**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-Q**

**(Mark One)**

**x****QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.**

**For thequarterly period ended September 30, 2006**

**OR**

**o****TRANSITION REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.**

**For thetransition period from                  to                  .**

**CommissionFile Number 0-26944**

****

**SILICON STORAGETECHNOLOGY, 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 TelephoneNumber, including Area Code)

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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 o  No x

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

| Large Accelerated filer o |   | Accelerated filer x |   | Non-accelerated filer 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, October 31, 2006:  103,562,820.

 

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**SILICON STORAGE TECHNOLOGY,INC.**

**FORM 10-Q: QUARTER ENDEDSEPTEMBER 30, 2006**

**TABLE 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 |   | 21 |
|                                |       |                                                                                        |   |   |
|                                | Item 3.    | Quantitative  and Qualitative Disclosures About Market Risk                                 |   | 31 |
|                                |       |                                                                                        |   |   |
|                                | Item 4.    | Controls and  Procedures                                                                    |   | 31 |
|                                |       |                                                                                        |   |   |
| **Part  II - OTHER INFORMATION**    |       |                                                                                        |
| ** **                          |       |                                                                                        |
|                                | Item 1.    | Legal Proceedings                                                                           |   | 33 |
|                                |       |                                                                                        |   |   |
|                                | Item  1A.  | Risk  Factors                                                                               |   | 34 |
|                                |       |                                                                                        |   |   |
|                                | Item 5.    | Other Information                                                                           |   | 44 |
|                                |       |                                                                                        |   |   |
|                                | Item  6.   | Exhibits                                                                                    |   | 44 |
|                                |       |                                                                                        |   |   |
|                                | Signatures |                                                                                        | 45 |

 

2

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**PART I - FINANCIAL INFORMATION**

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

**SILICON STORAGE TECHNOLOGY, INC. AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS(Unaudited)(in thousands, except per share data)**
| ** **                                                                                                                             | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                                             | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                                                                                             | ** ** | **2005**                         | ** ** | **2006**                        | ** ** | **2005** | ** ** | **2006** | ** ** |
|                                                                                                                                   |       | **As Adjusted**                  |       |                            |       | **As Adjusted** |   |   |   |
|                                                                                                                                   |       | **(Note 13)**               |       |                            |       | **(Note 13)** |   |   |   |
| Net revenues:                                                                                                                          |       |                             |       |                            |       |   |   |   |   |
| Product revenues  - unrelated parties                                                                                                  |       | $                                | 40,509     |                            | $          | 44,125 |   | $ | 115,002 |   | $ | 122,932 |   |
| Product revenues  - related parties                                                                                                    |       | 67,215                           |       | 63,385                          |       | 156,874 |   | 183,819 |   |
| Technology  licensing                                                                                                                  |       | 10,319                           |       | 8,443                           |       | 25,650 |   | 26,084 |   |
| Technology  licensing - related parties                                                                                                |       | 29                               |       | 65                              |       | 160 |   | 1,443 |   |
| Total net  revenues                                                                                                                    |       | 118,072                          |       | 116,018                         |       | 297,686 |   | 334,278 |   |
|                                                                                                                                   |       |                             |       |                            |       |   |   |   |   |
| Cost of revenues:                                                                                                                      |       |                             |       |                            |       |   |   |   |   |
| Cost of revenues  - unrelated parties                                                                                                  |       | 34,407                           |       | 32,481                          |       | 100,116 |   | 89,555 |   |
| Cost of revenues  - related parties                                                                                                    |       | 64,520                           |       | 53,250                          |       | 154,570 |   | 153,149 |   |
| Total cost of  revenues                                                                                                                |       | 98,927                           |       | 85,731                          |       | 254,686 |   | 242,704 |   |
| Gross profit                                                                                                                           |       | 19,145                           |       | 30,287                          |       | 43,000 |   | 91,574 |   |
|                                                                                                                                   |       |                             |       |                            |       |   |   |   |   |
| Operating expenses:                                                                                                                    |       |                             |       |                            |       |   |   |   |   |
| Research and  development                                                                                                              |       | 11,770                           |       | 12,313                          |       | 36,821 |   | 40,573 |   |
| Sales and  marketing                                                                                                                   |       | 7,178                            |       | 6,829                           |       | 21,524 |   | 22,032 |   |
| General and  administrative                                                                                                            |       | 5,683                            |       | 5,437                           |       | 19,508 |   | 17,243 |   |
| Other operating  expenses                                                                                                              |       | (16                              | )          | —                          |       | 2,895 |   | — |   |
| Total operating  expenses                                                                                                              |       | 24,615                           |       | 24,579                          |       | 80,748 |   | 79,848 |   |
| Income (loss) from  operations                                                                                                         |       | (5,470                           | )          | 5,708                           |       | (37,748 | ) | 11,726 |   |
| Other income (expense),  net                                                                                                           |       | 556                              |       | 2,560                           |       | 2,032 |   | 4,104 |   |
| Interest expense                                                                                                                       |       | (98                              | )          | (111                            | )          | (156 | ) | (247 | ) |
| Gain on sale of equity  investments                                                                                                    |       | —                           |       | —                          |       | — |   | 12,206 |   |
| Impairment of equity  investments                                                                                                      |       | —                           |       | —                          |       | — |   | (3,523 | ) |
| Income (loss) before  provision for (benefit from) income taxes, pro rata share of loss from equity  investments and minority interest |       | (5,012                           | )          | 8,157                           |       | (35,872 | ) | 24,266 |   |
| Provision for (benefit  from) income taxes                                                                                             |       | (403                             | )          | 2,800                           |       | 2,037 |   | 6,115 |   |
| Minority interest                                                                                                                      |       | —                           |       | —                          |       | (77 | ) | — |   |
| Income (loss) before  pro rata share of loss from equity investments                                                                   |       | (4,609                           | )          | 5,357                           |       | (37,832 | ) | 18,151 |   |
| Pro rata share of loss from  equity investments                                                                                        |       | (427                             | )          | (614                            | )          | (1,267 | ) | (1,087 | ) |
| Net income (loss)                                                                                                                      |       | $                                | (5,036     | )                               | $          | 4,743 |   | $ | (39,099 | ) | $ | 17,064 |   |
| Net income (loss) per  share - basic                                                                                                   |       | $                                | (0.05      | )                               | $          | 0.05 |   | $ | (0.39 | ) | $ | 0.17 |   |
| Shares used in per  share calculation - basic                                                                                          |       | 102,677                          |       | 103,495                         |       | 100,899 |   | 103,271 |   |
| Net income (loss) per  share - diluted                                                                                                 |       | $                                | (0.05      | )                               | $          | 0.05 |   | $ | (0.39 | ) | $ | 0.16 |   |
| Shares used in per share calculation - diluted                                                                                         |       | 102,677                          |       | 104,732                         |       | 100,899 |   | 104,667 |   |

 

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

3

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

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(Unaudited)**

**(inthousands)**
| ** **                                                                                                                                        | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|------------------------|------------|
| ** **                                                                                                                                        | ** ** | **2005**              | ** ** | **2006**               | ** ** |
| ** **                                                                                                                                        | ** ** | ** **            | ** ** | ** **             | ** ** |
| ** **                                                                                                                                        | ** ** | ** **            | ** ** | ** **             | ** ** |
| **ASSETS**                                                                                                                                        |       |                  |       |                   |       |
| ** **                                                                                                                                        |       |                  |       |                   |       |
| Current assets:                                                                                                                                   |       |                  |       |                   |       |
| Cash and cash equivalents                                                                                                                         |       | $                     | 77,382     |                   | $          | 85,056 |   |
| Short-term available-for-sale investments                                                                                                         |       | 1,008                 |       | 37,945                 |       |
| Trade accounts receivable-unrelated parties, net of  allowance for doubtful accounts of $758 at December 31, 2005 and $879 at  September 30, 2006 |       | 21,378                |       | 19,392                 |       |
| Trade accounts receivable-related parties                                                                                                         |       | 55,858                |       | 43,162                 |       |
| Inventories                                                                                                                                       |       | 108,343               |       | 86,109                 |       |
| Other current assets                                                                                                                              |       | 13,109                |       | 12,711                 |       |
| Total current assets                                                                                                                              |       | 277,078               |       | 284,375                |       |
|                                                                                                                                              |       |                  |       |                   |       |
| Property and  equipment, net                                                                                                                      |       | 19,415                |       | 18,264                 |       |
| Long-term  available-for-sale investments                                                                                                         |       | 39,057                |       | 23,998                 |       |
| Equity  investments, GSMC                                                                                                                         |       | 83,150                |       | 83,150                 |       |
| Equity  investments, others                                                                                                                       |       | 12,962                |       | 27,360                 |       |
| Goodwill                                                                                                                                          |       | 29,637                |       | 29,637                 |       |
| Intangible  assets, net                                                                                                                           |       | 11,816                |       | 10,833                 |       |
| Other assets                                                                                                                                      |       | 4,722                 |       | 2,083                  |       |
| Total assets                                                                                                                                      |       | $                     | 477,837    |                   | $          | 479,700 |   |
|                                                                                                                                              |       |                  |       |                   |       |
| **LIABILITIES**                                                                                                                                   |       |                  |       |                   |       |
|                                                                                                                                              |       |                  |       |                   |       |
| Current  liabilities:                                                                                                                             |       |                  |       |                   |       |
| Notes payable, current portion                                                                                                                    |       | $                     | 39         |                   | $          | — |   |
| Borrowing under line of credit facility                                                                                                           |       | 3,000                 |       | 3,032                  |       |
| Trade accounts payable-unrelated parties                                                                                                          |       | 48,660                |       | 22,638                 |       |
| Trade accounts payable-related parties                                                                                                            |       | 21,867                |       | 33,906                 |       |
| Accrued expenses and other liabilities                                                                                                            |       | 17,318                |       | 22,053                 |       |
| Deferred revenue                                                                                                                                  |       | 4,493                 |       | 4,209                  |       |
| Total current liabilities                                                                                                                         |       | 95,377                |       | 85,838                 |       |
|                                                                                                                                              |       |                  |       |                   |       |
| Other  liabilities                                                                                                                                |       | 2,627                 |       | 2,159                  |       |
| Total liabilities                                                                                                                                 |       | 98,004                |       | 87,997                 |       |
|                                                                                                                                              |       |                  |       |                   |       |
| 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 103,561 shares at September 30, 2006                  |       | 377,027               |       | 385,687                |       |
| Accumulated  other comprehensive income                                                                                                           |       | 31,780                |       | 17,926                 |       |
| Accumulated  deficit                                                                                                                              |       | (28,974               | )          | (11,910                | )          |
| Total shareholders’ equity                                                                                                                   |       | 379,833               |       | 391,703                |       |
| Total  liabilities and shareholders’ equity                                                                                                  |       | $                     | 477,837    |                   | $          | 479,700 |   |

 

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

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

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

**(inthousands)**
| ** **                                                                                                 | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                 | ** ** | **September 30,**          | ** ** |
| ** **                                                                                                 | ** ** | **2005**                        | ** ** | **2006** | ** ** |
|                                                                                                       |       | **As Adjusted**                 |       |   |   |
|                                                                                                       |       | **(Note 13)**              |       |   |   |
| Cash flows from  operating activities:                                                                     |       |                            |       |   |   |
| Net income (loss)                                                                                          |       | $                               | (39,099    | ) | $ | 17,064 |   |
| Adjustments to reconcile net income (loss) to net  cash provided by (used in) operating activities:        |       |                            |       |   |   |
| Depreciation and amortization                                                                              |       | 7,154                           |       | 7,511 |   |
| Purchased in process research and development                                                              |       | 1,661                           |       | — |   |
| Stock-based compensation expense                                                                           |       | —                          |       | 6,130 |   |
| Provision (credits) for doubtful accounts receivable                                                       |       | 245                             |       | 59 |   |
| Provision for sales returns                                                                                |       | 1,815                           |       | 384 |   |
| Provision for excess and obsolete inventories,  write-down of inventories and adverse purchase commitments |       | 32,067                          |       | 11,889 |   |
| Loss in equity interest                                                                                    |       | 1,267                           |       | 1,087 |   |
| Impairment loss on equity investment                                                                       |       | —                          |       | 3,523 |   |
| Gain on sale of equity investments                                                                         |       | —                          |       | (12,206 | ) |
| (Gain) loss on disposal of equipment                                                                       |       | 82                              |       | (5 | ) |
| Minority interest                                                                                          |       | (77                             | )          | — |   |
| Changes in operating assets and liabilities:                                                               |       |                            |       |   |   |
| Trade accounts receivable-unrelated parties                                                                |       | 2,254                           |       | 1,535 |   |
| Trade accounts receivable-related parties                                                                  |       | (20,111                         | )          | 12,704 |   |
| Inventories                                                                                                |       | (6,018                          | )          | 8,946 |   |
| Other current and non-current assets                                                                       |       | 3,966                           |       | 2,802 |   |
| Trade accounts payable-unrelated parties                                                                   |       | (14,839                         | )          | (25,582 | ) |
| Trade accounts payable-related parties                                                                     |       | (13,415                         | )          | 12,039 |   |
| Accrued expenses and other liabilities                                                                     |       | (8,906                          | )          | 5,926 |   |
| Deferred revenue                                                                                           |       | 1,438                           |       | (284 | ) |
| Net cash provided by (used in) operating activities                                                        |       | (50,516                         | )          | 53,522 |   |
|                                                                                                       |       |                            |       |   |   |
| Cash flows from  investing activities:                                                                     |       |                            |       |   |   |
| Acquisitions, net of cash                                                                                  |       | (7,818                          | )          | — |   |
| Investments in equity securities                                                                           |       | (333                            | )          | (18,854 | ) |
| Purchase of property and equipment                                                                         |       | (4,139                          | )          | (3,628 | ) |
| Proceeds from sale of equipment                                                                            |       | 4                               |       | 11 |   |
| Purchase of intellectual property license                                                                  |       | —                          |       | (494 | ) |
| Purchases of available-for-sale investments                                                                |       | (21,584                         | )          | (49,875 | ) |
| Sales and maturities of available-for-sale and  equity investments                                         |       | 88,010                          |       | 26,428 |   |
| Net cash provided by (used in) investing activities                                                        |       | 54,140                          |       | (46,412 | ) |
|                                                                                                       |       |                            |       |   |   |
| Cash flows from  financing activities:                                                                     |       |                            |       |   |   |
| Debt repayments                                                                                            |       | (325                            | )          | (857 | ) |
| Repayments against line of credit                                                                          |       | —                          |       | (3,000 | ) |
| Borrowing against line of credit                                                                           |       | 3,000                           |       | 3,020 |   |
| Issuance of shares of common stock                                                                         |       | 3,354                           |       | 2,530 |   |
| Capital lease payments                                                                                     |       | —                          |       | (1,129 | ) |
| Net cash provided by financing activities                                                                  |       | 6,029                           |       | 564 |   |
| Net increase in  cash and cash equivalents                                                                 |       | 9,653                           |       | 7,674 |   |
| Cash and cash  equivalents at beginning of period                                                          |       | 35,365                          |       | 77,382 |   |
| Cash and cash  equivalents at end of period                                                                |       | $                               | 45,018     |   | $ | 85,056 |   |

 

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

5

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**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 nine months ended September 30, 2006, includes theapplicable amounts of: (a) compensation cost of all stock-based payments grantedprior 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 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, 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 have initiated a project to develop thedocumentation required to support uncertain tax positions as required by FIN48.  The work required is not sufficiently complete to determine if theimplementation of FIN 48 will have a material impact on our consolidatedfinancial statements.

6

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In September 2006,the FASB issued Statement No. 157, “*FairValue Measurements*.” This new standard defines fair value, establishesa framework for measuring fair value in generally accepted accountingprinciples, and expands disclosures about fair value measurements. The newstandard is effective for financial statements issued for fiscal yearsbeginning after November 15, 2007, and interim periods within those years.The provisions of the new standard are to be applied prospectively for mostfinancial instruments and retrospectively for others as of the beginning of thefiscal year in which the standard is initially applied. We will be required toadopt this new standard in the first quarter of 2008. We are currentlyevaluating the requirements of Statement No. 157 and have not yet determinedthe impact on our consolidated financial statements.

