

In the past, we were suedby Atmel Corporation and Intel Corporation, among others, regarding patentinfringement.  Significant managementtime and financial resources were devoted to defending these lawsuits.  We settled with Intel in May 1999 and withAtmel in 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 ofour products is based on SuperFlash technology, any legal finding that the useof our SuperFlash technology infringes the patent of another company would havea significantly negative effect on our entire product line and operatingresults.  Furthermore, if such a findingwere made, there can be no assurance that we could license the other company’stechnology on commercially reasonable terms or that we could successfullyoperate without such technology. Moreover, if we are found to infringe, we could be required to paydamages to the owner of the

38

----

 

protected technology andcould be prohibited from making, using, selling, or importing into the UnitedStates any products that infringe the protected technology.  In addition, the management attentionconsumed by and legal cost associated with any litigation could harm ouroperating results. During the course of these lawsuits there may be publicannouncements of the results of hearings, motions, and other interimproceedings or developments in the litigation. If securities analysts or investors perceive these results to benegative, it could harm the market 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 corporateheadquarters are located in California near major earthquake faults.  In addition, some of our suppliers arelocated near fault lines.  In the eventof a major earthquake or other natural disaster near our headquarters, ouroperations could be harmed.  Similarly, amajor earthquake or other natural disaster such as typhoon near one or more ofour major suppliers, like the earthquakes in September 1999 and March 2002 orthe typhoons 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.

**A virusor viral outbreak in Asia could harm our business.**

Wederive substantially all of our revenues from Asia and our logistics center islocated in Taiwan.  A virus or viraloutbreak in Asia, such as the SARS outbreak in early 2003 or the current threatof the Avian flu, could harm the operations of our suppliers, distributors,logistics center and those of our end customers, which could harm our business.

**Prolongedelectrical power outages, energy shortages, or increased costs of energy couldharm our business.**

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 systems at our main California facilities are on batteryback-up.  ****Inaddition, all of our engineering and back-up servers and selected corporateservers are on generator back-up****.  While the majority of our productionfacilities are not located in California, more extensive power shortages in thestate could delay our design and process research and development as well asincrease 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 have implemented a supply-chain managementsystem and a vendor electronic data interface system.  There is no guarantee that these measures, inthemselves, will be adequate to address any growth, or that we will be able toforesee in a timely manner other infrastructure needs before they arise.  Our success depends on the ability of ourexecutive officers to effectively manage our growth.  If we are unable to manage our growtheffectively, our results of operations will be harmed.  If we fail to successfully implement newmanagement information systems, our business may suffer severe inefficienciesthat may harm the results 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 in accounting standards or practices ora change in existing taxation rules or practices can have a significant effecton our reported results and may even affect reporting of transactions completedbefore the change is effective. New accounting pronouncements and taxationrules and varying interpretations of accounting pronouncements and taxationpractice have occurred and may occur in the future. Changes to existing rulesor the questioning of current practices may adversely affect our reportedfinancial results or the way we conduct our business. For example, we adoptedSFAS No. 123(R) in the first quarter of 2006 which requires us to recordcharges to earnings for the stock options we grant and purchases of our commonstock under our employee stock purchase plan.

39

----

 

**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 and NASDAQMarketplace rules are creating uncertainty for public companies.  We continually evaluate and monitordevelopments with respect to new and proposed rules and cannot predict orestimate the amount of the additional costs we may incur or the timing of suchcosts.  These new or changed laws,regulations and standards are subject to varying interpretations, in many casesdue to their lack of specificity, and as a result, their application inpractice may evolve over time as new guidance is provided by regulatory andgoverning bodies.  This could result incontinuing uncertainty regarding compliance matters and higher costsnecessitated by ongoing revisions to disclosure and governance practices.  We are committed to maintaining highstandards of corporate governance and public disclosure.  As a result, we have invested resources tocomply with evolving laws, regulations and standards, and this investment hasresulted in increased general and administrative expenses and a diversion ofmanagement time and attention from revenue-generating activities to complianceactivities.  If our efforts to complywith new or changed laws, regulations and standards differ from the activitiesintended by regulatory or governing bodies due to ambiguities related topractice, regulatory authorities may initiate legal proceedings against us andwe may be harmed.

**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, such events could cause ourcurrent and potential stockholders to lose confidence in our financialreporting, which would harm our business and the trading price of our 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.

40

----

 

**Acquisitionscould result in operating difficulties, dilution and other harmfulconsequences.**

Over the past twoyears we have acquired Emosyn, LLC a fablesssemiconductor manufacturer specializing in the design and marketing of smartcard ICs for subscriber identification module 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 companythat designs 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 such transactions could be material to our financial condition and results ofoperations. There is no assurance that any such discussions or negotiationswill result in the consummation of any transaction. The process of integratingany acquired business may create unforeseen operating difficulties andexpenditures and is itself risky. The areas where we may face difficultiesinclude:

·                       diversion of management time, aswell as a shift of focus from operating the businesses to issues of integrationand future products;

·                       declining employee morale andretention issues resulting from changes in compensation, reportingrelationships, future prospects, or the direction of the business;

·                       the need to integrate eachcompany’s accounting, management information, human resource and otheradministrative systems to permit effective management, and the lack of controlif such integration is delayed or not implemented;

·                       the need to implement controls,procedures and policies appropriate for a public company at companies thatprior to acquisition had lacked such controls, procedures and policies; and insome cases, the need to transition operations onto our platforms and

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

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.

