**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

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**FORM 10-K**

**(MARKONE)**

| **x** | ** ** | **ANNUAL REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** | ** ** |
|-------|------------|-----------------------------------------------------------------------------------------------------|------------|

 

**For the fiscal yearended December 31, 2005**

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

 

**FOR THE TRANSITIONPERIOD FROM                    TO                    **

**Commission filenumber 0-26944**

**Silicon Storage Technology, Inc.**

(Exact name of Registrant as Specified in its Charter) 

| **California**                   | **77-0225590**         |
|----------------------------------|------------------------|
| (State or Other  Jurisdiction of | (I.R.S. Employer       |
| Incorporation or  Organization)  | Identification Number) |

 

**1171 Sonora CourtSunnyvale, California  94086**

(Address of Principal Executive Offices including ZipCode)

**(408) 735-9110**

(Registrant’s Telephone Number, Including Area Code)

Securities registered pursuant to Section 12(b) ofthe Act: **None**

Securitiesregistered pursuant to Section 12(g) of the Act:

**Common Stock, no parvalue.**

Indicate by check mark if the registrant is awell-known seasoned issuer, as defined in Rule 405 of the Securities Act.   Yes o   No x

Indicate by check mark if the registrant is notrequired to file reports pursuant to Section 13 or Section 15(d) ofthe Act.   Yes o   No x

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.   Yes x   No o

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, and willnot be contained, to the best of Registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form 10-K,or any amendment to this Form 10-K.   Yes x   No o

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

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

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act).   Yes o   No x

Aggregate market value of the voting stock held bynon-affiliates of SST as of June 30, 2005: $359,725,905 based on theclosing price of SST’s Common Stock as reported on the NASDAQ National Market.Number of shares outstanding of SST’s Common Stock, no par value, as of thelatest practicable date, February 28, 2006: 103,146,352.

Documents incorporated byreference: Exhibits previously filed as noted on page 40. Part III -A portion of the Registrant’s definitive proxy statement for the Registrant’sAnnual Meeting of Shareholders, to be held on or about June 12, 2006,which will be filed with the Securities and Exchange Commission.

 

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**SiliconStorage Technology, Inc.Form 10-K For the Year Ended December 31, 2005 TABLE OF CONTENTS**
|                                                | ** ** | ** **                                                                                                                      | ** ** | **Page**   | ** ** |
|------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|
| **Part I.**                               | ** ** | ** **                                                                                                                      | ** ** |       | ** ** | ** ** |   |
| Item 1.                                        |       | Business                                                                                                                        |       |       | 3          | ** ** |   |
| Item 1A.                                       |       | Risk Factors                                                                                                                    |       |       | 13         | ** ** |   |
| Item 1B.                                       |       | Unresolved SEC Staff Comments                                                                                                   |       |       | 25         | ** ** |   |
| Item 2.                                        |       | Properties                                                                                                                      |       |       | 25         | ** ** |   |
| Item 3.                                        |       | Legal Proceedings                                                                                                               |       |       | 25         | ** ** |   |
| Item 4.                                        |       | Submission of Matters to a Vote of Security Holders                                                                             |       |       | 26         | ** ** |   |
| **Part II.**                              |       |                                                                                                                            |       |       |       | ** ** |   |
| Item 5.                                        |       | Market for the Registrant’s Common Equity, Related  Stockholder Matters and Issuer Purchases of Equity Securities          |       |       | 27         | ** ** |   |
| Item 6.                                        |       | Selected Consolidated Financial Data                                                                                            |       |       | 28         | ** ** |   |
| Item 7.                                        |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations       |       |       | 29         | ** ** |   |
| Item 7A.                                       |       | Quantitative and Qualitative Disclosures About Market  Risk                                                                     |       |       | 48         | ** ** |   |
| Item 8.                                        |       | Consolidated Financial Statements and Supplementary  Data                                                                       |       |       | 48         | ** ** |   |
| Item 9.                                        |       | Changes in and Disagreements with Accountants on  Accounting and Financial Disclosure                  |       |       | 50         | ** ** |   |
| Item 9A.                                       |       | Controls and Procedures                                                                                                         |       |       | 50         | ** ** |   |
| Item  9B.                                      |       | Other  Information                                                                                                              |       |       | 51         | ** ** |   |
| **Part III.**                             |       |                                                                                                                            |       |       |       | ** ** |   |
| Item 10.                                       |       | Directors and Executive Officers of the Registrant                                                                              |       |       | 52         | ** ** |   |
| Item 11.                                       |       | Executive Compensation                                                                                                          |       |       | 52         | ** ** |   |
| Item 12.                                       |       | Security Ownership of Certain Beneficial Owners and  Management and Related Shareholder Matters                  |       |       | 52         | ** ** |   |
| Item 13.                                       |       | Certain Relationships and Related Transactions                                                                                  |       |       | 52         | ** ** |   |
| Item 14.                                       |       | Principal Accountant Fees and Services                                                                                          |       |       | 52         | ** ** |   |
| **Part IV.**                              |       |                                                                                                                            |       |       |       | ** ** |   |
| Item 15.                                       |       | Exhibits and Financial Statement Schedule                                                                                       |       |       | 53         | ** ** |   |
| **Index to Exhibits**                          |       |                                                                                                                            | 53         | ** ** |       |
| **Signatures**                                 |       |                                                                                                                            | 56         | ** ** |       |
| **Index to Consolidated Financial Statements** |       |                                                                                                                            | 57         | ** ** |       |

 

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**PART I**

**Item 1.**                        Business

***Overview***

Silicon Storage Technology, Inc. (SST, us or we)is a leading supplier of flash memory semiconductor devices for the digitalconsumer, networking, wireless communications and Internet computing markets. Flashmemory is a form of non-volatile memory that allows electronic systems toretain information when the system is turned off. Flash memory is now used inhundreds of millions of consumer electronics and computing products annually.

We produce and sell many products based on ourSuperFlash design and manufacturing process technology. Our products areincorporated into products sold by many well-known companies including Apple,Asustek, BenQ, Cisco, Dell, First International Computer, or FIC, Gigabyte,Huawei, Infineon, Intel, IBM, Inventec, Legend Lenovo, LG Electronics,Freescale Semiconductor, Inc, NEC, Nintendo, Panasonic, Philips, Quanta,Samsung, Sanyo, Seagate, Sony, Sony Ericsson, Texas Instruments and VTech.

We also produce and sell other semiconductor productsincluding smart cards, subscriber identification module, or SIM, cards, radiofrequency, or RF, power amplifiers and transceivers and memory controllers.

We license our SuperFlash technology to leadingsemiconductor companies including 1st Silicon (Malaysia) Sdn. Bhd., Analog Devices,IBM, Freescale Semiconductor, Inc., National Semiconductor Corporation,NEC Corporation, Oki Electric Industry Co., Samsung Electronics Co. Ltd., SANYOElectric Co., Ltd., or Sanyo, Seiko Epson Corporation, Shanghai Grace SemiconductorManufacturing Corporation, or Grace, Shanghai Huahong NEC Electronics Co.,Ltd., Taiwan Semiconductor Manufacturing Co., Ltd., or TSMC, ToshibaCorporation, Vanguard International Semiconductor Corporation, PowerchipSemiconductor Corporation and Winbond Electronics Corporation for applicationsin semiconductor devices that integrate flash memory with other functions on asingle chip.

We have installed our semiconductor manufacturingprocesses at several leading wafer foundries and semiconductor manufacturersincluding Global Communication Semiconductor, Grace, Samsung Electronics Co.,Ltd., SANYO Electric Co., Ltd., Seiko Epson Corporation, Shanghai Hua Hong NECElectronics Co. Ltd., TSMC and Yasu Semiconductor Corporation, or Yasu. Thesecompanies produce silicon wafers for us that incorporate our process andproduct intellectual property. These wafers are electrically tested and thensubdivided into many small rectangular chips, or die. We work with leadingsemiconductor assembly and test companies to finish our products byencapsulating and testing them. We are working with Grace, PowerchipSemiconductor Corporation and TSMC to develop new technology for manufacturingour products.

The semiconductor industry has historically beencyclical, characterized by periodic changes in business conditions caused byproduct supply and demand imbalance. When the industry experiences downturns,they often occur in connection with, or in anticipation of, maturing productcycles and declines in general economic conditions. These downturns arecharacterized by weak product demand, excessive inventory and accelerateddecline of selling prices. We experienced a decrease in the average sellingprices of our products as a result of the industry-wide oversupply andexcessive inventory in the market in the second half of 2004 and the first halfof 2005. Although we have seen strengthening of market demand in the secondhalf of 2005, our business could be further harmed by industry-wide prolongeddownturns in the future.