In September 2006, the SEC issued Staff AccountingBulletin (“SAB”) No. 108, “*Considering theEffects of Prior Year Misstatements when Quantifying Misstatements in CurrentYear Financial Statements*.” SAB 108 addresses the views of the SECstaff regarding the process of quantifying financial statement misstatements.SEC registrants are expected to reflect the effects of initially applying theguidance in SAB 108 in their annual financial statements covering the firstfiscal year ending after November 15, 2006. The cumulative effect of the initialapplication should be reported in the carrying amounts of assets andliabilities as of the beginning of that fiscal year and the offsettingadjustment should be made to the opening balance of retained earnings for thatyear. We will be required to adopt the interpretations in SAB 108 in the fourthquarter of 2006. We are currently evaluating the impact, if any, of applyingthis guidance.

In March 2006, the Emerging Issues Task Force reacheda consensus on Issue No. 06-03 “How Taxes Collected from Customers and Remittedto Government Authorities Should Be Presented in the Income Statement (that is,Gross versus Net Presentation)” (“EITF No. 06-03”). We are required to adoptthe provisions of EITF No. 06-03 beginning in fiscal year 2007. We do not expectthe provisions of EITF No. 06-03 to have a material impact on the ourconsolidated financial position, results of operations or cash flows.

**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** | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                     | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                     | ** ** | **2005**                         | ** ** | **2006**                        | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **                                     | ** ** | **As Adjusted**                  | ** ** | ** **                      | ** ** | **As Adjusted** | ** ** | ** ** | ** ** |
|                                           |       | **(Note 13)**               |       |                            |       | **(Note 13)** |   |   |   |
| Numerator -basic                               |       |                             |       |                            |       |   |   |   |   |
| Net income (loss)                              |       | $                                | (5,036     | )                               | $          | 4,743 |   | $ | (39,099 | ) | $ | 17,064 |   |
|                                           |       |                             |       |                            |       |   |   |   |   |
| Denominator -  basic                           |       |                             |       |                            |       |   |   |   |   |
| Weighted average common stock outstanding      |       | 102,677                          |       | 103,495                         |       | 100,899 |   | 103,271 |   |
|                                           |       |                             |       |                            |       |   |   |   |   |
| Basic net income  (loss) per share             |       | $                                | (0.05      | )                               | $          | 0.05 |   | $ | (0.39 | ) | $ | 0.17 |   |
|                                           |       |                             |       |                            |       |   |   |   |   |
| Denominator -  diluted                         |       |                             |       |                            |       |   |   |   |   |
| Weighted average common stock outstanding      |       | 102,677                          |       | 103,495                         |       | 100,899 |   | 103,271 |   |
| Dilutive potential of common stock equivalents |       | —                           |       | 1,237                           |       | — |   | 1,396 |   |
| Options                                        |       | 102,677                          |       | 104,732                         |       | 100,899 |   | 104,667 |   |
|                                           |       |                             |       |                            |       |   |   |   |   |
| Diluted net income  (loss) per share           |       | $                                | (0.05      | )                               | $          | 0.05 |   | $ | (0.39 | ) | $ | 0.16 |   |

 

Stock options to purchase11,102,000 and 13,559,000 shares with a weighted average price of $7.55 and$6.38 were outstanding for the three and nine months ended September 30, 2005,respectively.  These stock options werenot included in the computation of diluted net loss per share for the three andnine months ended September 30, 2005 because we had a net loss for theseperiods. Stock options to purchase 8,820,180 and 8,553,643 shares with weighted

7

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average per share pricesof $8.70 and $8.99, respectively, were outstanding and not included in thecomputation of diluted net income per share for the three and nine months endedSeptember 30, 2006, respectively, as they were anti-dilutive under the treasurystock method.

**3*.             Stock Compensation***

***Employee StockPurchase 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 thepurchase, or, if lower, 85% of the fair market value of our common stock sixmonths after the grant date, by withholding up to 10 percent of their annualbase earnings.  Since July 31, 2005, thePurchase Plan provides for eligible employees to purchase shares of commonstock at a price equal to 90% of the fair value of our common stock six monthsafter the option date by withholding up to 10% of their annual baseearnings.  At September 30, 2006, 641thousand shares were available for purchase under the Purchase Plan. Shares issued under the Purchase Plan for the nine months ended September 30,2005 and 2006 were 769 thousand and 485 thousand, respectively.

***Equity IncentivePlan***

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, consultantsand affiliates.  Under the EquityIncentive Plan, the Board of Directors has the authority to determine to whomoptions will be granted, the number of shares under option, the option term andthe exercise price. The options generally are exercisable beginning one yearfrom date of grant and generally thereafter over periods ranging from four tofive years from the date of grant. The term of any options issued may notexceed ten years from the date of grant.

***Directors’ StockOption 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 September 30, 2006, theDirectors’ Plan had 169 thousand shares available for issuance.

Compensation expense is recognized as follows: Weamortize deferred stock-based compensation on the graded vesting method overthe vesting periods of the stock options, generally four years. The gradedvesting method provides for vesting of portions of the overall awards atinterim dates and results in accelerated vesting as compared to thestraight-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-month 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):

8

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|                                                 | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                      | ** ** | **September 30, 2006** | ** ** | **September 30, 2006** | ** ** |
| Cost of goods  sold                             |       | $                                | 159        |                             | $          | 469 |   |
| Research and  development                       |       | 1,195                            |       | 2,967                            |       |
| Sales and  marketing                            |       | 309                              |       | 806                              |       |
| General and  administrative                     |       | 665                              |       | 1,888                            |       |
| Effect on  pre-tax income                       |       | 2,328                            |       | 6,130                            |       |
| Tax effect of  stock-based compensation expense |       | —                           |       | —                           |       |
| Effect on net  income                           |       | $                                | 2,328      |                             | $          | 6,130 |   |
| Effect on net  income per share:                |       |                             |       |                             |       |
| Basic                                           |       | $                                | 0.02       |                             | $          | 0.06 |   |
| Diluted                                         |       | $                                | 0.02       |                             | $          | 0.06 |   |

 

There was no compensationcost capitalized for either of the above periods.

No similar expense wascharged against income in the prior periods as we had elected to apply theprovisions of APB No. 25, “*Accounting for StockIssued 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 thestatement of cash flows as a cash inflow from financing activities. Prior tothe adoption of SFAS No. 123(R), these tax benefits were reflected as a cashinflow from operations. Because we elected to adopt the “modified prospectiveapplication” transition method, the prior year statements of cash flows havenot been restated. The tax benefit from the exercise of options was $0 thousandthe three and nine months ended September 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 to doso in the future. Expected volatilities are based on the historical performanceof our common stock. The expected term of the options granted is 6.0 yearscalculated 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** | ** ** | **Nine Months Ended**  | ** ** |
|--------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **               | ** ** | **September 30, 2006** | ** ** | **September 30, 2006** | ** ** |
| Risk-free  interest rate |       | 5.2%                             |       | 4.3%-5.2%                        |       |
| Dividend yield           |       | 0.0%                             |       | 0.0%                             |       |
| Expected  volatility     |       | 79.2%                            |       | 77.0%-82.6%                      |       |
| Expected life            |       | 6.0 years                        |       | 6.0 years                        |       |

 

The following is asummary of all option activity for the three and nine months ended September30, 2006 (options in thousands):

9

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|                                                    | ** ** | ** **         | ** ** | ** **         | ** ** | ** **        | ** ** | **Weighted**      | ** ** | ** **                     | ** ** |
|----------------------------------------------------|------------|--------------------|------------|--------------------|------------|-------------------|------------|-------------------|------------|--------------------------------|------------|
| ** **                                         | ** ** | ** **         | ** ** | ** **         | ** ** | ** **        | ** ** | **Average**       | ** ** | **Aggregate**                  | ** ** |
| ** **                                         | ** ** | **Shares**         | ** ** | **Number of** | ** ** | **Weighted**      | ** ** | **Remaining**     | ** ** | **Intrinsic Value**       | ** ** |
| ** **                                         | ** ** | **Available**      | ** ** | **Shares**         | ** ** | **Average ** | ** ** | **Term (in** | ** ** | **at September 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                                          |       | 179                |       | (179               | )          | $                 | 5.95       |              |       |                           |       |   |
| Expired                                            |       | 170                |       | (170               | )          | $                 | 3.37       |              |       |                           |       |   |
| Outstanding at  June 30, 2006                      |       | 3,365              |       | 11,362             |       | $                 | 7.26       |              | 5.97       |                           | $          | 5,545 |   |
|                                               |       |               |       |               |       |              |       |              |       |                           |       |
| Granted                                            |       | (785               | )          | 785                |       | $                 | 3.80       |              |       |                           |       |   |
| Exercised                                          |       | —             |       | (127               | )          | $                 | 2.33       |              |       |                           |       |   |
| Forfeited                                          |       | 177                |       | (177               | )          | $                 | 6.75       |              |       |                           |       |   |
| Expired                                            |       | 268                |       | (268               | )          | $                 | 13.04      |              |       |                           |       |   |
| Outstanding at  September 30, 2006                 |       | 3,025              |       | 11,575             |       | $                 | 6.95       |              | 5.99       |                           | $          | 5,407 |   |
|                                               |       |               |       |               |       |              |       |              |       |                           |       |
| Vested and  Expected to Vest at September 30, 2006 |       |               |       | 11,336             |       | $                 | 6.99       |              | 5.90       |                           | $          | 5,373 |   |
|                                               |       |               |       |               |       |              |       |              |       |                           |       |
| Options Exercisable at  September 30, 2006         |       |               |       | 7,402              |       | $                 | 7.76       |              | 4.49       |                           | $          | 4,876 |   |

 

A summary of our stockoptions outstanding at September 30, 2006 as follows (options 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       | -                            | $          | 1.54                         |       |   | 1,141 |   | 1.50 |   | $ | 1.02 |   | 1,141 |   | $ | 1.02 |   |
| $                        | 1.84       | -                            | $          | 3.56                         |       |   | 1,226 |   | 5.18 |   | $ | 2.60 |   | 909 |   | $ | 2.50 |   |
| $                        | 3.60       | -                            | $          | 3.98                         |       |   | 1,248 |   | 8.15 |   | $ | 3.69 |   | 519 |   | $ | 3.66 |   |
| $                        | 4.00       | -                            | $          | 4.62                         |       |   | 1,163 |   | 6.95 |   | $ | 4.38 |   | 671 |   | $ | 4.41 |   |
| $                        | 4.63       | -                            | $          | 5.00                         |       |   | 1,135 |   | 7.25 |   | $ | 4.85 |   | 413 |   | $ | 4.82 |   |
| $                        | 5.02       | -                            | $          | 6.48                         |       |   | 1,304 |   | 8.04 |   | $ | 5.84 |   | 269 |   | $ | 5.84 |   |
| $                        | 6.66       | -                            | $          | 8.61                         |       |   | 1,209 |   | 7.30 |   | $ | 7.64 |   | 668 |   | $ | 7.80 |   |
| $                        | 8.63       | -                            | $          | 9.85                         |       |   | 1,112 |   | 5.41 |   | $ | 9.30 |   | 932 |   | $ | 9.31 |   |
| $                        | 9.92       | -                            | $          | 17.79                        |       |   | 1,032 |   | 5.54 |   | $ | 11.97 |   | 875 |   | $ | 11.85 |   |
| $                        | 18.60      | -                            | $          | 29.44                        |       |   | 1,005 |   | 3.77 |   | $ | 21.21 |   | 1,005 |   | $ | 21.21 |   |
| $                        | 0.44       | -                            | $          | 29.44                        |       |   | 11,575 |   | 5.99 |   | $ | 6.95 |   | 7,402 |   | $ | 7.76 |   |

 
|                                                                                                                        | ** ** | **Three Months Ended** | ** ** | **NIne Months Ended**  | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                             | ** ** | **September 30, 2006** | ** ** | **September 30, 2006** | ** ** |
|                                                                                                                   |       |                             |       |                             |       |
| Weighted average  grant date fair value of options granted                                                             |       | $                                | 2.78       |                             | $          | 2.82 |   |
| Total fair value  of shares vested                                                                                     |       | $                                | 1,900,964  |                             | $          | 5,695,702 |   |
| Total intrinsic  value of options exercised                                                                            |       | $                                | 221,199    |                             | $          | 496,598 |   |
| Total cash received  from employees as a result of employee stock option excercises and employee  stock plan purchases |       | $                                | 1,156,812  |                             | $          | 2,529,908 |   |

 

10

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We settle stock optionexercises with newly issued common shares. We do not have any equityinstruments outstanding other than the options described above as of September30, 2006.

Total unrecognizedcompensation expense from stock options was $9.6 million excluding estimatedforfeitures, which is expected to be recognized over a weighted-average periodof 1.51 years as follows, in thousands:
|                                | ** ** | **Compensation**               | ** ** |
|--------------------------------|------------|--------------------------------|------------|
| ** **                     | ** ** | **Expense excluding**     | ** ** |
| ** **                     | ** ** | **Estimated Forfeitures** | ** ** |
| 2006 (remaining  three months) |       | $                              | 1,749      |   |
| 2007                           |       | 4,803                          |       |
| 2008                           |       | 2,198                          |       |
| 2009                           |       | 747                            |       |
| 2010                           |       | 118                            |       |
| Total                          |       | $                              | 9,615      |   |

 

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

For the three and ninemonths ended September 30, 2005, we applied the intrinsic value based method ofaccounting for stock options prescribed by APB No. 25. Accordingly, nocompensation expense was recognized for these stock options since all optionsgranted have an exercise price equal to the market value of the underlyingstock on the grant date. If compensation expense had been recognized based onthe estimate of the fair value of each option granted in accordance with theprovisions of SFAS No. 123 “*Accounting for Stock-BasedCompensation*” as amended by SFAS No. 148 “*Accountingfor Stock-Based Compensation – Transition and Disclosure –An Amendment of FASBStatement No. 123*”, our net loss would have been increased to thefollowing pro forma amounts as follows, in thousands:
|                                                                                                                                               | ** ** | **Three Months Ended  September 30, 2005** | ** ** | **Nine Months Ended  September 30, 2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| Net loss as adjusted  (Note 13)                                                                                                               |       | $                                                              | (5,036     | )                                                             | $          | (39,099 | ) |
|                                                                                                                                          |       |                                                           |       |                                                          |       |
| 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 |       | (2,044                                                         | )          | (6,530                                                        | )          |
| Pro forma net  loss                                                                                                                           |       | $                                                              | (7,080     | )                                                             | $          | (45,629 | ) |
|                                                                                                                                          |       |                                                           |       |                                                          |       |
| Basic loss per  share                                                                                                                         |       |                                                           |       |                                                          |       |
| As reported:                                                                                                                                  |       | $                                                              | (0.05      | )                                                             | $          | (0.39 | ) |
| Pro forma:                                                                                                                                    |       | $                                                              | (0.07      | )                                                             | $          | (0.45 | ) |
| Diluted net loss  per share                                                                                                                   |       |                                                           |       |                                                          |       |
| As reported:                                                                                                                                  |       | $                                                              | (0.05      | )                                                             | $          | (0.39 | ) |
| Pro forma:                                                                                                                                    |       | $                                                              | (0.07      | )                                                             | $          | (0.45 | ) |

 

The fair value of each option grant is estimated on the date of grantusing the Black-Scholes multiple options pricing model. For the three monthsended September 30, 2005, we assumed a risk-free interest rate of 3.8%, anoption term of 4.7 years, volatility of 83% and an expected dividend yield of0%. with the following weighted average assumptions. For the nine months endedSeptember 30, 2005, we assumed risk-free interest rates between 3.7% and 4.2%,an option term of 4.7 years, volatility of 84% and an expected dividend yieldof 0%.

 

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 cashequivalents are in the custody of three major financial institutions.