**RisksRelated to Our Industry**

**Oursuccess is dependent on the growth 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 technology other than SuperFlash maybe adopted as an industry standard.  Ourcompetitors are generally in a better financial and marketing position than weare from which to influence industry acceptance of a particular memorytechnology.  In particular, a primarysource of competition may come from alternative technologies such as FRAM orMRAM devices if such technology is commercialized for higher densityapplications.  To the extent ourcompetitors are able to promote a technology other than SuperFlash as anindustry standard, our business will be 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 the industry experiences downturns, theyoften occur in connection with, or in anticipation of, maturing product cyclesand declines in general economic conditions. These downturns are characterizedby weak product demand, excessive inventory and accelerated decline of sellingprices.  We experienced a decrease in theaverage 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 first halfof 2006 although pricing remained stable. Our business could be further harmedby 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.**

Salesof our products in the consumer electronics applications market are subject toseasonality.  As a result, sales of theseproducts are impacted by seasonal purchasing patterns with higher salesgenerally occurring in the second half of each year.  In the past we have been able to mitigatesuch seasonality with the introduction of new products throughout theyear.  If we fail to continue tointroduce new products, our business may suffer and the seasonality of a portionof our sales may become more pronounced.

41

----

 

**Item 4.  Submission of Matters to a Vote of Security Holders**

OurAnnual Meeting of Shareholders was held on June 12, 2006. At the AnnualMeeting, the shareholders:

1.               elected the personslisted below to serve as directors of SST for the ensuing year and until theirsuccessors are elected,

2.               failed to approvethe amendment to the 1995 Equity Incentive Plan, as amended, to provide that(i) nonstatutory stock options may be granted to ten percent shareholders withan exercise price set by the Board of Directors with a maximum term of tenyears and (ii) restricted stock purchase awards may be granted to ten percentshareholders with a purchase price that is at least 85% of the fair marketvalue of such stock on the date of grant,

3.               ratified theselection of PricewaterhouseCoopers LLP as our independent registered publicaccounting firm  for the fiscal yearending December 31, 2006.

OnApril 20, 2006, the record date of the Annual Meeting, we had 103,155,985shares of Common Stock outstanding. At the Annual Meeting, holders of85,184,658 shares of Common Stock were present in person or represented byproxy. The following sets forth information regarding the results of the votingat the Annual Meeting.

Proposal1 - Election of Directors
| Director           | ** ** | **Votes in Favor** | ** ** | **Withheld** | ** ** |
|--------------------|------------|--------------------|------------|--------------|------------|
|               |       |               |       |         |       |
| Bing Yeh           |       | 76,626,389         |       | 8,558,269    |       |
|               |       |               |       |         |       |
| Yaw Wen Hu         |       | 78,976,567         |       | 6,208,091    |       |
|               |       |               |       |         |       |
| Tsuyoshi Taira     |       | 78,938,904         |       | 6,245,754    |       |
|               |       |               |       |         |       |
| Yasushi  Chikagami |       | 65,247,856         |       | 19,936,802   |       |
|               |       |               |       |         |       |
| Ronald Chwang      |       | 79,121,171         |       | 6,063,487    |       |
|               |       |               |       |         |       |
| Terry Nickerson    |       | 79,157,094         |       | 6,027,564    |       |

Proposal 2 – Approval of the 1995 Equity IncentivePlan, as amended.
| Votes in Favor |   | 21,424,767 |   |
|----------------|--------|------------|--------|
|           |   |       |   |
| Votes Against  |   | 23,623,247 |   |
|           |   |       |   |
| Abstentions    |   | 1,264,869  |   |

Proposal 3 - Ratification of Selection of IndependentRegistered Public Accounting Firm
| Votes in Favor |   | 84,672,477 |   |
|----------------|--------|------------|--------|
|           |   |       |   |
| Votes Against  |   | 315,940    |   |
|           |   |       |   |
| Abstentions    |   | 196,241    |   |

 

42

----

 

**Item 6.  Exhibits.**

(a)                                  *Exhibits.*

Weincorporate by reference all exhibits filed in connection with our Annual Reporton Form 10-K for the year ended December 31, 2005.
| 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 and Exhibit 32.2 accompany theQuarterly Report on Form 10-Q, are not deemed filed with the Securities andExchange Commission and are not to be incorporated by reference into any filingof Silicon Storage Technology, Inc. under the Securities Act of 1933, asamended, or the Securities Exchange Act of 1934, as amended (whether madebefore or after the date of the Form 10-Q), irrespective of any generalincorporation language contained in such filing.

43

----

 

**SIGNATURES**

Pursuant to the requirements ofthe Securities Exchange Act of 1934, the Registrant has caused this report tobe signed on its behalf by the undersigned, thereunto duly authorized, in theCity of Sunnyvale, County of Santa Clara, State of California, on the 4th day ofAugust, 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)* |
|          |                                   |  |  |  |

 

44

----