The consumer electronicsmanufacturing industry is concentrated in Asia. We manufacture virtually all ofour products in Asia and we sell most of our products in Asia. We derived90.0%, 86.0% and 87.6% of our net product revenues during 2003, 2004 and 2005,respectively, from product shipments to Asia.

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***Industry Background***

Semiconductor integrated circuits are criticalcomponents used in an increasingly wide variety of applications, such ascomputers and computer systems, communications equipment, consumer products andindustrial automation and control systems. As integrated circuit performancehas improved and physical size and costs have decreased, the use ofsemiconductors in many applications has grown significantly.

Nonvolatile memory devices were originally used by thepersonal computer, or PC, industry to provide the BIOS (basic input/outputsystem) to give the PC sufficient information to start up (boot) and tofacilitate its access to its high volume non-volatile memory stored in magneticmedia including today’s hard disks. Historically, the demand for semiconductorshas been driven by the PC market. In recent years, growth in demand forsemiconductors relating to PCs has been outpaced by growth in demand forsemiconductors that are used in digital electronic devices for communicationand consumer applications. Communications applications include digitalsubscriber line modems, cable modems, networking equipment, wireless local areanetwork, or WLAN, devices, cellular phones and Global Positioning Systems, orGPS. Consumer-oriented digital electronic devices include digital cameras, DVDplayers, MP3 players, personal data assistants, or PDAs, set-top boxes, DigitalTVs and video games.

In order to function correctly, PCs and other digitalelectronic devices require program code. The program code defines how devicesfunction and affects how they are configured. In PCs, this program code, calledBIOS, initiates the loading of the PC’s operating system, which is then readfrom the disk drive. In the case of other digital electronic devices, theprogram code is stored in its entirety in nonvolatile memory, generally flashmemory. As a result, virtually every digital electronic system that uses aprocessor or controller for computing, consumer electronics, communications,and industrial applications requires nonvolatile memory. The predominant formsof nonvolatile memory include Read-Only Memory, Programmable Read-Only Memoryand flash memory.

System manufacturers generally prefer nonvolatilememory devices that can be reprogrammed efficiently in the system in order toachieve several important advantages. With re-programmable memory,manufacturers can cost effectively change program codes in response to fasterproduct cycles and changing market specifications. This in turn greatlysimplifies inventory management and manufacturing processes. Reprogrammablememory also allows the manufacturer to reconfigure or update a system eitherlocally or through a network connection. In addition, in-system reprogrammabledevices can be used for data storage functions, such as storage of phonenumbers for speed dialing in a cellular phone or captured images in a digitalcamera. Flash memory provides these features better than other forms ofnonvolatile memory.

Flash memory is thepredominant reprogrammable nonvolatile memory device used to store program codeand data. Flash memory can electrically erase select blocks of data on thedevice much faster and more simply than with alternative solutions, such asErasable Programmable Read-Only Memory, or EPROM. Moreover, flash memory issignificantly less expensive than other re-programmable solutions, such asElectrically Erasable Programmable Read-Only Memory, or EEPROMs. As a result,the demand for flash memory has grown dramatically. This growth has been fueledby the need for code sharing and other storage functions in a wide array ofdigital devices. According to a January 2006 Webfeet Research report,worldwide flash memory revenue was $19.9 billion in 2005 and is expected togrow to $27.5 billion in 2006 and to $46.5 billion in 2010.

***Our Solution***

We are a leading supplier of flash memorysemiconductor devices. We believe our proprietary flash memory technology,SuperFlash, offers superior performance, high reliability and a fast, fixederase time. We further believe that our SuperFlash technology can be scaled touse the semiconductor industry’s most advanced technology nodes and can employthe industry’s lowest cost manufacturing processes.

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Our memory devices havedensities ranging from 256,000 bits (256 Kb) to 64 million bits (64 Mb) and aregenerally used for the storage of program code. These memory products aregenerally called NOR products. These products are generally used to store theinstruction set used by the microprocessor or controller in the electronicsystem product to direct its function. NOR memory can also be used to storedata for the system user, but it is generally less expensive to use NAND memoryfor this purpose. While NOR memory can be used to store data, NAND memory isgenerally not useful for the storage of instruction code as its interfaceallows only sequential access to data. As a result, electronic systems oftenuse NOR alone or NOR and NAND together but virtually never NAND memory alone.

***Our Strategy***

Our objective is to be the leading worldwide supplierof NOR flash memory devices, a leading supplier of other semiconductor productsin the consumer electronics market and the leading licensor of embedded flashtechnology. We intend to achieve our objectives by:

*Maintaininga leading position in the program code storage market.*   Webelieve that program code storage is an attractive segment of the flash memorymarket. The number, variety and performance of digital electronic applicationscontinue to increase. Virtually all of these devices need some sort ofnonvolatile memory to direct the function of the product’s microprocessor orcontroller. We believe that our proprietary SuperFlash technology is superiorbecause it offers higher reliability and better performance at a lower costthan competing solutions. We regularly introduce additional standard andapplication specific memory products, including our ComboMemory products. ComboMemoryproducts are used for wireless and portable applications that combine volatileand nonvolatile memory on a single monolithic device or on multiple die in acommon package for optimized performance. We are extending our family of serialflash products which offer smaller form factors for manufacturers that areproducing ever smaller and more compact consumer devices. In addition, we arecontinuing to develop versions of our products that consume less power. Theselower voltage devices are particularly desirable when applied inbattery-powered electronic systems. For PC BIOS applications, we are alsoexpanding our Low Pin Count, or LPC, Firmware Flash product offering.

*Continuingto enhance our leading flash memory technology.*   Webelieve that our proprietary SuperFlash technology is less complicated, morereliable, more scalable and more cost-effective than competing flash memorytechnologies. Our ongoing research and development efforts are focused onenhancing our leading flash memory technology by working closely with technologypartners who operate wafer fabrication facilities with advanced lithographicand other manufacturing equipment. As consumer electronics companies producemore complex and more compact products, we intend to meet their needs and continue to produce some of thesmallest and thinnest semiconductor products. We are also  developing and reducing the cost of theassociated assembly technologies.

*Leveragingour technology and supply chain to become a premier provider of additionalsemiconductor products.*   Many consumerelectronics products incorporate our flash memory products. We are expandingour product line to include additional devices that these manufacturers needfor their products. We provide RF power amplifier and transceiver products forwireless applications such as cellular phones, GPS, WLAN, Bluetooth, datapagers and cordless telephones. We also provide programmable high-density(NAND) memory controllers that we believe give electronics systemsmanufacturers superior flexibility in the design and manufacture of theirsystems. We also offer a selection of our products in die form. This allows ourcustomers to develop multi-chip module products for unusual or small formfactor products such as Bluetooth earsets and GPS receivers. We also providemulti-chip module products that incorporate die from other semiconductormanufacturers. We intend to continue to develop products and our supply chainto take advantage of the significant growth opportunities in the wirelessapplications market with specific focus on cellular phone, GPS, WLAN andBluetooth applications.

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*Maintaining a leadingposition in licensing embedded flash technology.*   Webelieve that our proprietary SuperFlash technology is well-suited for embeddedmemory applications, which integrate flash memory and other functions onto amonolithic chip. Many electronic system manufacturers have incorporated ourtechnology into the semiconductor devices that are at the heart of theirproducts. We are expanding our licensing of SuperFlash technology to additionalsemiconductor wafer foundries at finer technology nodes for embedded flashapplications to enhance the value of our technology to these electronic systemmanufacturers. Many digital electronic devices currently being introduced, suchas MP3 players, digital cameras and PDAs, require high-density (NAND) flashmemory for storing music, pictures and other data that require large datastorage capacities in addition to the NOR memory required to operate the system’scontroller. We believe that the market for high-density (NAND) flash memory isattractive based on its potential size and growth. We are further developingour technology to address the high-density (NAND) flash memory markets and arelicensing our technology to semiconductor manufacturers that intend to competein this market.

***Our Products***

Currently, we offer low and medium density devices(256 Kbit to 64 Mbit) that target a broad range of existing and emergingapplications in the digital consumer, networking, wireless communications andInternet computing markets. Our products are segmented largely based uponattributes such as density, voltage, access speed, package and targetapplication. We divide our products into four reportable segments: the StandardMemory Product Group, or SMPG, the Application Specific Product Group, or ASPG,the Special Product Group, or SPG and SST Communications Corporation, or SCC.