Short and long-terminvestments, which are comprised of federal, state and municipal governmentobligations, foreign and public corporate debt securities and marketable equitysecurities, are classified as available-for-sale and carried at fair value,based on quoted market prices, with the unrealized gains or losses, net of tax,reported in 

11

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shareholders’ equity asother comprehensive income.  The cost ofdebt securities is adjusted for amortization of premiums and accretion ofdiscounts to maturity, both of which are included in interest income. Realizedgains and losses are recorded on the specific identification method. In thefirst quarter of 2006, we sold 4.0 million common shares of our investment inPowertech Technology, Incorporated, or PTI, for a pre-tax gain of approximately$12.2 million. We still owned approximately 5.5 million shares of PTI atSeptember 30, 2006.

KingYuan Electronics Company Limited or KYE, Insyde Software Corporation or Insyde,PTI and Professional Computer Technology Limited or PCT, are Taiwanesecompanies 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 June 2004, we acquired9% interest in Advanced Chip Engineering Technology, or ACET, a privately heldTaiwanese company for $4.0 million cash. ACET, a related entity of KYE, is aproduction subcontractor. Chen Tsai, our Senior Vice President of WorldwideBackend Operations, is also a member of ACET’s board of directors. During 2005,we recorded a $2.2 million impairment charge due to ACET’s anticipatedsecondary financing price per share which was lower than our carrying value. InSeptember 2006, we completed an additional cash investment of $15.9 million inACET’s common stock. At September 30, 2006, our investment represents 46.9% ofthe outstanding equity of ACET.

In the first quarter of2006, we determined our investment in Nanotech Corporation, or Nanotech, aprivately held Cayman Island company, had become impaired as Nanotech defaultedon loan payments to certain of its business partners and is now in the processof discontinuing operations. Consequently, our remaining investment of $3.3million along with a loan of $225 thousand were written down to a netrealizable value of zero.

The fair values of available-for-sale investmentsas of September 30, 2006 were as follows (in thousands):
| ** **                                                | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair**  | ** ** |
|-----------------------------------------------------------|------------|---------------|------------|----------------|------------|----------------|------------|-----------|------------|
| ** **                                                | ** ** | **Cost**      | ** ** | **Gain**       | ** ** | **Loss**       | ** ** | **Value** | ** ** |
| Corporate bonds  and notes                                |       | $             | 20,302     |           | $          | —         | ** ** | **$**     | **(4**     | **)** | $ | 20,298 |   |
| Government bonds  and notes                               |       | 48,370        |       | 4              |       | —         |       | 48,374    |       |
| Foreign listed  equity securities                         |       | 6,095         |       | 17,903         |       | —         |       | 23,998    |       |
| Total bonds,  notes and equity securities                 |       | $             | 74,767     |           | $          | 17,907         |       | $         | (4         | ) | $ | 92,670 |   |
|                                                      |       |          |       |           |       |           |       |      |       |
| Less amounts  classified as cash equivalents              |       |          |       |           |       |           |       | (30,728   | )          |
| Total short and  long-term available-for-sale investments |       |          |       |           |       |           |       | $         | 61,942     |   |

 

Contractualmaturity dates of our available-for-sale investments for debt securitiesare in 2006 and 2007.  All of thesesecurities are classified as current as they are expected to be realized incash or sold or consumed during the normal operating cycle of our business.

The unrealized gains and losses as of September30, 2006 are recorded in accumulated other comprehensive income, net of tax.

The fair values of available-for-sale investmentsas 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.  With respect to our foreign listed equitysecurities, our policy is to review our equity holdings on a regular basis to 

12

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evaluate whether or notsuch securities have experienced an other than temporary decline in fairvalue.  Our policy includes, but is notlimited to, reviewing each company’s cash position, earnings and revenueoutlook, stock price performance over the past nine 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 appropriate.  Asof September 30, 2006, the carrying value of these investments was $110.5million, which includes an investment of $83.2 million in Grace SemiconductorManufacturing Corporation, or GSMC, which represents a 10% interest and a $16.6million investment in Advanced Chip Engineering Technology Inc. or ACET, whichrepresents a 46.9% interest.  As ofDecember 31, 2005, the carrying value of these investments was $96.1 million.

**5.             Selected BalanceSheet Detail**

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

Inventories comprise:
| ** **                                           | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
|------------------------------------------------------|------------|-----------------------|------------|------------------------|------------|
| ** **                                           | ** ** | **2005**              | ** ** | **2006**               | ** ** |
| Raw materials                                        |       | $                     | 65,404     |                   | $          | 54,145 |   |
| Work in process                                      |       | 6,491                 |       | 9,138                  |       |
| Finished goods                                       |       | 29,450                |       | 16,977                 |       |
| Finished goods  inventories held at logistics center |       | 6,998                 |       | 5,849                  |       |
|                                                 |       | $                     | 108,343    |                   | $          | 86,109 |   |

 

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 torecord a provision for excess inventory. Our inventories include high technology parts and components that arespecialized in 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.  In the event that this becomes acommon 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, which could result in a material adjustment and couldharm our financial results.  We reviewon-hand inventory including inventory held at the logistic center for potentialexcess, obsolescence and lower of cost or market exposure and record provisionsaccordingly.  Due to the large number ofunits in our inventory, even a small change in average selling prices couldresult in a significant adjustment and have a material impact on our financialposition 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 and for certain products with a date of manufacture of greater than oneyear.  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 minimize inventorieson hand and we consider technological obsolescence when estimating allowancesfor potentially excess and obsolete inventories and those required to reducerecorded amounts to market values, it is reasonably possible that suchestimates 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):

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| ** **                              | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
|-----------------------------------------|------------|-----------------------|------------|------------------------|------------|
| ** **                              | ** ** | **2005**              | ** ** | **2006**               | ** ** |
| Accrued  compensation and related items |       | $                     | 5,934      |                   | $          | 6,196 |   |
| Accrued adverse  purchase commitments   |       | 1,752                 |       | 354                    |       |
| Accrued  commission                     |       | 2,762                 |       | 2,355                  |       |
| Accrued income  tax payable             |       | 1,319                 |       | 6,219                  |       |
| Accrued warranty                        |       | 803                   |       | 434                    |       |
| Other accrued  liabilities              |       | 4,748                 |       | 6,495                  |       |
|                                    |       | $                     | 17,318     |                   | $          | 22,053 |   |

 

Changes in the warranty reserves during the three months endedSeptember 30, 2005 and 2006 were as follows (in thousands):
| ** **                                  | ** ** | **Nine Months Ended September 30,** | ** ** |
|---------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                  | ** ** | **2005**                                                | ** ** | **2006** | ** ** |
| Beginning  balance                          |       | $                                                       | 3,826      |   | $ | 803 |   |
| Provisions for  warranty                    |       | 1,972                                                   |       | 2,113 |   |
| Change in  estimate of prior period accrual |       | (1,058                                                  | )          | — |   |
| Consumption of  reserves                    |       | (3,576                                                  | )          | (2,482 | ) |
| Ending balance                              |       | $                                                       | 1,164      |   | $ | 434 |   |

 

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 as of September 30, 2005 compared toSeptember 30, 2006 related mainly to the rescreening test work related to twospecific customers.  The test work wascompleted during 2005 so there is no comparable reserve as of September 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 theseguarantees approximate the terms of the technology license agreements, whichtypically range from five to ten years. Our current license agreements expirefrom 2006 through 2014.  The maximumpossible amount of future payments we could be required to make, if suchindemnifications were required on all of these agreements, is $41.7 million. Wehave not recorded any liabilities as of September 30, 2006 related to theseindemnities 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 to occur.The duration of these indemnities, commitments and guarantees varies.  The majority of these indemnities,commitments and guarantees do not provide for any limitation of the maximumpotential future payments that we could be obligated to make.  We have not recorded any liability for theseindemnities, commitments and guarantees in the accompanying condensedconsolidated balance sheets. We do, however, accrue for losses for any knowncontingent liability, including those that may arise from indemnificationprovisions, when future payment is probable and the amount is reasonablyestimatable.

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**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 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 heard arguments on the motion todismiss.  On March 10, 2006, theCourt granted our motion to dismiss the consolidated amended complaint, withleave to file an amended complaint. Plaintiffs filed a second amended complainton May 1, 2006. We responded with a motion to dismiss on June 19, 2006. Weintend to 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.  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 SST 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.  The*Brien*and *Bazargani*cases were consolidated into one case: *In re Silicon StorageTechnology, Inc*. *Derivative Litigation*,Case No. C06-04310 JF and a consolidated amended shareholder derivativecomplaint was filed on October 30, 2006. On October 31, 2006, a similar shareholder derivative complaint wasfiled in the Superior Court of the State of California for the County of SantaClara by Alex Chuzhoy under the caption *Chuzhoy v. Yeh, et al.,*CaseNo. 1-06-CV-074026.  This complaint wasbrought purportedly on behalf of SST against certain of our current and formerofficers and directors and alleges among other things, that the named officersand directors breached their fiduciary duties as they colluded with each otherto backdate stock options and were allegedly unjustly enriched by theiractions.  The *Chuzhoy*complaintalso alleges that certain of our officers and directors violated section 25402of the California Corporations Code by selling shares of our common stock whilein possession of material non-public adverse information.  We intend to take all appropriate action inresponding to all of the complaints. 

From time to time,we are also involved in other legal actions arising in the ordinary course ofbusiness.  We have accrued certain costsassociated with defending these matters. There can be no assurance that the shareholder class action complaints,the shareholder derivative complaints or other third party assertions will beresolved without costly litigation, in a manner that is not adverse to ourfinancial position, results of operations or cash flows or without requiringroyalty payments in the future which may adversely impact gross margins. Noestimate can be made of the possible loss or possible range of loss associatedwith the resolution of these contingencies. As a result, no losses have beenaccrued in our financial statements as of September 30, 2006.

**8.             Line of Credit**

On August 11, 2006, weentered into a 1-year loan and security agreement with Cathay Bank, a U.S.bank, for a $40.0 million revolving line of credit all of which was availableto us as of September 30, 2006. The line of credit will be used for workingcapital but there are no restrictions in the agreement as to how the funds maybe used.  The interest rate for the lineof credit is 1% below the prime rate reported from time to time by the WallStreet Journal, Western Edition (8.25% at September 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. As of September 30, 2006, a standby letter of creditin the amount of $8.0 million has been issued against the line as collateralfor the line of credit with Bank of America in China.

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On September 15, 2006,SST China Limited entered into a 10-month facility agreement with Bank ofAmerica, N.A. Shanghai Branch, a U.S. bank, for RMB 60.8 million revolving lineof credit. The line of credit will be used for working capital but there are norestrictions in the agreement as to how the funds may be used.  The interest rate for the line of credit is90% of People’s Bank of China’s base rate (5.58% at September 30, 2006).  This facility line is secured by a standbyletter of credit of $8 million issued by Cathay Bank for Silicon StorageTechnology, Inc, and is guaranteed by Silicon Storage Technology, Inc. As ofSeptember 30, 2006, SST China Limited has drawn RMB $24 million, orapproximately $3.0 million US dollars, at the interest rate of 5.02%.

**9.             Goodwill and Intangible Assets:**

Our acquisitions in prioryears included the acquisition of $16.5 million of finite-lived intangibleassets.  Certain of our acquisitions alsoincluded an aggregate of $29.6 million of goodwill. The goodwill is not beingamortized but is tested for impairment annually, as well as when an event orcircumstance occurs indicating a possible impairment in value.  Of our $1.7 million of intellectual property,$1.2 of was acquired prior to fiscal 2006 and included in property, plant andequipment.

As of September 30, 2006,our intangible assets consisted of the following (in thousands):
|                         | ** ** | ** ** | ** ** | **Accumulated**  | ** ** | ** ** | ** ** |
|-------------------------|------------|------------|------------|------------------|------------|------------|------------|
| ** **              | ** ** | **Cost**   | ** ** | **Amortization** | ** ** | **Net**    | ** ** |
| Existing  technology    |       | $          | 11,791     |             | $          | 4,767      |       | $ | 7,024 |   |
| Intellectual  property  |       | 1,694      |       | —           |       | 1,694      |       |
| Trade name              |       | 1,198      |       | 492              |       | 706        |       |
| Customer  relationships |       | 1,857      |       | 902              |       | 955        |       |
| Backlog                 |       | 811        |       | 811              |       | —     |       |
| Non-Compete Agreements  |       | 810        |       | 356              |       | 454        |       |
|                    |       | $          | 18,161     |             | $          | 7,328      |       | $ | 10,833 |   |

 

As of December 31, 2005,our intangible assets consisted of the following (in thousands):
|                         | ** ** | ** ** | ** ** | **Accumulated**  | ** ** | ** ** | ** ** |
|-------------------------|------------|------------|------------|------------------|------------|------------|------------|
| ** **              | ** ** | **Cost**   | ** ** | **Amortization** | ** ** | **Net**    | ** ** |
| Existing  technology    |       | $          | 11,791     |             | 2,830      |       | $          | 8,961 |   |
| Trade name              |       | 1,198      |       | 313              |       | 885        |       |
| Customer  relationships |       | 1,857      |       | 528              |       | 1,329      |       |
| Backlog                 |       | 811        |       | 806              |       | 5          |       |
| Non-Compete  Agreements |       | 810        |       | 174              |       | 636        |       |
|                    |       | $          | 16,467     |             | $          | 4,651      |       | $ | 11,816 |   |
|                         |            |            |            |                  |            |            |            |  |  |  |

 

All intangible assets arebeing amortized on a straight-line method over their estimated usefullives.  Existing technologies have beenassigned useful lives of between four and five years, with a weighted averagelife of approximately 4.6 years.  Non-competeagreements have been assigned useful lives between two and four years, with aweighted average of 3.6 years. Intellectual property has been assigned an estimated life of five yearsand will begin amortization as it is put into service. Trade names and backlogshave been assigned useful lives of five years, and one year, respectively. Customer relationships have been assigned useful lives between three andfive years with a weighted average of 4.0 years. Amortization expense forintangible assets for the nine months ended September 30, 2006 was $2.7million.

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

16

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| Fiscal Year             | ** ** | **Amortization of  Intangible Assets** | ** ** |
|------------------------------|------------|--------------------------------------------------|------------|
| 2006 remaining  three months |       | $                                                | 891        |   |
| 2007                         |       | 3,679                                            |       |
| 2008                         |       | 3,395                                            |       |
| 2009                         |       | 1,963                                            |       |
| 2010 and after               |       | 905                                              |       |
|                         |       | $                                                | 10,833     |   |

 

There was no change inthe carrying amount of goodwill for the nine months ended September 30, 2006from December 31, 2005.

**10.          SegmentReporting**

A key objective of oursis to diversify our product offerings from primarily flash to a multi-productline company and to be a leading worldwide supplier of low to medium densityNOR flash memory devices, a leading supplier of other semiconductor products inthe consumer electronics market and a leading licensor of embedded flashtechnology.  As a result, the operatingresults that the company’s chief operating decision maker reviews to makedecisions about resource allocations and to assess performance havechanged.  Effective January 1, 2006, wehave re-evaluated our operating segments to bring them in line with our keyobjectives and focus.  The new segmentsinclude Memory Products, Non-Memory Products and Technology Licensing.

Our Memory Productsegment, which is comprised of NOR flash memory products, includes theMulti-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.

Our Non-Memory Productssegment includes other semiconductor products including flash microcontrollers,smart card integrated circuits, or ICs, and modules, radio frequency, or RF,ICs and modules, NAND controllers and NAND-controller based modules.

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

We do not allocateoperating expenses, interest and other income/expense, interest expense,impairment of equity investments or provision for or benefit from income taxesto any of these segments for internal reporting purposes, as we do not believethat allocating these expenses are material in evaluating segment performance.

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

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

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|                       | ** ** | **Three Months Ended** | ** ** | **Three Months Ended** | ** ** |
|-----------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **            | ** ** | **September 30, 2005** | ** ** | **September 30, 2006** | ** ** |
| ** **            | ** ** | ** **                       | ** ** | **Gross**                        | ** ** | ** ** | ** ** | **Gross** | ** ** |
| ** **            | ** ** | **Revenues**                     | ** ** | **Profit**                       | ** ** | **Revenues** | ** ** | **Profit** | ** ** |
|                  |       |                             |       |                             |       |   |   |   |   |
| Memory                |       | $                                | 89,556     |                             | $          | 4,820 |   | $ | 90,676 |   | $ | 17,055 |   |
| Non-Memory            |       | 18,168                           |       | 3,977                            |       | 16,834 |   | 4,724 |   |
| Technology  Licensing |       | 10,348                           |       | 10,348                           |       | 8,508 |   | 8,508 |   |
|                  |       | $                                | 118,072    |                             | $          | 19,145 |   | $ | 116,018 |   | $ | 30,287 |   |

 
|                       | ** ** | **Nine Months Ended**  | ** ** | **Nine Months Ended**  | ** ** |
|-----------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **            | ** ** | **September 30, 2005** | ** ** | **September 30, 2006** | ** ** |
| ** **            | ** ** | ** **                       | ** ** | **Gross**                        | ** ** | ** ** | ** ** | **Gross** | ** ** |
| ** **            | ** ** | **Revenues**                     | ** ** | **Profit**                       | ** ** | **Revenues** | ** ** | **Profit** | ** ** |
|                  |       |                             |       |                             |       |   |   |   |   |
| Memory                |       | $                                | 232,490    |                             | $          | 8,893 |   | $ | 253,684 |   | $ | 49,027 |   |
| Non-Memory            |       | 39,386                           |       | 8,297                            |       | 53,067 |   | 15,020 |   |
| Technology  Licensing |       | 25,810                           |       | 25,810                           |       | 27,527 |   | 27,527 |   |
|                  |       | $                                | 297,686    |                             | $          | 43,000 |   | $ | 334,278 |   | $ | 91,574 |   |

 

**11.          Comprehensive Income (Loss)**

The components of comprehensive income (loss), as adjusted(Note 13), net of tax, are as follows (in thousands):
| ** **                                             | ** ** | **For the Three Months Ended** | ** ** | **For the Nine Months Ended** | ** ** |
|--------------------------------------------------------|------------|----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                             | ** ** | **September 30,**                             | ** ** | **September 30,**                            | ** ** |
| ** **                                             | ** ** | **2005**                                           | ** ** | **2006**                                          | ** ** | **2005** | ** ** | **2006** | ** ** |
|                                                   |       |                                               |       |                                              |       |   |   |   |   |
| Net income (loss) as adjusted  (Note13)                |       | $                                                  | (5,036     | )                                                 | $          | 4,743 |   | $ | (39,099 | ) | $ | 17,064 |   |
|                                                   |       |                                               |       |                                              |       |   |   |   |   |
| Other comprehensive  income:                           |       |                                               |       |                                              |       |   |   |   |   |
| Change in  unrealized gains on investments, net of tax |       | 640                                                |       | 1,408                                             |       | 10,430 |   | (13,871 | ) |
| Change in  cumulative translation adjustment           |       | 6                                                  |       | 1                                                 |       | (29 | ) | 17 |   |
| Total comprehensive income                             |       | $                                                  | (4,390     | )                                                 | $          | 6,152 |   | $ | (28,698 | ) | $ | 3,210 |   |

 

The components of accumulated other comprehensiveincome are, as adjusted (Note 13), asfollows (in thousands):
|                                                                             | ** ** | **Balances as of**    | ** ** |
|-----------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                  | ** ** | **December 31, 2005** | ** ** | **September, 30 2006** | ** ** |
| Componentsof  accumulated other comprehensive income as adjusted (Note 13): |       |                            |       |   |
|                                                                        |       |                            |       |   |   |
| Net unrealized  gains on investments, net of tax                            |       | $                               | 31,774     |   | $ | 17,903 |   |
| Cumulative  translation adjustment                                          |       | 6                               |       | 23 |   |
|                                                                        |       | $                               | 31,780     |   | $ | 17,926 |   |

 

**12.          Related Party Transactions and Balances**

Thefollowing table is a summary of our related party revenues and purchases forthe three and nine months ended September 30, 2005 and 2006, and our relatedparty accounts receivable and accounts payable and accruals as of December 31,2005 and September 30, 2006 (in thousands):

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| ** **                                      | ** ** | **Three Months Ended** | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                      | ** ** | **September 30, 2005** | ** ** | **September 30, 2006** | ** ** |
| ** **                                      | ** ** | **Revenues**                     | ** ** | **Purchases**                    | ** ** | **Revenues** | ** ** | **Purchases** | ** ** |
|                                            |       |                             |       |                             |       |   |   |   |   |
| Silicon Technology Co.,  Ltd.                   |       | $                                | 879        |                             | $          | — |   | $ | 413 |   | $ | — |   |
| Apacer Technology, Inc.  & related entities |       | 512                              |       | —                           |       | 542 |   | — |   |
| Silicon Professional  Technology Ltd.           |       | 65,824                           |       | —                           |       | 62,430 |   | — |   |
| Grace Semiconductor  Manufacturing Corp.        |       | 29                               |       | 4,138                            |       | 65 |   | 25,084 |   |
| King Yuan Electronics  Company, Limited         |       | —                           |       | 7,461                            |       | — |   | 7,958 |   |
| Powertech Technology,  Incorporated             |       | —                           |       | 3,317                            |       | — |   | 4,498 |   |
|                                            |       | $                                | 67,244     |                             | $          | 14,916 |   | $ | 63,450 |   | $ | 37,540 |   |

 
| ** **                                      | ** ** | **Nine Months Ended**  | ** ** | **Nine Months Ended**  | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                      | ** ** | **September 30, 2005** | ** ** | **September 30, 2006** | ** ** |
| ** **                                      | ** ** | **Revenues**                     | ** ** | **Purchases**                    | ** ** | **Revenues** | ** ** | **Purchases** | ** ** |
|                                            |       |                             |       |                             |       |   |   |   |   |
| Silicon Technology Co.,  Ltd.                   |       | $                                | 2,717      |                             | $          | — |   | $ | 899 |   | $ | — |   |
| Apacer Technology, Inc.  & related entities |       | 1,354                            |       | —                           |       | 2,222 |   | — |   |
| Silicon Professional  Technology Ltd.           |       | 152,803                          |       | —                           |       | 180,698 |   | — |   |
| Grace Semiconductor  Manufacturing Corp.        |       | 160                              |       | 38,910                           |       | 1,443 |   | 49,226 |   |
| King Yuan Electronics Company,  Limited         |       | —                           |       | 24,283                           |       | — |   | 22,991 |   |
| Powertech Technology,  Incorporated             |       | —                           |       | 10,144                           |       | — |   | 11,402 |   |
|                                            |       | $                                | 157,034    |                             | $          | 73,337 |   | $ | 185,262 |   | $ | 83,619 |   |

 
| ** **                                      | ** ** | **December 31, 2005** | ** ** | **September 30, 2006** | ** ** |
|-------------------------------------------------|------------|---------------------------------|------------|----------------------------------|------------|
| ** **                                      | ** ** | **Trade**                       | ** ** | **Accounts**                     | ** ** | **Trade** | ** ** | **Accounts** | ** ** |
| ** **                                      | ** ** | **Accounts**                    | ** ** | **Payable and**             | ** ** | **Accounts** | ** ** | **Payable and** | ** ** |
| ** **                                      | ** ** | **Receivable**                  | ** ** | **Accruals**                     | ** ** | **Receivable** | ** ** | **Accruals** | ** ** |
|                                            |       |                            |       |                             |       |   |   |   |   |
| Silicon Technology Co.,  Ltd.                   |       | $                               | 370        |                             | $          | — |   | $ | 176 |   | $ | — |   |
| Apacer Technology, Inc.  & related entities |       | 237                             |       | —                           |       | 121 |   | — |   |
| Professional Computer  Technology Limited       |       | —                          |       | 123                              |       | — |   | 89 |   |
| Silicon Professional  Technology Ltd.           |       | 53,785                          |       | 846                              |       | 42,865 |   | 668 |   |
| Grace Semiconductor  Manufacturing Corp.        |       | 1,466                           |       | 4,949                            |       | — |   | 18,592 |   |
| King Yuan Electronics  Company, Limited         |       | —                          |       | 10,004                           |       | — |   | 10,206 |   |
| Powertech Technology,  Incorporated             |       | —                          |       | 5,945                            |       | — |   | 4,351 |   |
|                                            |       | $                               | 55,858     |                             | $          | 21,867 |   | $ | 43,162 |   | $ | 33,906 |   |

 

Professional Computer Technology Limited or PCT,earns commissions for point-of-sales transactions to customers.  PCT’s commissions are paid at the same rateas all of our other stocking representatives in Asia.  In addition, we pay Silicon ProfessionalTechnology Ltd. or SPT, a wholly-owned subsidiary of PCT, a fee for providinglogistics center functions.  This fee isbased on a percentage of revenue for each product shipped through SPT to ourend customers. The fee paid to SPT covers the costs of warehousing and insuringinventory and processing accounts receivable, the personnel costs required tomaintain logistics and information technology functions and the costs toperform demand forecasting, billing and collection of accounts receivable.

**13.          Change in AccountingPrinciple**

In September 2006, weinvested an additional $15.9 million in Advanced Chip Engineering TechnologyInc. or ACET, a development stage, private company in Taiwan that specializesin advanced semiconductor packaging technology. This investment increased ourownership share of ACET’s outstanding capital stock from 9.4% to 46.9% andrequired us to change from the cost method of accounting to the equity methodof accounting for this investment. Under the equity method of accounting, weare required to record our 46.9% interest in ACET’s reported net income or losseach reporting period as well as require that prior period financial results berestated to reflect the

19

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equity method ofaccounting from the date of the initial investment. The third quarter of 2006results includes a charge of $607 thousand, as a result our increasedinvestment in ACET.

The following table liststhe relevant captions from our statements of operations as originally presentedand after the change in accounting principle.

|                                                          | ** ** | **(in thousands, except per share data)** | ** ** |
|----------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                               | ** ** | **3Q04**                                                           | ** ** | **4Q04** | ** ** | **1Q05** | ** ** | **2Q05** | ** ** | **3Q05** | ** ** | **4Q05** | ** ** | **1Q06** | ** ** | **2Q06** | ** ** |
| **As previously presented**                              | ** ** | ** **                                                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Income  (loss) from operations                           |       | $                                                                  | 14,752     |   | $ | (27,330 | ) | $ | (13,414 | ) | $ | (18,864 | ) | $ | (5,470 | ) | $ | 10,998 |   | $ | 4,548 |   | $ | 1,470 |   |
| Other  income (expense), net                             |       | $                                                                  | 684        |   | $ | 828 |   | $ | 201 |   | $ | 1,014 |   | $ | 371 |   | $ | 204 |   | $ | 439 |   | $ | 1,056 |   |
| Equity  Impairment                                       |       | —                                                             |       | (509 | ) | — |   | — |   | — |   | (2,240 | ) | (3,523 | ) | — |   |
| Net  income (loss)                                       |       | 14,522                                                             |       | (26,925 | ) | (13,897 | ) | (19,587 | ) | (4,793 | ) | 8,440 |   | 11,290 |   | 1,455 |   |
| Earnings  per share                                      |       |                                                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                                    |       | $                                                                  | 0.15       |   | $ | (0.28 | ) | $ | (0.14 | ) | $ | (0.19 | ) | $ | (0.05 | ) | $ | 0.08 |   | $ | 0.11 |   | $ | 0.01 |   |
| Diluted                                                  |       | $                                                                  | 0.15       |   | $ | (0.28 | ) | $ | (0.14 | ) | $ | (0.19 | ) | $ | (0.05 | ) | $ | 0.08 |   | $ | 0.11 |   | $ | 0.01 |   |
| ** **                                               | ** ** | ** **                                                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **As adjusted**                                          | ** ** | ** **                                                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Income  (loss) from operations                           |       | $                                                                  | 14,752     |   | $ | (27,330 | ) | $ | (13,414 | ) | $ | (18,864 | ) | $ | (5,470 | ) | $ | 10,998 |   | $ | 4,548 |   | $ | 1,470 |   |
| Pro  rata share of income (loss) from equity investments |       | $                                                                  | (254       | ) | $ | (411 | ) | $ | (374 | ) | $ | (466 | ) | $ | (427 | ) | $ | (277 | ) | $ | (239 | ) | $ | (233 | ) |
| Other  income (expense), net                             |       | $                                                                  | 684        |   | $ | 921 |   | $ | 322 |   | $ | 1,154 |   | $ | 556 |   | $ | 240 |   | $ | 463 |   | $ | 1,080 |   |
| Equity  Impairment                                       |       | —                                                             |       | (509 | ) | — |   | — |   | — |   | (605 | ) | (3,547 | ) | — |   |
| Net  income (loss)                                       |       | 14,268                                                             |       | (27,243 | ) | (14,150 | ) | (19,913 | ) | (5,036 | ) | 9,834 |   | 11,075 |   | 1,246 |   |
| Earnings  per share                                      |       |                                                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                                    |       | $                                                                  | 0.15       |   | $ | (0.28 | ) | $ | (0.14 | ) | $ | (0.19 | ) | $ | (0.05 | ) | $ | 0.10 |   | $ | 0.11 |   | $ | 0.01 |   |
| Diluted                                                  |       | $                                                                  | 0.15       |   | $ | (0.28 | ) | $ | (0.14 | ) | $ | (0.19 | ) | $ | (0.05 | ) | $ | 0.09 |   | $ | 0.11 |   | $ | 0.01 |   |
|                                                     |       |                                                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Cumulative effect of change  in retained earnings        |       | $                                                                  | (254       | ) | $ | (572 | ) | $ | (828 | ) | $ | (1,151 | ) | $ | (1,394 | ) | $ | 0 |   | $ | (715 | ) | $ | (424 | ) |

 

**14.          Income Taxes**

We maintained a full valuation allowance on our netdeferred tax assets as of September 30, 2006. The valuation allowance wasdetermined in accordance with the provisions of Statement of FinancialAccounting Standards No. 109, or SFAS No. 109, “*Accountingfor Income Taxes*,” which requires an assessment of both positive andnegative evidence when determining whether it is more likely than not thatdeferred tax assets are recoverable; such assessment is required on ajurisdiction by jurisdiction basis. Cumulative losses incurred in the U.S. inrecent years represented sufficient negative evidence under SFAS No. 109 suchthat a full valuation allowance was recorded against U.S. deferred tax assets.We intend to maintain a full valuation allowance in the U.S. deferred taxassets until sufficient positive evidence exists to support reversal of thevaluation allowance.  Our tax provisionfor the three and nine months ended September 30, 2006 was $2.8 million and$6.1 million, respectively, which consists primarily of foreign withholdingtaxes and tentative U.S. minimum tax.

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**Item 2.  Management’s Discussion and Analysis ofFinancial Condition and Results of Operations.**

*The following discussion may beunderstood more fully by reference to the consolidated financial statements,notes to the consolidated financial statements and management’s discussion andanalysis of financial condition and results of operations contained in ourAnnual Report on Form 10-K for the year ended December 31, 2005, as filed withthe Securities and Exchange Commission.*

*The following discussion containsforward-looking statements, which involve risk and uncertainties.  All forward-looking statements included inthis document are based on information available to us on the date hereof, andwe assume no obligation to update any such forward-looking statements. Ouractual results could differ materially from those anticipated in theseforward-looking statements as a result of certain factors which are difficultto forecast and can materially affect our quarterly or annual operatingresults. Fluctuations in revenues and operating results may cause volatility inour stock price.   Please also see PartII, Item 1A. “Risk Factors.”*

###### **Overview**

We are a leading supplierof NOR flash memory semiconductor devices for the digital consumer, networking,wireless communications and Internet computing markets.  NOR flash memory is a form of non-volatilememory that allows electronic systems to retain information when the system isturned off.  NOR flash memory is now usedin hundreds of millions of consumer electronics and computing products annually.

We produce and sell manyproducts based on our SuperFlash design and manufacturing process technology.Our products are incorporated into products sold by many well-known companiesincluding Apple, Asustek, Cambridge Silicon Radio, Canon, Compal, Dell, Epson,First International Computer, or FIC, Foxconn, or Honhai, Fujitsu, Funai,Garmin, Gigabyte, GN Netcom, Haier, Hewlett Packard, Huawei, Infineon, Intel,IBM, Inventec, JVC, Lenovo, Lexmark, LG Electronics, Lite-On IT, Matsushita, orPanasonic, Micronas, Motorola, NEC, Nintendo, Philips, Pioneer, Quanta, Sagem,Samsung, Sanyo, Seagate, Sony, Sony Ericsson, TCL, Thomson, TiVO, Toshiba, USI,Western Digital, and ZTE.