*SMPG.*   SMPGincludes the Multi-Purpose Flash, or MPF, family, the Multi-Purpose Flash Plus,or MPF+, family and the Many-Time Programmable, or MTP, family. These productfamilies allow us to produce products optimized for cost and functionality tosupport a broad range of mainstream applications that use nonvolatile memoryproducts. Effective July 1, 2003, we transferred the Small Sector Flash,or SSF, family from SMPG to SPG. Effective January 1, 2004, we transferredthe last MTP series of products from SMPG to SPG. Accordingly, our segmentrevenues and gross profit information have been reclassified for presentationpurposes as if transfers occurred as of January 1, 2003.

*ASPG.*   ASPGincludes Concurrent SuperFlash, Serial Flash, Firmware Hub, or FWH, and Low PinCount, or LPC, flash products. These products are designed to address specificapplications such as cellular phones, hard disk drives, optical drives and PCs.ASPG also includes flash embedded controllers such as the ATA flash diskcontroller for consumer, industrial and mass data storage applications. Weacquired a majority ownership of Emosyn on September 10, 2004. On April 15,2005, we acquired the remaining minority interest of Emosyn. As a result of theacquisition of the remaining minority interest, the management of Emosyn’sproducts was integrated into ASPG. Commencing in the second quarter of 2005, weno longer considered Emosyn its own reportable segment and Emosyn’s flashmemory based smart-card IC’s were included in ASPG. These products are usedprimarily in cell phone applications and include such benefits of use as lowerpower consumption, long term data retention and high endurance of data access. Oursegment revenues and gross margin information have been reclassified forpresentation purposes as if the transfer occurred as of September 10, 2004.Effective January 1, 2003, we transferred FlashFlex51 microcontrollerproducts from ASPG to SPG. Accordingly, our segment revenues and gross profitinformation have been reclassified for presentation purposes as if the transferoccurred as of January 1, 2003.

*SPG.  **SPG* includesComboMemory, ROM/RAM Combos, SSF, MTP, FlashFlex51 microcontroller and otherspecial flash products. These products are used in applications requiring lowpower and a small form factor such as cellular phones, wireless modems, MP3systems, pagers and digital organizers. Effective January 1, 2003, wetransferred certain MTP products from SMPG to SPG and certain flashmicrocontroller products from ASPG to SPG. Effective July 1, 2003, wetransferred the SSF family from 

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SMPG to SPG. Effective January 1,2004, we transferred the last MTP series of products from SMPG to SPG. Accordingly,our segment revenues and gross profit information have been reclassified forpresentation purposes as if the transfer occurred as of January 1, 2003.

*SCC.*   SCCproducts include RF transceiver, synthesizer, power amplifier and switchproducts. These products provide end-to-end RF solutions to enable wirelessmultimedia and broadband networking applications. We formed SST CommunicationsCorporation and acquired substantially all of the assets of G-Plus, Inc.on November 5, 2004.

***Technology Licensing***

We license our SuperFlashtechnology to semiconductor manufacturers for use in embedded flashapplications. We intend to increase our market share by entering into additionallicense agreements for our SuperFlash process and memory cell technology withleading wafer foundries and semiconductor manufacturers. We expect to continueto receive licensing fees and royalties from these agreements. We design ourproducts using our patented memory cell technology and fabricate them using ourpatented process technology. As of December 31, 2005, we held 168 patentsin the United States relating to certain aspects of our products and processes,with expiration dates ranging from 2010 to 2024 and have filed for severalmore. In addition, we hold several patents in Europe, Japan, Korea, Taiwan, andChina.

***Customers***

We provide high-performance flash memory solutions andother products to customers in four major markets: digital consumer,networking, wireless communications and Internet computing. Our customersbenefit by obtaining products that we believe are highly reliable,technologically advanced and have attractive cost structures. As a result ofthese highly desirable benefits, we have developed relationships with many ofthe industry’s leading companies. In digital consumer products, we provideproducts for consumer electronic companies including Funai, Orion, Apple, ALCO,Inventec, Reingncom, Sagem, Bang & Olufsen, BenQ, Canon, CreativeTechnologies, Daewoo, Hitachi, Hon Hai, JVC, LG, Lite-On, BBK, Kaon Media,Sandmartin, Matetel, Micro, Mustek, Nintendo, Panasonic, Philips, Pioneer,Samsung, Sanyo, Sharp, Sony, TCL, TEAC, Toshiba, Thomson, TiVo and Micronas. Innetworking, we provide products for Broadcom, Atheros, Buffalo, CameoCommunications, Conexant, Austek, Gemtech, Hon Hai, Mitsumi, Sagem, Samsung,Tecom, Huawei, ZTE, Alpha Networks, Cybertan and Avocent. In wirelesscommunications, we provide products for companies including Cambridge SiliconRadio, Sagem, Mitsumi, Alps, Bang & Olufsen, Binatone, CCT,Crestfounder, Eastern Peace Smart Card, GN Netcom, Haier, Hon Hai, Inventec,Ningbo Bird, Orga Samsung, Sagem, Syscom, Tecom, USI, Watchdata, Vtech , Xinweiand ZTE. In Internet computing, we provide a wide array of products forcompanies including Apple, Asustek, Compal, Dell, ECS, FIC, Fitjitsu, Gigabyte,Hon Hai, HP, Intel, Inventec, Lenovo, LG, Lexmark, Lite-On, Matsushita, Mitac, Quanta, Samsung, Fujitsu, Siemens,Sharp, Seagate, Western Digital Maxtor and Wistron.

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Thefollowing tables illustrate the geographic regions in which our customers orlicensees operate based on the country to which the product is shipped by us orthe logistics center or license revenue is generated.

| ** **                   | ** ** | **Year ended December 31,** | ** ** |
|------------------------------|------------|--------------------------------------------|------------|
| ** **                   | ** ** | **2003**                                   | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                   | ** ** | **(in thousands)**                    | ** ** |
| United States                |       | $                                          | 19,600     |   | $ | 32,833 |   | $ | 21,261 |   |
| Europe                       |       | 9,957                                      |       | 28,863 |   | 32,008 |   |
| Japan                        |       | 27,575                                     |       | 35,233 |   | 26,455 |   |
| Korea                        |       | 25,214                                     |       | 36,715 |   | 32,702 |   |
| Taiwan                       |       | 109,254                                    |       | 125,491 |   | 74,753 |   |
| China (including  Hong Kong) |       | 76,107                                     |       | 148,100 |   | 208,658 |   |
| Other Asian  Countries       |       | 27,334                                     |       | 41,963 |   | 35,062 |   |
|                         |       | $                                          | 295,041    |   | $ | 449,198 |   | $ | 430,899 |   |

 

***Sales and Distribution***

We sell a majority of ourproducts to customers in Asia through our representatives. We distribute amajority of our products through our logistics center. We also sell anddistribute our products in North America and Europe through manufacturers’representatives and distributors. Our manufacturer representative anddistributor relationships are generally cancelable, with reasonable notice, byeither party.

***Backlog***

Our product sales are madeprimarily using short-term cancelable purchase orders. The quantities actuallypurchased by the customer, as well as shipment schedules, are frequentlyrevised to reflect changes in the customer’s needs and in our supply ofproducts.  Accordingly, the dollar amountassociated our backlog of open purchase orders at any given time is not ameaningful indicator of future sales. Changes in the amount of our backlog do not necessarily reflect acorresponding change in the level of actual or potential sales. 

***Applications***

As theDigital Consumer, Networking, Wireless Communications and Internet Computingindustries continue to expand and diversify, new applications are likely to bedeveloped. We believe our products are designed to address this expanding setof applications:

| **Digital Consumer** | ** ** | **Networking**  | ** ** | **Wireless  Communications** | ** ** | **Internet  Computing** |
|----------------------|------------|-----------------|------------|------------------------------|------------|-------------------------|
| TV Replayer          |       | Set-top Box     |       | VoIP                         |       | Cellular Phone          |   | Information Appliance |
| Digital TV           |       | CD-ROM Drive    |       | DSL Modem                    |       | Data Pager              |   | Notebook PC |
| Digital Camera       |       | CD-RW Drive     |       | Cable Modem                  |       | Cordless                |   | Desktop PC |
| Digital Camcorder    |       | DVD-ROM Drive   |       | V.90/56K Modem               |       | Telephone               |   | Hard Disk Drive |
| DVD Player           |       | DVD-RAM Drive   |       | Wireless LAN                 |       | GPS on Cellular         |   | ICD Monitor |
| DVD Recorder         |       | DVD-RW Drive    |       | Network                      |       | Phone                   |   | Palm PC |
| VCD Player           |       | Web Browser     |       | Interface Card               |       | Bluetooth               |   | X-PC |
| MP3 Player           |       | Hand-held GPS   |       | Router/Switch                |       | Applications            |   | Server |
| Video Game           |       | Electronic Toys |       |                         |       | Wireless Modems         |   | Graphics Card |
| PDA                  |       | Smart Cards     |       |                         |       |                    |   | Printer |
| Electronic Book      |       | Memory Cards    |       |                         |       |                    |   | Copier/Scanner |
| Remote Controller    |       | Electronic      |       |                         |       |                    |   | Bar Code Scanner |
|                 |       | Organizer       |       |                         |       |                    |   | Thin Client System |

 

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***Manufacturing***

We purchase wafers and sorted die from semiconductormanufacturing foundries, have this product shipped directly to subcontractorsfor packaging, testing, and finishing, and then ship the final product to ourcustomers. Virtually all of our subcontractors are located in Asia.