We also produce and sell othersemiconductor products including flash microcontrollers, smartcard ICs andmodules, radio frequency, or RF, ICs and modules, NAND controllers andNAND-controller based memory modules.

One of our key initiatives is the activedevelopment of our non-memory business. Our objective is to transform SST from a pure-play in flash to amulti-product line company.  We continueto execute on our plan to derive, by mid-2008, 30% of our revenue fromnon-memory products, which includes embedded controllers, NAND-controller basedproducts, smart card ICs and radio frequency ICs and modules.* *We believenon-memory products represent an area in which we have significant competitiveadvantages and also an area that can yield profitable revenue with higher andmore stable gross margins than our memory products in the long run.

As a result of thetransition in our objectives, the operating results that our chief executiveofficer reviews to make decisions about resource allocations and to assess ourperformance have changed. Effective January 1, 2006, we have re-evaluated ouroperating segments to bring them in line with our key objectives andfocus.  The new segments include MemoryProducts, Non-Memory Products and Technology Licensing.  For other information related to oursegments, see “Note 10 – Segment Reporting” to our Notes to the ConsolidatedFinancial Statements.

Duringthe third quarter of 2006, we had growth in our unit shipments across our fourapplication categories as the electronic industry entered the holiday-buildseason. Our unit shipments increased 19.8% quarter over quarter. As a result,we improved our profitability, made progress in reducing our inventory leveland increased our cash position during the quarter. As we move into the lastquarter of the year, expect continued strength in product demand across many ofour application categories.

Lookingat our application categories, unit shipments to the digital consumerapplications experienced a 23.1% increase sequentially. We saw strong unitshipments in the digital TV, MP3 player, video game and DVD player applicationsand had record shipments in digital TV and DVD recorder applications. Unitshipments to the Internet computing category increased 17.8% sequentially,driven by the growth in Notebook PC, hard disk drive, graphics card and POSterminal applications. We had record shipments to Notebook PC, LCD monitor,hard disk drive, POS terminal and server applications.  Desktop PC shipments, however, decreasedslightly from the previous quarter.  Unitshipments to the networking category increased 23.1% as a result of strength inthe wireless LAN, Voice-over-IP phones, security system and other networkingequipment applications. Finally, units shipped to the wireless

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communicationscategory increased 17.0% sequentially in the third quarter, mainly due tostrong shipments to the SIM card market. Shipments to Bluetooth, GPS and cellular handset applications decreasedslightly from the second quarter.

Inthe area of memory technologies, we are continuing to reduce manufacturingcosts through the transition to smaller process technologies that generallycarry a lower cost per die. Wafer starts are primarily now in the 0.18 and 0.25micron geometry. We are also in the process of developing 0.13 micron and 0.12micron process technologies.

The semiconductorindustry has historically been cyclical, characterized by periodic changes inbusiness conditions caused by product supply and demand imbalance. When theindustry experiences downturns, they often occur in connection with, or inanticipation of, maturing product cycles and declines in general economicconditions.  These downturns arecharacterized by weak product demand, excessive inventory and accelerateddecline of selling prices.

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

We derived 86.0%, 87.6%and 87.4% of our net product revenues during 2004, 2005 and the nine monthsended September 30, 2006, respectively, from product shipments to Asia.Additionally, substantially all of our wafer suppliers and packaging andtesting subcontractors are located in Asia.

Our top ten end customers,excluding stocking representatives and distributors, accounted for 29.1%, 27.2%and 21.3% of our net product revenues in 2004, 2005 and the nine months endedSeptember 30, 2006, respectively.

No single end customer,which we define as original equipment manufacturers, or OEMs, original designmanufacturers, or ODMs, contract electronic manufacturers, or CEMs, or endusers, represented 10.0% or more of our net product revenues during 2004, 2005or the nine months ended September 30, 2006.

We out-source our endcustomer service logistics in Asia to Silicon Professional Technology Ltd. orSPT, which supports our customers in Taiwan, China and other Southeast Asiacountries. SPT provides forecasting, planning, warehousing, delivery, billing,collection and other logistic functions for us in these regions.  SPT is a wholly-owned subsidiary ofProfessional Computer Technology Limited or PCT, one of our stockingrepresentatives 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 ended December 31,2005. Products shipped to SPT are accounted for as our inventory held at ourlogistics center, and revenue is recognized when the products have beendelivered and are considered as a sale to our end customers by SPT. For 2004and 2005 and the nine months ended September 30, 2006, SPT serviced endcustomer sales accounting for 52.9%, 58.5% and 58.9%, respectively, of our netproduct revenues recognized.  As ofDecember 31, 2005 and September 30, 2006, SPT represented 69.6% and 68.5% ofour net accounts receivable, respectively.

We ship products to, andhave accounts receivable from, OEMs, ODMs, CEMs, stocking representatives,distributors and our logistics center. Our stocking representatives, distributors and logistics center reshipour products to our end customers, including OEMs, ODMs, CEMs and endusers.  Shipments, by us or our logisticscenter, to our top three stocking representatives for reshipment accounted for34.0%, 40.3% and 47.1% of our product shipments in 2004, 2005 and the ninemonths ended September 30, 2006, respectively. In addition, the top three stocking representatives solicited sales, forwhich they received a commission, for 25.1%, 18.3% and 10.5% of our shipmentsto end users in 2004, 2005 and the nine months ended September 30, 2006,respectively.

**Critical Accounting Estimates**

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 quarter ended September 30, 2006 includes the applicableamounts of: (a) compensation cost of all stock-based payments grantedprior to, but not yet vested as of, January 1, 2006 (based on thegrant-date fair value estimated in

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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 in accordancewith the new provisions of SFAS No. 123(R)). Results for prior periodshave not been restated to reflect our adoption of SFAS No. 123(R).

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

**Results of Operations: Three andNine months Ended September 30, 2006**

**Net Revenues (in thousands)**
|                      | ** ** | **Three Months Ended** | ** ** | ** **              | ** ** | ** **                   | ** ** | ** **                       | ** ** | ** **                       | ** ** |
|----------------------|------------|----------------------------------|------------|-------------------------|------------|------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **           | ** ** | **September 30,  2005**     | ** ** | **June 30,  2006** | ** ** | **September 30,  2006** | ** ** | **3Q06-Over-  3Q05 Change** | ** ** | **3Q06-Over-  2Q06 Change** | ** ** |
| Memory revenue       |       | $                                | 89,556     |                    | $          | 82,970                       |       | $                                | 90,676     |                             | $          | 1,120 |   | 1.3 | % | $ | 7,706 |   | 9.3 | % |
| Non-Memory revenue   |       | $                                | 18,168     |                    | $          | 15,968                       |       | $                                | 16,834     |                             | $          | (1,334 | ) | (7.3 | )% | $ | 866 |   | 5.4 | % |
| Product revenue      |       | $                                | 107,724    |                    | $          | 98,938                       |       | $                                | 107,510    |                             | $          | (215 | ) | (0.2 | )% | $ | 8,572 |   | 8.7 | % |
| Technology licensing |       | $                                | 10,348     |                    | $          | 8,791                        |       | $                                | 8,508      |                             | $          | (1,840 | ) | (17.8 | )% | $ | (283 | ) | (3.2 | )% |
| Total net revenues   |       | $                                | 118,072    |                    | $          | 107,729                      |       | $                                | 116,018    |                             | $          | (2,054 | ) | (1.7 | )% | $ | 8,289 |   | 7.7 | % |

 
|                       | ** ** | **Nine Months Ended** | ** ** | ** **                   | ** ** | ** **                       | ** ** |
|-----------------------|------------|---------------------------------|------------|------------------------------|------------|----------------------------------|------------|
| ** **            | ** ** | **September 30,  2005**    | ** ** | **September 30,  2006** | ** ** | **3Q06-Over-  3Q05 Change** | ** ** |
| Memory revenue        |       | $                               | 232,490    |                         | $          | 253,684                          |       | $ | 21,194 |   | 9.1 | % |
| Non-Memory  revenue   |       | $                               | 39,386     |                         | $          | 53,067                           |       | $ | 13,681 |   | 34.7 | % |
| Product revenue       |       | $                               | 271,876    |                         | $          | 306,751                          |       | $ | 34,875 |   | 12.8 | % |
| Technology  licensing |       | $                               | 25,810     |                         | $          | 27,527                           |       | $ | 1,717 |   | 6.7 | % |
| Total net revenues    |       | $                               | 297,686    |                         | $          | 334,278                          |       | $ | 36,597 |   | 12.3 | % |

 

Net revenues increased7.7% in the third quarter of 2006 from the second quarter of 2006 primarily dueto a 19.8% increase in unit shipments. Average selling prices of our productsfor the third quarter of 2006 decreased 9.7% from the second quarter of 2006 due to product mix as wellas pricing pressures on serial flash and Smartcard IC products. Netrevenues for the third quarter of 2006 decreased 1.7% compared to the thirdquarter of 2005 due to decreases in non-memory revenue and lower technologylicensing revenue.  For the nine monthsended September 30, 2006, net revenues increased 12.3% as compared to the sameperiod in the prior year primarily due to a 13.3% increase in total unitsshipped and higher technology license revenue.

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

*Memory Products*

Memory revenue increased9.3% in the third quarter of 2006 from the second quarter of 2006 primarily dueto a 17.0% increase in unit shipments. Increase in demand for several consumerelectronic and computer applications as the electronics industry entered the holiday-buildseason led to the results. Memory revenue increased in the third quarter of2006 compared to the third quarter of 2005 primarily due to a 5.7% increase inaverage selling prices although total unit shipments fell 1.9%. The increase inaverage selling prices was primarily a result of product mix with increasedshipments of combo memory and higher density products. For the nine monthsended September 30, 2006 compared to the same period in 2005, memory revenueincreased due a 7.9% increase in unit shipments led primarily by increasedactivity of serial flash devices, many-time programmable and ComboMemoryproducts.

*Non-Memory Products*

Non-memory revenueincreased in the third quarter of 2006 from the second quarter of 2006primarily due to a 31.9% increase in unit shipments. The increase in unitshipments was somewhat offset by a 32.7% decrease in average selling prices dueto product mix although we experienced some price pressures particularly on thesmartcard IC products. Non-memory revenue decreased in the third quarter of2006 compared to the third quarter of 

23

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2005 due to a 43.2%decrease in average selling prices largely from product mix. For the ninemonths ended September 30, 2006 compared to the same period in 2005, non-memoryrevenue increased due to a 41.7% increase in unit shipments.

*Technology Licensing Revenue*

Technology licenserevenue includes a combination of up-front fees and royalties. Technologylicensing revenue for the third quarter of 2006 declined from the secondquarter of 2006 as a result of lower upfront fees as well as some fluctuationin royalties. Technology licensing revenue for the third quarter of 2006decreased compared to the third quarter of 2005 due to timing of fees. For thenine months ended September 30, 2006 technology license revenues, compared tothe same period in 2005, increased 6.7% primarily due to license fees on newand existing licenses. We anticipate revenues from technology licensing mayfluctuate significantly in the future.

###### **GrossProfit (in thousands)**

| ** **                         | ** ** | **Three Months Ended** | ** ** | ** **              | ** ** | ** **                   | ** ** |
|------------------------------------|------------|----------------------------------|------------|-------------------------|------------|------------------------------|------------|
| ** **                         | ** ** | **September 30,  2005**     | ** ** | **June 30,  2006** | ** ** | **September 30,  2006** | ** ** | **3Q06-Over-  3Q05 Change** | ** ** | **3Q06-Over-  2Q06 Change** | ** ** |
| Memory gross profit                |       | $                                | 4,820      |                    | $          | 14,036                       |       | $ | 17,055 |   | $ | 12,235 |   | 253.9 | % | $ | 3,019 |   | 21.5 | % |
| Memory gross  margin               |       | 5.4                              | %          | 16.9                    | %          | 18.8                         | %          |   |   |   |   |   |   |   |   |
| Non-Memory gross profit            |       | $                                | 3,977      |                    | $          | 4,547                        |       | $ | 4,724 |   | $ | 747 |   | 18.8 | % | $ | 177 |   | 3.9 | % |
| Non-Memory gross  margin           |       | 21.9                             | %          | 28.5                    | %          | 28.1                         | %          |   |   |   |   |   |   |   |   |
| Product gross profit               |       | $                                | 8,797      |                    | $          | 18,583                       |       | $ | 21,779 |   | $ | 12,982 |   | 147.6 | % | $ | 3,196 |   | 17.2 | % |
| Product gross  margin              |       | 8.2                              | %          | 18.8                    | %          | 20.3                         | %          |   |   |   |   |   |   |   |   |
| Technology licensing  gross profit |       | $                                | 10,348     |                    | $          | 8,791                        |       | $ | 8,508 |   | $ | (1,840 | ) | (17.8 | )% | $ | (283 | ) | (3.2 | )% |
| Technology  licensing gross margin |       | 100.0                            | %          | 100.0                   | %          | 100.0                        | %          |   |   |   |   |   |   |   |   |
| Total gross profit                 |       | $                                | 19,145     |                    | $          | 27,374                       |       | $ | 30,287 |   | $ | 11,142 |   | 58.2 | % | $ | 2,913 |   | 10.6 | % |
| Total gross margin                 |       | 16.2                             | %          | 25.4                    | %          | 26.1                         | %          |   |   |   |   |   |   |   |   |

 
|                                    | ** ** | **Nine Months Ended** | ** ** | ** **                   | ** ** | ** **                       | ** ** |
|------------------------------------|------------|---------------------------------|------------|------------------------------|------------|----------------------------------|------------|
| ** **                         | ** ** | **September 30,  2005**    | ** ** | **September 30,  2006** | ** ** | **3Q06-Over-  3Q05 Change** | ** ** |
| Memory gross  profit               |       | $                               | 8,893      |                         | $          | 49,027                           |       | $ | 40,134 |   | 451.3 | % |
| Memory gross margin                |       | 3.8                             | %          | 19.3                         | %          |                             |       |   |   |
| Non-Memory gross  profit           |       | $                               | 8,297      |                         | $          | 15,020                           |       | $ | 6,723 |   | 81.0 | % |
| Non-Memory gross margin            |       | 21.1                            | %          | 28.3                         | %          |                             |       |   |   |
| Product gross  profit              |       | $                               | 17,190     |                         | $          | 64,047                           |       | $ | 46,857 |   | 272.6 | % |
| Product gross margin               |       | 6.3                             | %          | 20.9                         | %          |                             |       |   |   |
| Technology  licensing gross profit |       | $                               | 25,810     |                         | $          | 27,527                           |       | $ | 1,717 |   | 6.7 | % |
| Technology licensing gross margin  |       | 100.0                           | %          | 100.0                        | %          |                             |       |   |   |
| Total gross  profit                |       | $                               | 43,000     |                         | $          | 91,574                           |       | $ | 48,574 |   | 113.0 | % |
| Total gross  margin                |       | 14.4                            | %          | 27.4                         | %          |                             |       |   |   |

 

Gross margin increased inthe third quarter of 2006 compared to the second quarter of 2006 as we shipped a greater number of highermargin products, including embedded controllers and RF ICs. Gross margin alsobenefited from our continuing transition to the smaller 0.18 and 0.25 microndie geometries. Our blended average selling prices, which take into accountboth product mix and selling prices decreased by 9.7% in the third quarter,mainly due to the product mix as the unit shipments of our low ASP productsincreased in the current quarter. Gross profit increased more than 50%for the third quarter of 2006 compared to the same period the same period in 2005due to a $4.9 million lower inventory and adverse purchase commitment provisionand a 4.5% increase in the number of units shipped. For the nine months endedSeptember 30, 2006, compared to the same period in 2005, gross profit grewsubstantially as our inventory provision declined $11.9 million. In addition, wecontinued our transition to smaller production geometries which produce highergross margin and we shipped 13.3% more units.

For other factors thatcould affect our gross profit, please also see “Part II, Item 1A.”Risk Factors- We incurred material inventory valuation adjustments in 2003, 2004 and 2005and in the first nine months of 2006, and we may incur additional materialinventory valuation adjustments in the future.”

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*Product Gross Profit*

*Memory products*

Gross profit for memoryproducts increased in the third quarter of 2006 compared to the second quarterof 2006 largely due to a 17.0% increase in the number of units shipped and thecontinuing transition of moving 8Mbit and lower density products to smallergeometries. Compared to the third quarter of 2005, gross profit increased by$12.2 million based on a 5.7% increase in average selling prices from productmix coupled with more shipments of higher margin products and lower provisionsfor inventory and adverse purchase commitments. For the nine months endedSeptember 30, 2006 gross profit grew substantially over 2005 due to a 7.9%increase in unit shipments as well as a lower provision for inventory andadverse purchase commitments in the current year.

*Non-memory products*

Gross profit fornon-memory products increased in the third quarter of 2006 compared to thesecond quarter of 2006 as total unit shipments increased 31.9% partially offsetby a 32.7% decline in average selling prices largely a result of changes inproduct mix. In comparison to the third quarter of 2005, unit shipmentsincreased 39.6%. For the nine months ended September 30, 2006 in comparison to2005, gross profit rose on 41.7% higher shipments in the current year. Weexpect some revenue fluctuation in non-memory business until at least late 2007as we expect to grow and diversify our revenue and customer base.

Operating Expenses (inthousands)

*Researchand development*
| ** **                | ** ** | **Three Months Ended** | ** ** | ** **              | ** ** | ** **                   | ** ** | ** **                       | ** ** | ** **                       | ** ** |
|---------------------------|------------|----------------------------------|------------|-------------------------|------------|------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                | ** ** | **September 30,  2005**     | ** ** | **June 30,  2006** | ** ** | **September 30,  2006** | ** ** | **3Q06-Over-  3Q05 Change** | ** ** | **3Q06-Over-  2Q06 Change** | ** ** |
| Research and  development |       | $                                | 11,770     |                    | $          | 13,093                       |       | $                                | 12,313     |                             | $          | 543 |   | 4.6 | % | $ | (780 | ) | (6.0 | )% |
| Percent of revenue        |       | 10.0                             | %          | 12.2                    | %          | 10.6                         | %          |                             |       |                             |       |   |   |   |   |
|                           |            |                                  |            |                         |            |                              |            |                                  |            |                                  |            |  |  |  |  |  |  |  |  |  |

 
|                           | ** ** | **Nine Months Ended** | ** ** | ** **                   | ** ** | ** **                       | ** ** |
|---------------------------|------------|---------------------------------|------------|------------------------------|------------|----------------------------------|------------|
| ** **                | ** ** | **September 30,  2005**    | ** ** | **September 30,  2006** | ** ** | **3Q06-Over-  3Q05 Change** | ** ** |
| Research and  development |       | $                               | 36,821     |                         | $          | 40,573                           |       | $ | 3,752 |   | 10.2 | % |
| Percent of  revenue       |       | 12.4                            | %          | 12.1                         | %          |                             |       |   |   |
|                           |            |                                 |            |                              |            |                                  |            |  |  |  |  |  |

 

Research anddevelopment expenses include costs associated with the development of newproducts, enhancements to existing products, quality assurance activities andoccupancy costs. These costs consist primarily of employee salaries,stock-based compensation expense and other benefit-related costs and the costof materials such as wafers and masks.

In comparison tothe second quarter of 2006, research and development spending decreasedprimarily due to a $721 thousand decrease in expense related to lower wafer,mask and evaluations parts due primarily to the timing of projects. Researchand development expenses rose in the third quarter of 2006 compared to thethird quarter of 2005 due to stock-based compensation expense of $1.2 millionas a result of the implementation of SFAS No. 123(R). This was partially offsetby reduced wafer and evaluation parts costs of $542 thousand due to timing ofengineering projects. For the nine months ended September 30, 2006 compared tothe same period in 2005, increased research and development spending of $3.8million was primarily due to stock-based compensation expense of $3.0 millionas a result of the implementation of SFAS No. 123(R) in 2006, as well asincreases in wafer and evaluation parts, depreciation expense and increasedpatent fees, previously recorded in Sales and Marketing.  We expect that research and development expenseswill fluctuate based on the timing of engineering projects for new productintroductions and the development of new technologies to support future growth.

*Sales and marketing*
| ** **          | ** ** | **Three Months Ended** | ** ** | ** **              | ** ** | ** **                   | ** ** | ** **                       | ** ** | ** **                       | ** ** |
|---------------------|------------|----------------------------------|------------|-------------------------|------------|------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **          | ** ** | **September 30,  2005**     | ** ** | **June 30,  2006** | ** ** | **September 30,  2006** | ** ** | **3Q06-Over-  3Q05 Change** | ** ** | **3Q06-Over-  2Q06 Change** | ** ** |
| Sales and marketing |       | $                                | 7,178      |                    | $          | 7,042                        |       | $                                | 6,829      |                             | $          | (349 | ) | (4.9 | )% | $ | (213 | ) | (3.0 | )% |
| Percent of revenue  |       | 6.1                              | %          | 6.5                     | %          | 5.9                          | %          |                             |       |                             |       |   |   |   |   |
|                     |            |                                  |            |                         |            |                              |            |                                  |            |                                  |            |  |  |  |  |  |  |  |  |  |

 

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|                      | ** ** | **Nine Months Ended** | ** ** | ** **             | ** ** | ** **           | ** ** |
|----------------------|------------|---------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **           | ** ** | **September 30,**          | ** ** | **September 30,** | ** ** | **3Q06-Over-**       | ** ** |
| ** **           | ** ** | **2005**                        | ** ** | **2006**               | ** ** | **3Q05 Change** | ** ** |
| Sales and  marketing |       | $                               | 21,524     |                   | $          | 22,032               |       | $ | 508 |   | 2.4 | % |
| Percent of  revenue  |       | 7.2                             | %          | 6.6                    | %          |                 |       |   |   |
|                      |            |                                 |            |                        |            |                      |            |  |  |  |  |  |

 

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

Sales and marketingexpense decreased in the third quarter of 2006 compared to the second quarterof 2006 due to lower commission related expenses of $102 thousand as well aslower freight expense of $131 thousand partially offset by an increase inprofit sharing expense as a result of profitability in the third quarter of2006. Sales and marketing expenses decreased slightly in the third quarter of2006 compared to the third quarter of 2005 primarily due to lower commissionrelated expenses of $162 thousand and lower freight expense of $143 thousand,offset by stock-based compensation expense of $309 thousand as a result of theimplementation of SFAS 123(R).  On a year-to-datebasis, 2006 spending was greater than the same period of 2005 primarily due tostock-based compensation expense of $806 thousand as a result of theimplementation of SFAS 123(R) in 2006. We expect that future sales andmarketing expenses may increase in absolute dollars. In addition, fluctuationsin revenues will cause fluctuations in sales and marketing expenses due to ourcommission expenses.

*General and administrative*
| ** **                  | ** ** | **Three Months Ended** | ** ** | ** **        | ** ** | ** **             | ** ** | ** **           | ** ** | ** **           | ** ** |
|-----------------------------|------------|----------------------------------|------------|-------------------|------------|------------------------|------------|----------------------|------------|----------------------|------------|
| ** **                  | ** ** | **September 30,**           | ** ** | **June 30,** | ** ** | **September 30,** | ** ** | **3Q06-Over-**       | ** ** | **3Q06-Over-**       | ** ** |
| ** **                  | ** ** | **2005**                         | ** ** | **2006**          | ** ** | **2006**               | ** ** | **3Q05 Change** | ** ** | **2Q06 Change** | ** ** |
| General and  administrative |       | $                                | 5,683      |              | $          | 5,769                  |       | $                    | 5,437      |                 | $          | (246 | ) | (4.3 | )% | $ | (332 | ) | (5.8 | )% |
| Percent of revenue          |       | 4.8                              | %          | 5.4               | %          | 4.7                    | %          |                 |       |                 |       |   |   |   |   |
|                             |            |                                  |            |                   |            |                        |            |                      |            |                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
|                             | ** ** | **Nine Months Ended** | ** ** | ** **             | ** ** | ** **           | ** ** |
|-----------------------------|------------|---------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                  | ** ** | **September 30,**          | ** ** | **September 30,** | ** ** | **3Q06-Over-**       | ** ** |
| ** **                  | ** ** | **2005**                        | ** ** | **2006**               | ** ** | **3Q05 Change** | ** ** |
| General and  administrative |       | $                               | 19,508     |                   | $          | 17,243               |       | $ | (2,265 | ) | (11.6 | )% |
| Percent of  revenue         |       | 6.6                             | %          | 5.2                    | %          |                 |       |   |   |
|                             |            |                                 |            |                        |            |                      |            |  |  |  |  |  |

 

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

General andadministrative expenses decreased in the third quarter of 2006 compared to thesecond quarter of 2006 primarily due to lower accruals for bad debt of $426thousand partially offset by profit sharing accruals of $135 thousand in thethird quarter of 2006. In comparison to the third quarter of 2005, expensesdecreased in the third quarter of 2006 primarily due to lower recurring legalfees of $321 thousand and lower accruals for bad debt of $458 thousand offsetby stock-based compensation expense of $665 thousand from the implementation ofSFAS 123(R). For the nine months ended September 30, 2006 compared to the sameperiod in 2005, lower general and administrative expenses were due to decreasedexternal professional fees of $1.3 million, primarily due to contingent workassociated with a tax refund project, and outside professional services of $1.5million primarily due to lower Sarbanes-Oxley compliance costs, partiallyoffset by stock-based compensation expense of $1.9 million as a result of theimplementation of SFAS No. 123(R) in 2006. In addition to the increased expenserelated to SFAS No. 123(R), we anticipate that general and administrativeexpenses may increase in absolute dollars as we scale our facilities,infrastructure and headcount to support our overall expected growth.

*Other operating expenses*
| ** **                | ** ** | **Three Months Ended** | ** ** | ** **        | ** ** | ** **             | ** ** | ** **           | ** ** | ** **           | ** ** |
|---------------------------|------------|----------------------------------|------------|-------------------|------------|------------------------|------------|----------------------|------------|----------------------|------------|
| ** **                | ** ** | **September 30,**           | ** ** | **June 30,** | ** ** | **September 30,** | ** ** | **3Q06-Over-**       | ** ** | **3Q06-Over-**       | ** ** |
| ** **                | ** ** | **2005**                         | ** ** | **2006**          | ** ** | **2006**               | ** ** | **3Q05 Change** | ** ** | **2Q06 Change** | ** ** |
| Other operating  expenses |       | $                                | (16        | )                 | $          | —                 |       | $                    | —     |                 | $          | 16 |   | (100.0 | )% | $ | — |   | 0.0 | % |
| Percent of revenue        |       | 0.0                              | %          | 0.0               | %          | 0.0                    | %          |                 |       |                 |       |   |   |   |   |
|                           |            |                                  |            |                   |            |                        |            |                      |            |                      |            |  |  |  |  |  |  |  |  |  |

 

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|                           | ** ** | **Nine Months Ended** | ** ** | ** **             | ** ** | ** **           | ** ** |
|---------------------------|------------|---------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                | ** ** | **September 30,**          | ** ** | **September 30,** | ** ** | **3Q06-Over-**       | ** ** |
| ** **                | ** ** | **2005**                        | ** ** | **2006**               | ** ** | **3Q05 Change** | ** ** |
| Other operating  expenses |       | $                               | 2,895      |                   | $          | —               |       | $ | (2,895 | ) | (100.0 | )% |
| Percent of  revenue       |       | 1.0                             | %          | 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 nine months of 2006.

*Otherincome and expense, net*
|                                            | ** ** | **Three Months Ended** | ** ** | ** **        | ** ** | ** **             | ** ** |
|--------------------------------------------|------------|----------------------------------|------------|-------------------|------------|------------------------|------------|
| ** **                                 | ** ** | **September 30,**           | ** ** | **June 30,** | ** ** | **September 30,** | ** ** | **3Q06-Over-** | ** ** | **3Q06-Over-** | ** ** |
| ** **                                 | ** ** | **2005**                         | ** ** | **2006**          | ** ** | **2006**               | ** ** | **3Q05 Change** | ** ** | **2Q06 Change** | ** ** |
| Other income (expense), net |       | $                                | 556        |              | $          | 1,080                  |       | $ | 2,560 |   | $ | 2,004 |   | 360.4 | % | $ | 1,480 |   | 137.0 | % |
| Percent of revenue               |       | 0.5                              | %          | 1.0               | %          | 2.2                    | %          |   |   |   |   |   |   |   |   |
|                                            |            |                                  |            |                   |            |                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
|                              | ** ** | **Nine Months Ended** | ** ** | ** **             | ** ** | ** **           | ** ** |
|------------------------------|------------|---------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                   | ** ** | **September 30,**          | ** ** | **September 30,** | ** ** | **3Q06-Over-**       | ** ** |
| ** **                   | ** ** | **2005**                        | ** ** | **2006**               | ** ** | **3Q05 Change** | ** ** |
| Other income  (expense), net |       | $                               | 2,032      |                   | $          | 4,104                |       | $ | 2,072 |   | 102.0 | % |
| Percent of  revenue          |       | 0.7                             | %          | 1.2                    | %          |                 |       |   |   |
|                              |            |                                 |            |                        |            |                      |            |  |  |  |  |  |

 

Other income and expensefor the periods presented included mainly interest and dividend income on ourcash and investments. Other income (expense) increased during the three monthsended September 30, 2006 in comparison to the prior quarter and the thirdquarter of 2005 due to higher levels of invested cash and higher short-terminterest rates as well as the annual dividends declared by our investeecompanies. For the nine months ended September 30, 2006 in comparison to thenine months ended September 30, 2005, other income rose due to greater levelsof invested cash, and rising interest rates. We expect other income and expensewill fluctuate as a result of changes in cash balances and the timing fordividends on our investments.

*Interest expense*
| ** **         | ** ** | **Three Months Ended** | ** ** | ** **        | ** ** | ** **             | ** ** |
|--------------------|------------|----------------------------------|------------|-------------------|------------|------------------------|------------|
| ** **         | ** ** | **September 30,**           | ** ** | **June 30,** | ** ** | **September 30,** | ** ** | **3Q06-Over-** | ** ** | **3Q06-Over-** | ** ** |
| ** **         | ** ** | **2005**                         | ** ** | **2006**          | ** ** | **2006**               | ** ** | **3Q05 Change** | ** ** | **2Q06 Change** | ** ** |
| Interest expense   |       | $                                | 98         |              | $          | 57                     |       | $ | 111 |   | $ | 13 |   | 13.3 | % | $ | 54 |   | 94.7 | % |
| Percent of revenue |       | 0.1                              | %          | 0.1               | %          | 0.1                    | %          |   |   |   |   |   |   |   |   |
|                    |            |                                  |            |                   |            |                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
|                     | ** ** | **Nine Months Ended** | ** ** | ** **             | ** ** | ** **           | ** ** |
|---------------------|------------|---------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **          | ** ** | **September 30,**          | ** ** | **September 30,** | ** ** | **3Q06-Over-**       | ** ** |
| ** **          | ** ** | **2005**                        | ** ** | **2006**               | ** ** | **3Q05 Change** | ** ** |
| Interest expense    |       | $                               | 156        |                   | $          | 247                  |       | $ | 91 |   | 58.3 | % |
| Percent of  revenue |       | 0.1                             | %          | 0.1                    | %          |                 |       |   |   |
|                     |            |                                 |            |                        |            |                      |            |  |  |  |  |  |

 

Interest expense remainedrelatively low as we do not have significant outstanding debt.  Interest expense in the third quarter of 2006increased compared to the second quarter of 2006 due to higher use fee taxesand loan fee amortization. For the nine months ended September 30, 2006 incomparison to the prior year interest expense was higher due to our borrowingsbeing outstanding for a longer period of time. On August 11, 2006, we enteredinto a 1-year loan and security agreement with Cathay Bank, a U.S. bank, for a$40.0 million revolving line of credit all of which was available to us as ofSeptember 30, 2006. As of September 30, 2006, a standby letter of credit in theamount of $8.0 million has been issued to Bank of America. As of September 30,2006, SST China Limited has drawn RMB $24 million, or approximately $3.0million US dollars, at the interest rate of 5.02%.