*Waferand Sorted Die.*   During 2005, our major waferfabrication foundries were TSMC, Grace, Sanyo, Samsung and Seiko-Epson. In2005, wafer sort, which is the process of testing individual die on siliconwafer, was performed at King Yuan Electronics Company, Limited, or KYE, Lingsen,Samsung, Sanyo, Seiko-Epson and TSMC. Although capacity is not guaranteed,under our arrangements, we generally receive preferential treatment regardingwafer pricing and capacity. In order to obtain, on an ongoing basis, anadequate supply of wafers, we have considered and will continue to considervarious possible options, including equity investments in foundries in exchangefor guaranteed production volumes, the formation of joint ventures to own andoperate foundries and the licensing of our proprietary technology. We haveinvested $83.2 million in Grace Semiconductor Manufacturing Corporation, orGSMC, a Cayman Islands company, which has been funded mostly by investors whoreside outside of China. Grace is GSMC’s wafer foundry subsidiary and islocated in Shanghai, People’s Republic of China. Grace has been manufacturingour products since late 2003.

*Packaging, Testing andFinishing.*   In the assembly process, theindividual dies are separated and assembled into packages. Following assembly,the packaged devices require testing and finishing to segregate conforming fromnonconforming devices and to identify devices by performance levels. Currently,all devices are tested and inspected pursuant to our quality assurance programat our domestic or international subcontracted test facilities or at our testfacilities in Sunnyvale, California before shipment to customers. Certainfacilities currently perform consolidated assembly, packaging, test andfinishing operations all at the same location. During 2005, most subcontractedfacilities performing the substantial majority of our operations were in Taiwan.The subcontractors with the largest amount of our activity are KYE, Lingsen,and Powertech Technology, Incorporated, or PTI. We hold equity investments inthree subcontractors: Apacer Technology, Inc., or Apacer, KYE and PTI. Fornewly released products, the initial test and finishing activities areperformed at our Sunnyvale facility.

***Research and Development***

We believe that our futuresuccess will depend in part on the development of next generation technologieswith reduced feature size. During 2003, 2004 and 2005, we spent $43.1 million, $46.9million and $49.0 million, respectively, on research and development. Ourresearch efforts are focused on process development and product development. Ourresearch strategy is to collaborate with our partners to advance ourtechnologies. We work simultaneously with several partners on the developmentof multiple generations of technologies. In addition, we allocate our resourcesand personnel into category-specific teams to focus on new product development.From time to time we invest in, jointly develop with, license or acquiretechnology from other companies in the course of developing products.

***Competition***

The semiconductor industry is intensely competitiveand has been characterized by price erosion, rapid technological change andproduct obsolescence. We compete with major domestic and internationalsemiconductor companies, many of whom have substantially greater financial,technical, marketing, distribution, manufacturing and other resources than us.Our low density memory products, sales of which presently account forsubstantially all of our revenues, compete against products offered by Spansion(AMD/Fujitsu), Atmel, Intel, Macronix, ST Microelectronics, PMC and Winbond. Ourmedium-density memory products compete with products offered by Spansion,Intel, ST Microelectronics, Mitsubishi, Samsung, Sharp Electronics and Toshiba.If we are successful in developing our high-density products, 

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these products willcompete principally with products offered by Spansion, Atmel, Fujitsu, Hitachi,Intel, Mitsubishi, Samsung, SanDisk, Sharp Electronics, ST Microelectronics andToshiba, as well as any new entrants to the market. In addition, competitionmay come from alternative technologies such as ferroelectric random accessmemory device, or FRAM, technology.

The competition in the existing markets for some ofour other product families, such as the FlashFlex51 microcontroller productfamily, is extremely intense. We compete principally with major companies suchas Atmel, Microchip Technology, Freescale Semiconductor, Inc, Philips andWinbond in the microcontroller market. We may, in the future, also experiencedirect competition from our foundry partners. We have licensed to our foundrypartners the right to fabricate certain products based on our proprietary technologyand circuit design, and to sell such products worldwide, subject to royaltypayments back to us. Our SmartCard products compete with Masked ROM and flashor EEPROM offerings primarily from Infineon, Renesas, Samsung and STMicroelectronics. For radio frequency and IC products, the competition in theexisting markets is also extremely intense. SCC competes primarily withMicrosemi, SiGe, Micromobio, Anadigics and Maxim especially in the WLAN (WiFi802) markets.

We compete principally onprice, reliability, functionality and the ability to offer timely delivery tocustomers. While we believe that our low density memory products currentlycompete favorably on the basis of cost, reliability and functionality, it isimportant to note that some of our principal competitors have a significantadvantage over us in terms of greater financial, technical and marketingresources. Our long-term ability to compete successfully in the evolving flashmemory market will depend on factors both within and beyond our control,including access to advanced process technologies at competitive prices,successful and timely product development, wafer supply, product pricing,actions of our competitors and general economic conditions.

***Employees***

As of December 31,2005, we employed 631 individuals on a full-time basis, all but 240 of whomreside in the United States. Of these 631 employees, 96 were employed inmanufacturing support, 339 in engineering, 102 in sales and marketing and 94 inadministration, finance and information technology. Our employees are notrepresented by a collective bargaining agreement, nor have we ever experiencedany work stoppage related to strike activity. We believe that ourrelationship with our employees is good.

***Executive Officers***

Thefollowing table lists the names, ages and positions of our executive officersas of January 1, 2006. There are no family relationships between anyexecutive officer of SST. Executive officers serve at the discretion of ourboard of directors. 

| **Name**          | ** ** | ** ** | ** ** | **Age**                                                    | ** ** | **Position** |
|-------------------|------------|------------|------------|------------------------------------------------------------|------------|--------------|
| Bing Yeh          |       | 55         |       | President and Chief  Executive Officer                     |
| Yaw Wen Hu        |       | 56         |       | Executive Vice President  and Chief Operating Officer      |
| Derek Best        |       | 55         |       | Senior Vice President,  Sales and Marketing                |
| Michael Briner    |       | 58         |       | Senior Vice President,  Application Specific Product Group |
| Chen Tsai         |       | 54         |       | Senior Vice President,  Worldwide Backend Operations       |
| Paul Lui          |       | 55         |       | Vice President, Special  Product Group                     |
| Jack K. Lai       |       | 51         |       | Vice President,  Administration and Corporate Development  |
| Arthur O. Whipple |       | 57         |       | Vice President, Finance and Chief Financial Officer        |

 

*Bing Yeh*, one of our co-founders, has served as our Presidentand Chief Executive Officer and has been a member of our board of directorssince our inception in 1989. Prior to that, Mr. Yeh served as a senior researchand development manager of Xicor, Inc., a nonvolatile memory semiconductorcompany. 

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*From1981 to 1984, Mr. Yeh held program manager and other positions atHoneywell Inc. From 1979 to 1981, Mr. Yeh was a senior developmentengineer of EEPROM technology of Intel Corporation. He was a Ph.D. candidate inApplied Physics and earned an Engineer degree at Stanford University. Mr. Yehholds a M.S. and a B.S. in Physics from National Taiwan University.*

*Yaw Wen Hu, Ph.D*., joined us in July 1993 as Vice President,Technology Development. In 1997, he was given the additional responsibility ofwafer manufacturing and, in August 1999, he became Vice President,Operations and Process Development. In January 2000, he was promoted toSenior Vice President, Operations and Process Development. In April 2004,he was promoted to Executive Vice President and Chief Operating Officer.Dr. Hu has been a member of our board of directors since September 1995.From 1990 to 1993, Dr. Hu served as deputy general manager of technologydevelopment of Vitelic Taiwan Corporation. From 1988 to 1990, he served as FABengineering manager of Integrated Device Technology, Inc. From 1985 to1988, he was the director of technology development at Vitelic Corporation. From1978 to 1985, he worked as a senior development engineer in Intel Corporation’sTechnology Development Group. Dr. Hu holds a B.S. in Physics from NationalTaiwan University and a M.S. in Computer Engineering and a Ph.D. in AppliedPhysics from Stanford University.