*Equityinvestments*

During the first quarterof 2006, we realized a pre-tax gain of $12.2 million from the sale of 4.0million shares of our investment in Powertech Technology, Inc. or PTI. As ofSeptember 30, 2006, we still owned 5.5 million shares of PTI.

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

*Change in accounting principle*

In September 2006, weinvested an additional $15.9 million in Advanced Chip Engineering TechnologyInc., or ACET, that increased our ownership share of ACET’s outstanding capitalstock from 9.4% to 46.9% and required us to change from the cost method ofaccounting to the equity method of accounting for this investment. Under theequity method of accounting, we are required to record our 46.9% interest inACET’s reported net income or loss each reporting period as well as requirethat prior period financial results be restated to reflect the equity method ofaccounting from the date of the initial investment. The third quarter of 2006results includes a charge recorded in “pro rata share of loss from equityinvestments” on our condensed consolidated statement of operations of $607thousand, as a result our increased investment in ACET. Under this accountingtreatment, we would have recorded a charge of $209 thousand for the threemonths ended June 30, 2006 and $1.0 million for the nine months ended September30, 2006. In comparison to the same periods in the prior year, we would haverecorded a charge of $242 thousand and $822 thousand for the three and ninemonths ended September 30, 2005.  Forfurther information, please refer to Note 13 “Change in Accounting Principle.”The following tables compare the quarter over quarter and year over yearamounts as restated on our consolidated statement of operations.
|                                                 | ** ** | **Three Months Ended** | ** ** | ** **        | ** ** | ** **             | ** ** | ** **       | ** ** | ** **       | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|-------------------|------------|------------------------|------------|------------------|------------|------------------|------------|
| ** **                                      | ** ** | **September 30,**           | ** ** | **June 30,** | ** ** | **September 30,** | ** ** | **3Q06-Over-**   | ** ** | **3Q06-Over-**   | ** ** |
| ** **                                      | ** ** | **2005**                         | ** ** | **2006**          | ** ** | **2006**               | ** ** | **3Q05  Change** | ** ** | **2Q06  Change** | ** ** |
| Pro rata share of loss  from equity investments | ** ** | $                                | (427       | )                 | $          | (233                   | )          | $                | (614       | )                | $          | (187 | ) | 43.8 | % | $ | (381 | ) | 163.5 | % |
|                                                 |            |                                  |            |                   |            |                        |            |                  |            |                  |            |  |  |  |  |  |  |  |  |  |

 
|                                                 | ** ** | **Nine Months Ended** | ** ** | ** **             | ** ** | ** **           | ** ** |
|-------------------------------------------------|------------|---------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                      | ** ** | **September 30,**          | ** ** | **September 30,** | ** ** | **3Q06-Over-**       | ** ** |
| ** **                                      | ** ** | **2005**                        | ** ** | **2006**               | ** ** | **3Q05 Change** | ** ** |
| Pro rata share  of loss from equity investments |       | $                               | (1,267     | )                      | $          | (1,087               | )          | $ | 180 |   | (14.2 | )% |
|                                                 |            |                                 |            |                        |            |                      |            |  |  |  |  |  |  |  |  |  |  |

 

**Provisionfor Income Taxes**

We maintained a fullvaluation allowance on our net deferred tax assets as of September 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*,” which requires an assessmentof both positive and negative evidence when determining whether it is morelikely than not that deferred tax assets are recoverable; such assessment isrequired on a jurisdiction by jurisdiction basis. Cumulative losses incurred inthe U.S. in recent years represented sufficient negative evidence under SFASNo. 109 such that a full valuation allowance was recorded against U.S. deferredtax assets. We intend to maintain a full valuation allowance in the U.S.deferred tax assets until sufficient positive evidence exists to supportreversal of the valuation allowance.

Our tax provision for thethree and nine months ended September 30, 2006 was $2.8 million and $6.1million, respectively, which consists primarily of foreign withholding taxesand tentative U.S. minimum tax.

**Liquidityand Capital Resources (in thousands)**
|                              | ** ** | **Nine Months Ended** | ** ** |
|------------------------------|------------|---------------------------------|------------|
| ** **                   | ** ** | **September 30,**          | ** ** |
| ** **                   | ** ** | **2005**                        | ** ** | **2006** | ** ** |
| Cash provided by  (used in): | ** ** | ** **                      | ** ** | ** ** | ** ** |
| Operating  activities        |       | $                               | (50,516    | ) | $ | 53,522 |   |
| Investing  activities        |       | $                               | 54,140     |   | $ | (46,412 | ) |
| Financing Activities         |       | $                               | 6,029      |   | $ | 564 |   |

 

*Operating activities.*  The major contributing factorsto our sources and uses of operating cash during the nine months were netincome of $17.1 million, and the reduction of receivables of $14.2 million as aresult of payments from our

28

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customers. This was offset by decreased trade accounts payable of $13.5million. Net income was also affected by non-cash items in the first ninemonths 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 $6.1million, depreciation and amortization expense of $7.5 million, a $3.5 millioncharge for the impairment of our in investment in Nanotech, Inc. and an $11.9million charge to our inventory and adverse purchase commitments provision. Ouroperating activities used cash of $50.5 million for the nine months endedSeptember 30, 2005. Our net loss of $39.1 million for the nine months endedSeptember 30, 2005, included non-cash charges of $32.1 million for provisionagainst inventory, $7.2 million of depreciation and amortization, $1.7 millionfor purchasing in process research and development and $1.8 million for theprovision of sales returns.  In additionto our net loss, the primary usage of cash related to an increase in tradeaccounts receivable of $17.9 million, decreased accounts payable from relatedand unrelated parties of $28.3 million and a decrease in accrued expenses andother liabilities of $8.9 million.

*Investing activities.*  The primary uses of cash frominvesting activities were $49.9 million used for the purchase of otheravailable-for-sale instruments and $18.9 million in cash to purchase additionalequity securities including $15.9 million for additional shares of ACET toincrease our ownership total to 46.9%. In addition, we used $3.6 million inpurchases of fixed assets.  These uses ofcash were partially offset by $26.4 million in cash from the sales andmaturities of available-for-sale equity investments. Our investing activitiesprovided cash of $54.1 million for the first nine months of 2005. Cash providedby investing activities in the first nine months of 2005 was primarily attributableto $88.0 million of cash from the net sales and maturities of available-for-saleinvestments, offset by the purchase of $21.6 million in available-for-saleinvestments, $7.8 million net cash used in the acquisition of Actrans and theminority interest of Emosyn, $4.1 million in capital expenditures and $333thousand in equity investments. 

*Financing activities.*  Cash from financing activitiesin the nine months of 2006 related primarily to the issuance of common stockunder our employee stock purchase plan and the exercise of employee stockoptions of $2.5 million offset by capital lease payments of $1.1 million and$857 thousand in debt repayments. Our financing activities provided cash of $6.0million during the first nine months of 2005. Cash generated from financingactivities in the first nine months of 2005 primarily related to the borrowingagainst the line of credit of $3.0 million, and the issuance of common stockunder the employee stock purchase plan and the exercise of employee stockoptions totaling $3.4 million.

Principalsources of liquidity at September 30, 2006 consisted of $123.0 million of cash,cash equivalents and short-term available-for-sale investments.  In addition, in August 2006, we entered into a1-year loan and security agreement with Cathay Bank, for a $40.0 millionrevolving line of credit.  For moreinformation regarding the line of credit, refer to Note 8 of the Notes to theUnaudited Condensed Consolidated Financial Statements

Asof September 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 to December31, 2005.

*Purchase Commitments.*As of September 30, 2006, we had outstanding purchase commitments withour foundry vendors of $41.4 million for delivery in 2006.  We have recorded a liability of $354 thousandfor adverse purchase commitments.  Incomparison, as of December 31, 2005, we hadoutstanding purchase commitments with our foundry vendors of $51.7 million fordelivery in 2006, with a recorded liability of $1.8 million for adversepurchase commitments.

*OperatingCapital Requirements*. We believe our cash balances, together with the funds we expect to generatefrom operations, will be sufficient to meet our projected working capital andother cash requirements through at least the next twelve months. However, if wefail to execute to our business strategies, we could experience declines in ourcash balances.  We have secured a line ofcredit for up to $40.0 million from Cathay Bank to meet operating capitalrequirements if needed. This line of credit expires on August 11, 2007. As ofSeptember 30, 2006, a standby letter of credit in the amount of $8.0 millionhas been issued against the line as collateral for the line of credit with Bankof America in China. As of September 30, 2006, SST China Limited has drawn RMB$24 million, or approximately $3.0 million US dollars, at an interest rate of5.02%. 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 average selling prices of our products;

·                  customer demand for our products;

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·                  the need to secure future wafer production capacityfrom our suppliers;

·                  the timing of significant orders and of license androyalty revenue;

·                  the ability to manage our inventory levels accordingto plan; and

·                  unanticipated research anddevelopment expenses associated with new product introductions.

Please also see “Part II. Item 1A. “Risk Factors - Our operatingresults fluctuate significantly and an unanticipated decline in revenues maydisappoint securities analyst or investors and result in a decline in our stockprice.”

In January and February2005, multiple putative shareholder class action complaints were filed againstus and certain of our directors and officers in the United States DistrictCourt for the Northern District of California. Following the filing of 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 and October 2006, multipleshareholder derivative complaints were filed against us and certain of ourdirectors and officers in the United States District Court for the NorthernDistrict of California. In the event of unfavorable outcome of the suits, wemay be required to pay damages.  For moreinformation, please also see “Part II. Item 1A. “Risk Factors – We are engagedin securities class action suits and derivative suits, which may become timeconsuming, costly and divert management resources and could impact our stockprice.”

From time to time, we arealso involved in other legal actions arising in the ordinary course ofbusiness.  We have accrued certain costsassociated with defending these matters. There can be no assurance that the shareholder class action complaints,the shareholder derivative complaints or other third party assertions will beresolved without costly litigation, in a manner that is not adverse to ourfinancial position, results of operations or cash flows or without requiringroyalty payments in the future which may adversely impact gross margins.  No estimate can be made of the possible lossor possible range of loss associated with the resolution of thesecontingencies.  As a result, no losses have been accrued in our financial statements asof September 30, 2006.

**Recent AccountingPronouncements**

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, 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 wedo not expect the adoption of FIN 48 to have a material impact on ourconsolidated financial statements.

In September 2006,the FASB issued Statement No. 157, “*FairValue Measurements*.” This new standard defines fair value,establishes a framework for measuring fair value in generally acceptedaccounting principles, and expands disclosures about fair value measurements.The new standard is effective for financial statements issued for fiscal yearsbeginning after November 15, 2007, and interim periods within those years.The provisions of the new standard are to be applied prospectively for mostfinancial instruments and retrospectively for others as of the beginning of thefiscal year in which the standard is initially applied. We will be required toadopt this new standard in the first quarter of 2008. We are currentlyevaluating the requirements of Statement No. 157 and have not yet determinedthe impact on our consolidated financial statements.

In September 2006, the SEC issued Staff AccountingBulletin (“SAB”) No. 108, “*Considering theEffects of Prior Year Misstatements when Quantifying Misstatements in CurrentYear Financial Statements*.” SAB 108 addresses the views of the SECstaff regarding the process of quantifying financial statement misstatements.SEC registrants are

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expected to reflect the effects of initially applyingthe guidance in SAB 108 in their annual financial statements covering the firstfiscal year ending after November 15, 2006. The cumulative effect of theinitial application should be reported in the carrying amounts of assets andliabilities as of the beginning of that fiscal year and the offsetting adjustmentshould be made to the opening balance of retained earnings for that year. Wewill be required to adopt the interpretations in SAB 108 in the fourth quarterof 2006. We are currently evaluating the impact, if any,  of applying this guidance.

In March 2006, the Emerging Issues Task Force reacheda consensus on Issue No. 06-03 “How Taxes Collected from Customers and Remittedto Government Authorities Should Be Presented in the Income Statement (that is,Gross versus Net Presentation)” (“EITF No. 06-03”). We are required to adoptthe provisions of EITF No. 06-03 beginning in fiscal year 2007. We do notexpect the provisions of EITF No. 06-03 to have a material impact on the ourconsolidated financial position, results of operations or cash flows.

**Item 3.Quantitative and Qualitative Disclosures about Market Risk**

We are exposed to risksassociated with foreign exchange rate fluctuations due to our internationalmanufacturing and sales activities. These exposures may change over time as business practices evolve andcould negatively impact our operating results and financial condition.Currently, we do not hedge these foreign 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 declinein the demand could reduce revenues and/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. had becomeimpaired as Nanotech defaulted on its loan payments to certain of its businesspartners and began preparations to liquidate itself. As a result, we wrote our$3.3 million investment down to zero as well as an outstanding loan for $225thousand.

At any time, fluctuations in interest rates could affect interestearnings on our cash, cash equivalents and available-for-sale investments, orthe fair value of our investment portfolio. A 10% move in interest rates as ofSeptember 30, 2006 would have an immaterial effect on our financial position,results of operations and cash flows. Currently, we do not hedge these interestrate exposures. As of September 30, 2006, the carrying value of ouravailable-for-sale investments approximated fair value.  The table below presents the carrying valueand related weighted average interest rates for our unrestricted and restrictedcash, cash equivalents and available-for-sale investments as of September 30,2006 (in thousands):
|                                                         | ** ** | **Carrying** | ** ** | **Interest** | ** ** |
|---------------------------------------------------------|------------|--------------|------------|--------------|------------|
| ** **                                              | ** ** | **Value**    | ** ** | **Rate**     | ** ** |
| Cash and cash  equivalents - variable rate              |       | $            | 85,056     |         | 4.2        | % |
| Short-term  available-for-sale investments - fixed rate |       | 37,945       |       | 5.3          | %          |
|                                                    |       | $            | 123,001    |         | 4.6        | % |

 

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

**Disclosure Controls and Procedures**

We maintaindisclosure controls and procedures that are designed to ensure that informationrequired to be disclosed in our reports filed or submitted pursuant to theSecurities Exchange Act of 1934, as amended, or the Exchange Act, is recorded,processed, summarized and reported within the time periods specified in theSecurities and Exchange Commission’s rules and forms.  Disclosure controls and procedures also aredesigned to ensure that such information is accumulated and communicated to ourmanagement, including our Chief Executive Officer and Chief Financial Officer,as appropriate, to allow timely decisions regarding required disclosure. Acontrol system, no matter how well designed and operated, can provide onlyreasonable, not absolute, assurance that the control system’s objectives willbe met.

Ourmanagement, with the participation of the Chief Executive Officer and ChiefFinancial Officer, conducted an evaluation of the effectiveness of ourdisclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e)

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and15d-15(e)) as of September 30, 2006. Based on their evaluation, the Chief Executive Officer and the ChiefFinancial Officer have concluded that our disclosure controls and procedureswere effective at the reasonable assurance level as of September 30, 2006.

**Changes in Internal Control Over Financial Reporting**

There have been nochanges in our internal control over financial reporting during the quarterended September 30, 2006 that have materially affected or are reasonably likelyto materially affect our internal control over financial reporting, as definedin Rule 13a-15(f) under the Exchange Act.

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**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 thecomplaint on September 16, 2005. Plaintiff served an opposition to the motion to dismiss on November 4,2005.  Our reply in further support ofthe motion to dismiss was filed on December 19, 2005. On January 18, 2006, theCourt heard 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.Plaintiffs filed a second amended complaint on May 1, 2006. We responded with amotion to dismiss on June 19, 2006. We intend to take all appropriate action inresponse to these lawsuits.  The impactrelated to the outcome of these matters is undeterminable at this time.

In January and February2005, following the filing of the putative class actions, multiple shareholderderivative complaints were filed in California Superior Court for the County ofSanta Clara, purportedly on behalf of SST against certain of our directors andofficers. The factual allegations of these complaints are substantiallyidentical to those contained in the putative shareholder class actions filed infederal court.  The derivative complaintsassert claims for, among other things, breach of fiduciary duty and violationsof the California Corporations Code. These derivative actions have been consolidated under the caption *In Re Silicon Storage Technology, Inc. Derivative Litigation*,Lead Case No. 1:05CV034387 (Cal. Super. Ct., Santa Clara Co.).  On April 28, 2005, the derivative action 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 SST 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.  The*Brien*and *Bazargani*cases were consolidated into one case: *In re Silicon StorageTechnology, Inc*. *Derivative Litigation*,Case No. C06-04310 JF and a consolidated amended shareholder derivativecomplaint was filed on October 30, 2006. On October 31, 2006, a similar shareholder derivative complaint wasfiled in the Superior Court of the State of California for the County of SantaClara by Alex Chuzhoy under the caption *Chuzhoy v. Yeh, et al.,*CaseNo. 1-06-CV-074026.  This complaint wasbrought purportedly on behalf of SST against certain of our current and formerofficers and directors and alleges among other things, that the named officersand directors breached their fiduciary duties as they colluded with each otherto backdate stock options and were allegedly unjustly enriched by theiractions.  The *Chuzhoy*complaintalso alleges that certain of our officers and directors violated section 25402of the California Corporations Code by selling shares of our common stock whilein possession of material non-public adverse information.  We intend to take all appropriate action inresponding to all of the complaints.

From time to time, we arealso involved in other legal actions arising in the ordinary course ofbusiness.  We have accrued certain costsassociated with defending these matters. There can be no assurance that the shareholder class action complaints,the shareholder derivative complaints or other third party assertions will beresolved without costly litigation, in a manner that is not adverse to ourfinancial position, results of operations or cash flows or without requiringroyalty payments in the future which may adversely impact gross margins. No estimatecan be made of the possible loss or possible range of loss associated with theresolution of these contingencies.  As a result, no losses have been accrued in ourfinancial statements as of September 30, 2006.

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**Item 1A. *  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 last four quarters and the year ended December 31, 2004, weincurred net losses for the years ended December 31, 2005 and 2003. Ouroperating results have fluctuated significantly and our past financialperformance should not be used to predict future operating results. Our recentquarterly and annual operating results have fluctuated, and may continue tofluctuate, due to the following factors, all of which are difficult to forecastand many of which are out of our control:

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

·                  competitivepricing pressures and related changes in selling prices;

·                  fluctuations inmanufacturing yields and significant yield losses;

·                  new productannouncements and introductions of competing products by us or our competitors;

·                  productobsolescence;

·                  lower of cost ormarket, obsolescence or other inventory adjustments;

·                  changes indemand for, or in the mix of, our products;

·                  the gain or lossof significant customers;

·                  marketacceptance of products utilizing our SuperFlash® technology;

·                  changes in thechannels through which our products are distributed and the timeliness ofreceipt of distributor resale information;

·                  exchange ratefluctuations;

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

·                  changes in ourallowance for doubtful accounts;

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

·                  difficulties inforecasting, planning and management of inventory levels;

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

·                  the timing ofsignificant 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 inconsumer demand which may cause customers to cancel backlog, push out shipmentschedules, or reduce new orders, possibly due to a slowing economy or inventorycorrections among our customers;

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

·                  sudden shortagesof raw materials for fabrication, test or assembly capacity constraints thatlead our suppliers to allocate available supplies or capacity to othercustomers which, in turn, harm our ability to meet our sales obligations; and

·                  the reduction,rescheduling or cancellation of customer orders.

In addition,political or economic events beyond our control can suddenly result inincreased operating costs.  In addition,we are now required to record compensation expense on stock option grants andpurchases under our employee stock purchase plan which substantially increasesour operating costs and impacts our earnings (loss) per share.

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**We incurred significant inventoryvaluation and adverse purchase commitment adjustments in 2003, 2004, 2005 andin the first nine 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 berequired to adjust our inventory value to reflect the lower of cost ormarket.  As of September 30, 2006, we had$86.1 million of net inventory on hand, a decrease of $22.2 million, or 20.5%,from December 31, 2005.  Total valuationadjustments to inventory and adverse purchase commitments were $37.3 million in2005 and $11.9 million in the first nine months of 2006. Due to the largenumber of units in our inventory, even a small change in average selling pricescould result in a significant adjustment and could harm our financial results.Some of our customers have requested that we ship them product that has afinished goods date of manufacture that is less than one year.  As of September 30, 2006, our allowance forexcess and obsolete inventories includes an allowance for our on hand finishedgoods inventory with a date of manufacture of greater than two years and forcertain products with a date of manufacture of greater than one year.  In the event that this becomes a commonrequirement, it may be necessary for us to provide for an additional allowancefor our on hand finished goods inventory with a date of manufacture of greaterthan one year, which could result in a significant adjustment and could harmour 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. During the third quarter of 2006, wehad growth in our unit shipments across our four application categories as theelectronics industry entered the holiday-build season. We expect to seecontinued strength in product demand across many of our application categoriesin the fourth quarter of 2006. Our business could be further harmed byindustry-wide prolonged downturns in the future.

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

During 2005 and the firstnine months of 2006, our international product and licensing revenues accountedfor 92.7% and 94.5% of our net revenues, respectively. Our internationalbusiness activities are subject to a number of risks, each of which couldimpose unexpected costs on us that would harm our operating results. Theserisks include:

·                  difficulties incomplying with regulatory requirements and standards;

·                  tariffs andother trade barriers;

·                  costs and risksof localizing products for foreign countries;

·                  reliance onthird parties to distribute our products;

·                  extendedaccounts receivable payment cycles;

·                  potentiallyadverse tax consequences;

·                  limits onrepatriation of earnings; and

·                  burdens ofcomplying with a wide variety of foreign laws.

In addition, we have made equity investments in companies withoperations in several Asian countries. The value of our investments is subject to the economic and political conditionsparticular to their industry, their countries and to foreign exchange rates andto the global economy. If we determine that a change in the recorded value ofan investment is other than temporary, we will adjust the value of theinvestment. Such an expense could have a negative impact on our operatingresults.

We derived 86.0%, 87.6%and 87.4% of our net product revenues from Asia during 2004, 2005 and the firstnine 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

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economic deflation, itcan negatively impact our revenues and also negatively impact our ability tocollect payments from customers. In this event, the lack of capital in thefinancial sectors of these countries may make it difficult for our customers toopen letters of credit or other financial instruments that are guaranteed byforeign banks.  Finally, the economicsituation can exacerbate a decline in selling prices for our products as ourcompetitors reduce 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 similarfuture events may disrupt our operations or those of our customers,distributors and suppliers, affect the availability of materials needed tomanufacture our products, or affect the means to transport those materials tomanufacturing facilities and finished products to customers.  In addition, these events have had and maycontinue to have an adverse impact on the U.S. and world economy in general andconsumer spending in particular, which could harm our business.

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

We do not typically enterinto long-term contracts with our customers. In addition, we cannot be 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 owned subsidiary of Professional Computer Technology,or PCT, which is one of our stocking representatives in Taiwan.  During 2004, 2005 and the first nine monthsof 2006, SPT serviced end customer shipments accounting for 52.9%, 58.5% and58.9%, respectively, of our net product revenues recognized.  As of December 31, 2005 and September 30,2006, SPT accounted for 69.6%, and 68.5% respectively, of our net accountsreceivable. For further description of our relationships with PCT and SPT,please refer to “Item 7. Management’s Discussion and Analysis of FinancialCondition and Results of Operation - Related Party Transactions” in our AnnualReport on Form 10-K for the 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 providingservices to us at any time.  If SPT, PCTor SPAC were to terminate their relationship with us we would experience adelay in reestablishing warehousing, logistics and distribution functions, andit could impair our ability to collect accounts receivable from SPT and mayharm our business.

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**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, TSMC inTaiwan, Seiko-Epson and Yasu in Japan and Grace and Shanghai Hua Hong NECElectronic Company Limited, or HHNEC, in China. We have invested $83.2 million in GSMC, a Cayman Islands company, whichowns a wafer 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 wecould suffer 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, our abilityto 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 manufacturing yields.Semiconductor manufacturing yields are a function of both our design technologyand the foundry’s manufacturing process technology. Low yields may result frommarginal design or manufacturing process drift. Yield problems may not be identified until the wafers are well into theproduction process, which often makes them difficult, time consuming and costlyto correct.  Furthermore, we rely onindependent foundries for our wafers which increases the effort and timerequired to identify, communicate and resolve manufacturing yieldproblems.  If our foundries fail toachieve acceptable manufacturing yields, we will experience higher costs ofrevenues and reduced product availability, which could harm our operatingresults.

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

Our wafer and productrequirements typically represent a small portion of the total production of thefoundries that manufacture our products. As a result, we are subject to therisk that a foundry will cease production on an older or lower-volumemanufacturing process that it uses to produce our parts.  Additionally, we cannot be certain ourfoundries will continue to devote resources to advance the process technologieson which the manufacturing of our

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products is based.  Either one of these events could increase ourcosts and harm our ability to deliver our products on time.

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

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

·                  reduced controlover delivery schedules and quality;

·                  the potentiallack of adequate capacity during periods of strong demand;

·                  difficultiesselecting and integrating new subcontractors;

·                  limitedwarranties on products supplied to us;

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

·                  potentialmisappropriation of our intellectual property.

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

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

Due to the flash memoryproduct cycle we usually require more than nine months to realize volumeshipments after we first contact a customer. We first work with customers toachieve a design win*,*which maytake three months or longer.  Ourcustomers then complete the design, testing and evaluation process and begin toramp up production, a period which typically lasts an additional nine months orlonger. As a result, a significant period of time may elapse between ourresearch and development efforts and our realization of revenue, if any, fromvolume purchasing of our products by our customers.

**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 changingtechnologies;

·                  evolving andcompeting industry standards;

·                  changingcustomer needs;

·                  frequent newproduct introductions and enhancements;

·                  increasedintegration with other functions; and

·                  rapid productobsolescence.

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

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have our productsdesigned into our customers’ future products and maintain close workingrelationships with key customers in order to develop new products that meettheir changing needs.  In addition,products for communications applications are based on continually evolvingindustry standards.  Our ability tocompete will depend on our ability to identify and ensure compliance with theseindustry standards.  As a result, wecould be required to invest significant time and effort and incur significantexpense to redesign our products and ensure compliance with relevantstandards.  We believe that products forthese applications will encounter intense competition and be highly pricesensitive.  While we are currently developingand introducing new products for these applications, we cannot assure you thatthese products will reach the market on time, will satisfactorily addresscustomer needs, will be sold in high volume, or will be sold at profitablemargins.

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 in parton the continued service of our key design engineering, sales, marketing andexecutive personnel and our ability to identify, recruit and retain additionalpersonnel.**

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 198 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,costly and 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 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,

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respectively, for theclass.  The lead plaintiff filed aConsolidated Amended Class Action Complaint on July 15, 2005.  The complaint seeks unspecified damages onalleged violations of federal securities laws during the period from April 21,2004 to December 20, 2004.  We moved todismiss the complaint on September 16, 2005. Plaintiff served an opposition to the motion to dismiss on November 4,2005.  Our reply in further support ofthe motion to dismiss 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. Pursuant to theCourt’s Order, any amended complaint must be filed no later than May 1, 2006.Plaintiffs filed a second amended complaint on May 1, 2006. We responded with amotion to dismiss on June 19, 2006. We intend to take all appropriate action inresponse to these lawsuits.  The impactrelated to the outcome of these matters is undeterminable at this time.

In January and February2005, following the filing of the putative class actions, multiple shareholderderivative complaints were filed in California Superior Court for the County ofSanta Clara, purportedly on behalf of SST against certain of our directors andofficers.  The factual allegations 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 SST 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.  The*Brien*and *Bazargani*cases were consolidated into one case: *In re Silicon StorageTechnology, Inc*. *Derivative Litigation*,Case No. C06-04310 JF and a consolidated amended shareholder derivativecomplaint was filed on October 30, 2006. On October 31, 2006, a similar shareholder derivative complaint wasfiled in the Superior Court of the State of California for the County of SantaClara by Alex Chuzhoy under the caption *Chuzhoy v. Yeh, et al.,*CaseNo. 1-06-CV-074026.  This complaint wasbrought purportedly on behalf of SST against certain of our current and formerofficers and directors and alleges among other things, that the named officersand directors breached their fiduciary duties as they colluded with each otherto backdate stock options and were allegedly unjustly enriched by theiractions.  The *Chuzhoy*complaintalso alleges that certain of our officers and directors violated section 25402of the California Corporations Code by selling shares of our common stock whilein possession of material non-public adverse information.  We intend to take all appropriate action inresponding to all of 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 operating

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results.  Furthermore, if such a finding were made,there can be no assurance that we could license the other company’s technologyon commercially reasonable terms or that we could successfully operate withoutsuch technology.  Moreover, if we arefound to infringe, we could be required to pay damages to the owner of theprotected technology and could be prohibited from making, using, selling, orimporting into the United States any products that infringe the protectedtechnology.  In addition, the managementattention consumed by and legal cost associated with any litigation could harmour operating 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 threat of theAvian flu, could harm the operations of our suppliers, distributors, logisticscenter 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 thisexposure, all corporate computer systems at our main California facilities areon battery back-up.  ****In addition, all of our engineering and back-upservers and selected corporate servers are on generator back-up****.  While the majority of our 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.

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

Changing laws,regulations and standards relating to corporate governance and publicdisclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations andNASDAQ Marketplace 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 thislegislation since its inception and will continue to do so for future fiscalperiods. We may encounter problems or delays in completing the review andevaluation, the implementation of improvements and the receipt of a positiveattestation, or any attestation at all, by our independent regional accountingfirm. Additionally, management’s assessment of our internal controls overfinancial reporting may identify deficiencies that need to be addressed in ourinternal controls over financial reporting or other matters that may raiseconcerns for investors.

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.

**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 resultsof operations. There is no assurance that any such discussions or negotiationswill result in the consummation of any transaction. The process of integratingany acquired business

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may createunforeseen operating difficulties and expenditures and is itself risky. Theareas where we may face difficulties include:

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

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

·                       the need tointegrate each company’s accounting, management information, human resource andother administrative systems to permit effective management, and the lack ofcontrol if such integration is delayed or not implemented;

·                       the need toimplement controls, procedures and policies appropriate for a public company atcompanies that prior to acquisition had lacked such controls, procedures andpolicies; and in some cases, the need to transition operations onto ourplatforms and

·                       in somecases, 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. In the third quarter of 2006, we hadgrowth in our unit shipments across our four application categories while ouraverage selling prices of our products decreased from the second quarter of2006.  Our business could be furtherharmed by industry-wide prolonged downturns in the future.

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

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 aportion of our sales may become more pronounced.

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** **

**Item 5.  Other Information.**

OnAugust 11, 2006, we entered into a 1-year loan and security agreement withCathay Bank, a U.S. bank, for a $40.0 million revolving line of credit all ofwhich was available to us as of September 30, 2006. The line of credit will beused for working capital but there are no restrictions in the agreement as tohow the funds may be used.  The interestrate for the line of credit is 1% below the prime rate reported from time totime by the Wall Street Journal, Western Edition (8.25% at September 30, 2006).The line of credit is collateralized by substantially all of the assets of SSTother than intellectual property.  Theagreement contains certain financial covenants, including the levels ofqualifying accounts receivable and inventories, which could limit theavailability of funds under the agreement.

The Loan and Security Agreement, dated August 11, 2006,is filed as Exhibit 10.17 to this Quarterly Report on Form 10-Q.

**Item 6.  Exhibits.**

(a)           *Exhibits.*

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

| 10.17  | Loan and Security Agreement, dated August 11, 2006,  by and among Cathay Bank, SST and certain subsidiaries of SST.                                                                                                                               |
|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                              |
| 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).* |

 

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*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.

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#  

# **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 9th day ofNovember, 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)*      |
|          |                                                      |  |  |

 

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