*Derek Best* joined us in June 1997 as Vice President ofSales and Marketing. In June 2000 he was promoted to Senior VicePresident, Sales & Marketing. Prior to joining SST he worked forMicromodule Systems, a manufacturer of high-density interconnect technology, asvice president marketing and sales world wide from 1992 to 1996. From 1987 to1992 he was a co-founder and owner of Mosaic Semiconductor, a SRAM and modulesemiconductor company. Mr. Best holds an Electrical Engineering degreefrom Portsmouth University in England.

*Michael Briner* joined us as Vice President, Design Engineering in November 1997,and became Vice President, Products during 1999. He was promoted to Senior VicePresident of Application Specific Product Group in February 2001. From1993 to 1997, he served as vice president of design engineering for MicronQuantum Devices, Inc., a subsidiary of Micron Technology, Inc.,chartered to develop and manufacture flash memory products. From 1986 through1992, he served as director of design engineering for the Nonvolatile Divisionof Advanced Micro Devices, Inc. In this position, he was instrumental inhelping AMD become a major nonvolatile memory manufacturer. Mr. Brinerholds a B.S. in Electrical Engineering from the University of Cincinnati.

*Chen Tsai* joined us in August 1996 as Senior Manager,Yield Enhancement and became Director, Product and Test Engineering the sameyear. In 1999, he became Director of Worldwide Backend Operations and in 2000he was promoted to Vice President of Worldwide Backend Operations. In October 2004,Mr. Tsai was appointed Senior Vice President of Worldwide BackendOperations. From 1992 to 1996, Mr. Tsai was Manager of Process Developmentat Atmel Corporation, a manufacturer of semiconductors, where he was also a staffengineer of E2PROM from 1989 to 1992. From 1988 to 1989, he was vice presidentof technology at Tristar Technology, Inc., a wireless systems company. From1980 to 1988 he held various positions at Xicor, Inc. and TeledyneSemiconductor. Mr. Tsai holds a B.S. in Physics from Show Chu Universityand a M.S. in both Physics and Electrical Engineering from Florida Institute ofTechnology.

*Paul Lui* joined us as Vice President and General Manager ofthe Linvex Product Line in June 1999 and became Vice President, Special ProductGroup in June 2001. From 1994 to 1999, he was the president and founder ofLinvex Technology Corporation. From 1987 to 1994, he was the president andchief executive officer of Macronix, Inc. From 1981 to 1985, he served asgroup general manager at VLSI Technology, Inc. where he was responsiblefor transferring that company’s technology to Korea. In addition, Mr. Luihas held senior engineering positions at the Synertek Division of Honeywell andMcDonnell Douglas. Mr. Lui holds an M.S.E.E. degree from University ofCalifornia, Berkeley and a B.S. 

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*degreein Electrical Engineering and Mathematics from California Polytechnic StateUniversity, San Luis Obispo.*

*Jack Lai* joined us as Vice President, Finance & Administration,Chief Financial Officer and Secretary in November 2003. In January 2006,Mr. Lai assumed the position of Vice President of Administration,Corporate Development and Secretary. Before joining SST, he was vice presidentand chief financial officer of Aplus Flash Technology, a memory design andmanufacturing company, from 2001 to 2003. Prior to this, Mr. Lai hadserved as vice president of operations and finance and chief financial officerat WireX Communications, Inc., a software system developer, from 2000 to2001 and vice president and chief financial officer at Genoa Electronics Corp.,a manufacturer of computer and related systems, from 1998 to 1999. Mr. Laiholds M.B.A.’s from San Jose State University in San Jose, CA and CultureUniversity in Taipei, Taiwan. He also holds a B.A. in business administrationfrom Tamkang University in Taipei, Taiwan.

*Arthur O. Whipple*joined us in March 2005 as our CorporateController and was promoted to Vice President, Finance and Chief FinancialOfficer in January 2006. Prior to joining SST, he was employed byQuickLogic Corp., a fabless manufacturer of field programmable logic productsand embedded standard products, starting in April 1998 as its vice presidentof finance, chief financial officer and secretary. From July 2002 toOctober 2003, he served as QuickLogic’s vice president and general manager, logicproducts and from October 2003 to March 2005, he served as its vice president,business development. In 2004 and 2005, he also served as a financialconsultant to Technovus, Inc., a privately-held fabless semiconductormanufacturer. Mr. Whipple holds a B.S.E.E. from the University of Washingtonand an M.B.A. from Santa Clara University.

***Available Information***

We were incorporated in California in 1989. Additionalinformation is available free of charge through our Internet website, *http://www.sst.com.* This information includes our annualreport on Form 10-K, quarterly reports on Form 10-Q,current reports on Form 8-K and, if applicable, amendments to thosereports filed or furnished pursuant to Section 13(a) of the ExchangeAct as soon as reasonably practicable after we electronically file suchmaterial with, or furnish it to, the SEC.

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**Item 1A.**                RiskFactors

***Business Risks***

**Risks Related to Our Business**

**Ouroperating results fluctuate materially, and an unanticipated decline inrevenues may disappoint securities analysts or investors and result in adecline in our stock price.**

Although we wereprofitable for the last quarter of 2005 and the year ended December 31,2004, we incurred net losses for  theyears ended December 31, 2005 and 2003. Our operating results havefluctuated significantly and our past financial performance should not be usedto predict future operating results. Our recent quarterly and annual operatingresults have fluctuated, and may continue to fluctuate, due to the followingfactors, all of which are difficult to forecast and many of which are out ofour control:

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

·       competitivepricing pressures and related changes in selling prices;

·       fluctuationsin manufacturing yields and significant yield losses;

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

·       productobsolescence

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

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

·       thegain or loss of significant customers;

·       marketacceptance of products utilizing our SuperFlash® technology;

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

·       exchangerate fluctuations;

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

·       changesin our allowance for doubtful accounts;

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

·       difficultiesin forecasting, planning and management of inventory levels;

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

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

As recent experience confirms, a downturn in themarket for goods that incorporate our products can also harm our operatingresults.

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**Ouroperating expenses are relatively fixed, and we order materials in advance ofanticipated customer demand. Therefore, we have limited ability to reduceexpenses quickly in response to any revenue shortfalls.**

Our operatingexpenses are relatively fixed, and we therefore have limited ability to reduceexpenses quickly in response to any revenue shortfalls. Consequently, ouroperating results will be harmed if our revenues do not meet our projections.We may experience revenue shortfalls for the following reasons:

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

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

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

·       thereduction, rescheduling or cancellation of customer orders.

In addition, political oreconomic events beyond our control can suddenly result in increased operatingcosts. In addition, we are now required to record compensation expense on stockoption grants and purchases under our employee stock purchase plan which willsubstantially increase our operating costs and impact our earnings (loss) pershare.

**Weincurred significant inventory valuation and adverse purchase commitmentadjustments in 2003, 2004 and 2005 and we may incur additional significantinventory valuation adjustments in the future.**

We typically plan ourproduction and inventory levels based on internal forecasts of customer demand,which are highly unpredictable and can fluctuate materially. The value of ourinventory is dependent on our estimate of future average selling prices, and,if our projected average selling prices are over estimated, we may be requiredto adjust our inventory value to reflect the lower of cost or market. As of December 31,2005, we had $108.3 million of net inventory on hand, a decrease of $48.3million, or 31%, from December 31, 2004. Total valuation adjustments toinventory and adverse purchase commitments were $6.7 million in 2003, $35.9million in 2004 and $37.3 million in 2005. Due to the large number of units inour inventory, even a small change in average selling prices could result in asignificant adjustment and could harm our financial results. Some of ourcustomers have requested that we ship them product that has a finished goodsdate of manufacture that is less than one year old. As of December 31,2005, our allowance for excess and obsolete inventories includes an allowancefor our on hand finished goods inventory with a date of manufacture of greaterthan two years old and for certain products with a date of manufacture ofgreater than one year old. In the event that this becomes a common requirement,it may be necessary for us to provide for an additional allowance for our onhand finished goods inventory with a date of manufacture of greater than oneyear old, which could result in a significant adjustment and could harm ourfinancial 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 of backlog during any particular period, or thefailure of our backlog to result in future revenue, could harm our business inthe future. We experienced a decrease in the average selling prices of ourproducts as a result of the industry-wide oversupply and excessive inventory inthe market in the second half of 2004 and 

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thefirst half of 2005. Although we have seen strengthening of market demand in thesecond half of 2005, our business could be further harmed by industry-wideprolonged downturns in the future.

**Ourbusiness may suffer due to risks associated with international sales andoperations.**

During 2003, 2004and 2005, our export product and licensing revenues accounted for 92.9%, 92.7%and 95.1% of our net revenues, respectively. Our international businessactivities are subject to a number of risks, each of which could imposeunexpected costs on us that would harm our operating results. These risksinclude:

·       difficultiesin complying with regulatory requirements and standards;

·       tariffsand other trade barriers;

·       costsand risks of localizing products for foreign countries;

·       relianceon third parties to distribute our products;

·       extendedaccounts receivable payment cycles;

·       potentiallyadverse tax consequences;

·       limitson repatriation of earnings; and

·       burdensof complying with a wide variety of foreign laws.

In addition, we have made equity investments incompanies with operations in several Asian countries. The value of ourinvestments is subject to the economic and political conditions particular totheir industry, their countries and to foreign exchange rates and to the globaleconomy. If we determine that a change in the recorded value of an investmentis other than temporary, we will adjust the value of the investment. Such anexpense could have a negative impact on our operating results.

We derived 90.0%, 86.0% and 87.6% of our net productrevenues from Asia during 2003, 2004 and 2005, respectively. Additionally,substantially all of our wafer suppliers and packaging and testingsubcontractors are located in Asia. Any kind of economic, political orenvironmental instability in this region of the world can have a severenegative impact on our operating results due to the large concentration of ourproduction and sales activities in this region. If countries where we dobusiness experience severe currency fluctuation and economic deflation, it cannegatively 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 economic situation can exacerbate a decline inselling prices for our products as our competitors reduce product prices togenerate 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 evenescalate, resulting in an economic embargo, a disruption in shipping or evenmilitary hostilities. Any of these events can delay production or shipment ofour products. Any kind of activity of this nature or even rumors of suchactivity can harm our operations, revenues, operating results, and stock price.

**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 

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tobecome more cautious. Any escalation in these events or similar future eventsmay disrupt our operations or those of our customers, distributors andsuppliers, affect the availability of materials needed to manufacture ourproducts, or affect the means to transport those materials to manufacturingfacilities and finished products to customers. In addition, these events havehad and may continue to have an adverse impact on the U.S. and world economy ingeneral and consumer spending in particular, which could harm our business.

**We donot typically enter into long-term contracts with our customers, and the lossof a major customer could harm our business.**

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

**Wedepend on stocking representatives and distributors to generate a majority ofour revenues.**

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

**Wedepend on Silicon Professional Technology Ltd., or SPT, our logistics center,to support many of our customers in Asia.**

We out-source our end customer service in Asia to SPT whichsupports our customers in Taiwan, China and other Southeast Asia countries. SPTprovides forecasting, planning, warehousing, delivery, billing, collection andother logistic functions for us in these regions. SPT is a wholly ownedsubsidiary of Professional Computer Technology, or PCT, which is one of ourstocking representatives in Taiwan. During 2003, 2004 and 2005, SPT servicedend customer shipments accounted for 64.2%, 52.9% and 58.5% of our net productrevenues recognized, respectively. As of December 31, 2003, 2004, and2005, SPT accounted for 73.4%, 55.1% and 69.6%, respectively, of our netaccounts receivable. For further description of our relationships with PCT andSPT, please refer to “Item 7. Management’s Discussion and Analysis of FinancialCondition and Results of Operation—Related Party Transactions.”

We do not have anylong-term contracts with SPT, PCT or Silicon Professional Alliance Corporation,or SPAC, a subsidiary of PCT. SPT, PCT or SPAC may cease providing services tous at any time. If SPT, PCT or SPAC were to terminate their relationship withus we would experience a delay in reestablishing warehousing, logistics anddistribution functions, and it could impair our ability to collect accountsreceivable from SPT and may harm our business.

**Wedepend on a limited number of foreign foundries to manufacture our products,and these foundries may not be able to satisfy our manufacturing requirements,which could cause our revenues to decline.**

We outsource substantially all of our manufacturingand testing activities. We currently buy all of our wafers and sorted die froma limited number of suppliers. The majority of our products are manufactured byfive foundries, TSMC in Taiwan, Seiko-Epson and Yasu in Japan and Grace andShanghai Hua Hong NEC Electronic Company Limited, or HHNEC, in China. We haveinvested $83.2 million in GSMC, a Cayman Islands company, which owns a waferfoundry subsidiary, Grace, in Shanghai, China. We anticipate that thesefoundries, together with Sanyo in Japan, Samsung in Korea and Vanguard andPowerchip Semiconductor Corporation, or PSC, in Taiwan will manufacturesubstantially all of our 

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products in 2006. If thesesuppliers fail to satisfy our requirements on a timely basis at competitiveprices we could suffer manufacturing delays, a possible loss of revenues orhigher than anticipated costs of revenues, any of which could harm our operatingresults.

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

**Manufacturingcapacity has in the past been difficult to secure and if capacity constraintsarise in the future our revenues may decline.**

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

**Ourcost of revenues may increase if we are required to purchase manufacturingcapacity in 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 may be required to seek additional debt orequity financing if we need substantial capital in order to secure thiscapacity and we cannot assure you that we will be able to obtain suchfinancing.

**Ifour foundries fail to achieve acceptable wafer manufacturing yields, we willexperience higher costs of revenues and reduced product availability.**

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

**Ifour foundries discontinue the manufacturing processes needed to meet ourdemands, or fail**to upgrade the technologiesneeded to manufacture our products, we may face production delays and lowerrevenues.**

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. 

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Additionally,we cannot be certain our foundries will continue to devote resources to advancethe process technologies on which the manufacturing of our products is based. Eitherone of these events could increase our costs and harm our ability to deliverour products on time.

**Our dependenceon third-party subcontractors to assemble and test our products subjects us toa number of risks, including an inadequate supply of products and higher costsof materials.**

We depend onindependent subcontractors to assemble and test our products. Our reliance onthese subcontractors involves the following significant risks:

·       reducedcontrol over delivery schedules and quality;

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

·       difficultiesselecting and integrating new subcontractors;

·       limitedwarranties on products supplied to us;

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

·       potentialmisappropriation of our intellectual property.

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

**Becauseour flash memory products typically have lengthy sales cycles, we mayexperience substantial delays between incurring expenses related to researchand development and the generation of revenues.**

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

**Weface intense competition from companies with significantly greater financial,technical and marketing resources that could harm sales of our products.**

We compete with major domestic and internationalsemiconductor companies, many of which have substantially greater financial,technical, marketing, distribution, and other resources 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 section entitled Competition (see above), ourlow density memory products, medium density memory products, and high densitymemory products (if we are successful in developing these products) facesubstantial competition.

In addition, we may in the future experience directcompetition from our foundry partners. We have licensed to our foundry partnersthe right to fabricate products based on our technology and circuit design, andto sell such products worldwide, subject to our receipt of royalty payments.

Competition may also come from alternativetechnologies such as ferroelectric random access memory devices, or FRAM, orother developing technologies.

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**Ourmarkets are subject to rapid technological change and, therefore, our successdepends on our ability to develop and introduce new products.**

The markets for ourproducts are characterized by:

·       rapidlychanging technologies;

·       evolvingand competing industry standards;

·       changingcustomer needs;

·       frequentnew product introductions and enhancements;

·       increasedintegration with other functions; and

·       rapidproduct obsolescence.

To develop new products for our target markets, wemust develop, gain access to and use leading technologies in a cost-effectiveand timely manner and continue to expand our technical and design expertise. Inaddition, we must have our products designed into our customers’ futureproducts and maintain close working relationships with key customers in orderto develop new products that meet their changing needs.

In addition, products for communications applicationsare based on continually evolving industry standards. Our ability to competewill depend on our ability to identify and ensure compliance with theseindustry standards. As a result, we could be required to invest significanttime and effort and incur significant expense to redesign our products andensure compliance with relevant standards. We believe that products for theseapplications will encounter intense competition and be highly price sensitive.While we are currently developing and introducing new products for theseapplications, we cannot assure you that these products will reach the market ontime, will satisfactorily address customer needs, will be sold in high volume,or will be sold at profitable margins.

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

**Ourfuture success depends in part on the continued service of our key designengineering, sales, marketing and executive personnel and our ability toidentify, recruit and retain additional personnel.**

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

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**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 benecessary in the future to enforce our intellectual property rights, to protectour trade secrets, to determine the validity and scope of the proprietaryrights of others, or to defend against claims of infringement or invalidity. Litigationcould result in substantial costs and diversion of resources and could harm ourbusiness, operating results and financial condition regardless of the outcomeof the litigation. We hold 168 patents in the United States relating to certainaspects of our products and processes, with expiration dates ranging from 2010to 2024 and have filed for several more. In addition, we hold several patentsin Europe, Japan, Korea, Taiwan, and China. We cannot assure you that anypending patent application will be granted. Our operating results could beharmed by the failure to protect our intellectual property.

**Weare engaged in securities class action suits and derivative suits, which maybecome time consuming, costly and divert management resources and could impactour stock price.**

Securities class action law suits are often broughtagainst companies, particularly technology companies, following periods ofvolatility in the market price of their securities. Irrespective of thevalidity or the successful assertion of such claims, we could incur significantcosts and management resources in defending against such claims.

In January and February 2005, multipleputative shareholder class action complaints were filed against SST and certaindirectors and officers, in the United States District Court for the NorthernDistrict of California, following our announcement of anticipated financialresults for the fourth quarter of 2004. On March 24, 2005, the putativeclass actions were consolidated under the caption *In re Silicon Storage Technology, Inc., Securities Litigation,*Case No. C 05 00295 PJH (N.D. Cal.). On May 3, 2005, the HonorablePhyllis J. Hamilton appointed the “Louisiana Funds Group,” consisting of theLouisiana School Employees’ Retirement System and the Louisiana DistrictAttorneys’ Retirement System, to serve as lead plaintiff and the law firms ofPomeranz Haudek Block Grossman & Gross LLP and Berman DeValerio PeaseTabacco Burt & Pucillo to serve as lead counsel and liason counsel,respectively, for the class. The lead plaintiff filed a Consolidated Amended Class ActionComplaint 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 to dismiss the complaint on September 16,2005. Plaintiff served an opposition to the motion to dismiss on November 4,2005. Our reply in further support of the motion to dismiss was filed on December 19,2005. On January 18, 2006, the Court heard arguments on the motion todismiss. On March 10, 2006, the Court granted our motion to dismiss theconsolidated amended complaint, with leave to file an amended complaint.Pursuant to the Court’s Order, any amended complaint must be filed no laterthat April 14, 2006. We intend to take all appropriate action in responseto these lawsuits. The impact related to the outcome of these matters isundeterminable at this time.

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

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

*Our litigation may beexpensive, may be protracted and confidential information may be compromised.**  *We have incurred certain costs associated withdefending these matters, and at any time, additional claims may be filedagainst us, which could increase the risk, expense and duration of thelitigation. Further, because of the amount of discovery required in connectionwith this type of litigation, there is a risk that some of our confidentialinformation could be compromised by disclosure. For more information withrespect to our litigation, please also see “Part I, Item 3—LegalProceedings.”

**If weare accused of infringing the intellectual property rights of other parties wemay become subject to time consuming and costly litigation. If we lose, wecould suffer a significant impact on our business and be forced to pay damages.**

Third parties may assert that our products infringetheir proprietary rights, or may assert claims for indemnification resultingfrom 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 sued by Atmel Corporation andIntel Corporation, among others, regarding patent infringement. Significant managementtime and financial resources were devoted to defending these lawsuits. Wesettled with Intel in May 1999 and with Atmel 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 all of our products is based on SuperFlashtechnology, any legal finding that the use of our SuperFlash technologyinfringes the patent of another company would have a significantly negativeeffect on our entire product line and operating results. Furthermore, if such afinding were made, there can be no assurance that we could license the othercompany’s technology on commercially reasonable terms or that we couldsuccessfully operate without such technology. Moreover, if we are found toinfringe, we could be required to pay damages to the owner of the protectedtechnology and could be prohibited from making, using, selling, or importinginto the United States any products that infringe the protected technology. Inaddition, the management attention consumed by and legal cost associated withany litigation could harm our operating results. During the course of theselawsuits there may be public announcements of the results of hearings, motions,and other interim proceedings or developments in the litigation. If securitiesanalysts or investors perceive these results to be negative, it could harm themarket price of our stock.

**If anearthquake or other natural disaster strikes our manufacturing facility orthose of our suppliers, we would be unable to manufacture our products for asubstantial amount of time and we would experience lost revenues.**

Our corporate headquartersare located in California near major earthquake faults. In addition, some ofour suppliers are located near fault lines. In the event of a major earthquakeor other natural disaster near our headquarters, our operations could be harmed.Similarly, a major earthquake or other natural disaster such as typhoon nearone or more of our major suppliers, like the earthquakes in September 1999and March 2002 or the typhoons in September 2001and July 2005that occurred in Taiwan, could potentially disrupt the operations of thosesuppliers, which could then limit the supply of our products and harm ourbusiness.

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**Avirus or viral outbreak in Asia could harm our business.**

We derive substantiallyall of our revenues from Asia and our logistics center is located in Taiwan. Avirus or viral outbreak in Asia, such as the SARS outbreak in early 2003 or thecurrent threat of the Avian flu, could harm the operations of our suppliers,distributors, logistics center and those of our end customers, which could harmour business.

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

Our design and processresearch and development facilities and our corporate offices are located inCalifornia, which is susceptible to power outages and shortages as well asincreased energy costs. To limit this exposure, all corporate computer systemsat our main California facilities are on battery back-up. In addition, all ofour engineering and back-up servers and selected corporate servers are ongenerator back-up. While the majority of our production facilities are notlocated in California, more extensive power shortages in the state could delayour design and process research and development as well as increase ouroperating costs.

**Ourgrowth has in the past placed a significant strain on our management systemsand resources and if we fail to manage our growth, our ability to market orsell our products or develop new products may be harmed.**

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

**Futurechanges in financial accounting standards or practices or existing taxation rules orpractices may cause adverse unexpected revenue fluctuations and affect ourreported results of operations.**

A change in accounting standards or practices or achange in existing taxation rules or practices can have a significanteffect on our reported results and may even affect reporting of transactionscompleted before the change is effective. New accounting pronouncements andtaxation rules and varying interpretations of accounting pronouncementsand taxation practice have occurred and may occur in the future. Changes toexisting rules or the questioning of current practices may adverselyaffect our reported financial results or the way we conduct our business.

For example, the FinancialAccounting Standards Board, or FASB, has issued changes to generally acceptedaccounting principles in the United States that, when implemented in the firstquarter of 2006, will require us to record charges to earnings for the stockoptions we grant and purchases of our common stock under our employee stockpurchase plan.

**Evolvingregulation of corporate governance and public disclosure may result inadditional expenses and continuing uncertainty**

Changing laws, regulationsand standards relating to corporate governance and public disclosure, includingthe Sarbanes-Oxley Act of 2002, new SEC regulations and NASDAQ National Market rules arecreating uncertainty for public companies. We continually evaluate and monitordevelopments with respect 

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to newand proposed rules and cannot predict or estimate the amount of theadditional costs we may incur or the timing of such costs. These new or changedlaws, regulations and standards are subject to varying interpretations, in manycases due 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 in continuing uncertainty regardingcompliance matters and higher costs necessitated by ongoing revisions todisclosure and governance practices. We are committed to maintaining highstandards of corporate governance and public disclosure. As a result, we haveinvested resources to comply with evolving laws, regulations and standards, andthis investment has resulted in increased general and administrative expensesand a diversion of management time and attention from revenue-generatingactivities to compliance activities. If our efforts to comply with new orchanged laws, regulations and standards differ from the activities intended byregulatory or governing bodies due to ambiguities related to practice,regulatory authorities may initiate legal proceedings against us and we may beharmed.

**We,and our independent registered public accounting firm, determined that we had amaterial weakness in our internal controls over financial reporting in 2004. Inthe future, such events could cause our current and potential stockholders tolose confidence in our financial reporting, which would harm our business andthe trading price of our stock.**

Under Section 404 of the Sarbanes-Oxley Act of2002, we are required to evaluate and determine the effectiveness of ourinternal controls over financial reporting. We have dedicated a significantamount of time and resources to ensure compliance with this legislation for theyear ended December 31, 2005 and will continue to do so for future fiscalperiods. We may encounter problems or delays in completing the review and evaluation,the implementation of improvements and the receipt of a positive attestation,or any attestation at all, by our independent regional accounting firm.Additionally, management’s assessment of our internal controls over financialreporting may identify deficiencies that need to be addressed in our internalcontrols over financial reporting or other matters that may raise concerns forinvestors.

As of December 31, 2004, we did not maintaineffective control over accounting for and review of the valuation of inventory,the income tax provision and related balance sheet accounts and licensingrevenue because we lacked a sufficient complement of personnel with a level ofaccounting expertise that is commensurate with our financial reportingrequirements. Because of this material weakness, our management concluded that,as of December 31, 2004, we did not maintain effective internal controlover financial reporting based on those criteria. As a result,PricewaterhouseCoopers LLP, issued an adverse opinion with respect to ourinternal controls over financial reporting and their report is included in our Form 10-Kfor the year ended December 31, 2004. As of December 31, 2005, thesematerial weaknesses had been remediated. For further information, see Item 9A—“Controlsand Procedures” on page 43.

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, G-Plus and Actrans. We expect to continue toevaluate and consider a wide array of potential strategic transactions,including business combinations, acquisitions and dispositions of businesses,technologies, services, products and other assets, including interests in ourexisting subsidiaries and joint ventures. At any given time we may be engagedin discussions or negotiations with respect to one or more of suchtransactions. Any of such transactions could be material to our financialcondition and results of operations. There is no assurance that any suchdiscussions or negotiations will result in the consummation of any transaction.The process of integrating 

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anyacquired business may create unforeseen operating difficulties and expendituresand is itself risky. The areas 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;

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

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

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

International acquisitionsinvolve additional risks, including those related to integration of operationsacross different cultures and languages, currency risks, and the particulareconomic, political, and regulatory risks associated with specific countries.Moreover, we may not realize the anticipated benefits of any or all of ouracquisitions. As a result of future acquisitions or mergers, we might need toissue additional equity securities, spend our cash, or incur debt, contingentliabilities, or amortization expenses related to intangible assets, any ofwhich could reduce our profitability and harm our business.

**Risks Related 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 technologyother than SuperFlash may be adopted as an industry standard. Our competitorsare generally in a better financial and marketing position than we are from whichto influence industry acceptance of a particular memory technology. Inparticular, a primary source of competition may come from alternativetechnologies such as FRAM devices if such technology is commercialized forhigher density applications. To the extent our competitors are able to promotea technology other than SuperFlash as an industry standard, our business willbe seriously harmed.

**Theselling prices for our products are extremely volatile and have historicallydeclined during periods of over capacity or industry downturns.**

The semiconductor industryhas historically been cyclical, characterized by periodic changes in businessconditions caused by product supply and demand imbalance. When the industryexperiences downturns, they often occur in connection with, or in anticipationof, maturing product cycles and declines in general economic conditions. Thesedownturns are characterized by weak product demand, excessive inventory andaccelerated declines of average selling prices. In some cases, downturns, suchas the one we experienced from late 2000 through 2002, have lasted for morethan a year. Our business could be further harmed by industry-wide prolongeddownturns in the future. These downturns are characterized by weak productdemand, excessive inventory and accelerated decline of selling prices. Weexperienced a decrease in the average selling prices of our products as aresult of the industry-wide oversupply and excessive inventory in the market inthe second half of 2004 and the first half of 2005. Although we have seenstrengthening of market demand in the second half of 2005, our business couldbe further harmed by industry-wide prolonged downturns in the future.

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**Thereis seasonality in our business and if we fail to continue to introduce newproducts this seasonality may become more pronounced.**

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

**Item 1B.**               UnresolvedStaff Comments

Not applicable.

**Item 2.**                        Properties

As of  December 31,2005, we occupied three major facilities totaling 131 thousand square feet inSunnyvale, California which our executive offices, research and development,principal manufacturing engineering and testing facilities are located. Of thethree major facilities occupied, we own one facility totaling 20 thousandsquare feet and we lease two facilities totaling 111 thousand square feet. Theleases on the two facilities expire in 2010.  We also have 94 thousand square feet of officespace in various domestic and international sites with expiration ranging from2006 to 2012. We believe these facilities are adequate to meet our needs for atleast the next 12 months.

For information regardinglong-lived assets by geography, see “Note 16—Segment Reporting’’ to our Notesto the Consolidated Financial Statements.

**Item 3.**                        LegalProceedings

In January and February 2005, multipleputative shareholder class action complaints were filed against SST and certaindirectors and officers, in the United States District Court for the NorthernDistrict of California, following our announcement of anticipated financialresults for the fourth quarter of 2004. On March 24, 2005, the putativeclass actions were consolidated under the caption *In re Silicon Storage Technology, Inc., Securities Litigation,*Case No. C 05 00295 PJH (N.D. Cal.). On May 3, 2005, the HonorablePhyllis J. Hamilton appointed the “Louisiana Funds Group,” consisting of theLouisiana School Employees’ Retirement System and the Louisiana DistrictAttorneys’ Retirement System, to serve as lead plaintiff and the law firms ofPomeranz Haudek Block Grossman & Gross LLP and Berman DeValerio PeaseTabacco Burt & Pucillo to serve as lead counsel and liason counsel,respectively, for the class. The lead plaintiff filed a Consolidated Amended Class ActionComplaint on July 15, 2005. The complaint seeks unspecified damages on allegedviolations of federal securities laws during the period from April 21,2004 to December 20, 2004. We moved to dismiss the complaint on September 16,2005. Plaintiff served an opposition to the motion to dismiss on November 4,2005. Our reply in further support of the motion to dismiss was filed on December 19,2005. On January 18, 2006, the Court heard arguments on the motion todismiss. On March 10, 2006, the Court granted our motion to dismiss theconsolidated amended complaint, with leave to file an amended complaint.Pursuant to the Court’s Order, any amended complaint must be filed no laterthat April 14, 2006. We intend to take all appropriate action in responseto these lawsuits. The impact related to the outcome of these matters isundeterminable at this time.

In January and February 2005, following thefiling of the putative class actions, multiple shareholder derivativecomplaints were filed in California Superior Court for the County of SantaClara, purportedly on behalf of SST against certain of our directors andofficers. The factual allegations of these complaints are substantiallyidentical to those contained in the putative shareholder class actions filed infederal court. The derivative complaints assert claims for, among other things,breach of fiduciary duty and violations of the California Corporations Code. Thesederivative actions have been consolidated under the caption *In*

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*ReSilicon Storage Technology, Inc. Derivative Litigation*,Lead Case No. 1:05CV034387 (Cal. Super. Ct., Santa Clara Co.). On April 28,2005, the derivative action was stayed by court order. We intend to take allappropriate action in response to these lawsuits. The impact related to theoutcome of these matters is undeterminable at this time.

From time to time, we arealso involved in other legal actions arising in the ordinary course of business.We have accrued certain costs associated with defending these matters. Therecan be no assurance that the shareholder class action complaints, theshareholder derivative complaints or other third party assertions will beresolved without costly litigation, in a manner that is not adverse to ourfinancial position, results of operations or cash flows or without requiringroyalty payments in the future which may adversely impact gross margins. Noestimate can be made of the possible loss or possible range of loss associatedwith the resolution of these contingencies. Asa result, no losses have been accrued in our financial statements as of December 31,2005.

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

No matters were submitted during the fourth quarter to a vote ofsecurity holders.

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**PART II**

**Item 5.**                        Marketfor Registrant’s Common Stock, Related Stockholder Matters and Issuer Purchasesof Equity Securities

***Price Range of Common Stock***

Theprincipal U.S. market for our Common Stock is the NASDAQ National Market. Theonly class of our securities that is traded is our Common Stock. Our CommonStock has traded on the NASDAQ National Market since November 21, 1995,under the symbol SSTI. The following table sets forth the quarterly high andlow closing sales prices of the Common Stock for the period indicated asreported by the NASDAQ National Market. These prices do not include retailmark-ups, markdowns, or commissions. The closing sales price of our CommonStock on December 30, 2005, the last trading day in 2005, was $5.07.

| **2004**        | ** ** | ** **                               | ** ** | ** ** | ** ** | **High Close** | ** ** | **Low Close** | ** ** |
|-----------------|------------|------------------------------------------|------------|------------|------------|---------------------|------------|--------------------|------------|
| First Quarter:  |       | January 1 -  March 31, 2004    |       |       | $          | 13.46               |       |               |       | $ | 10.64 |   |   |
| Second Quarter: |       | April 1 -  June 30, 2004       |       |       | 16.77      |                |       |               | 9.55       |   |   |
| Third Quarter:  |       | July 1 -  September 30, 2004   |       |       | 9.52       |                |       |               | 5.42       |   |   |
| Fourth Quarter: |       | October 1 -  December 31, 2004 |       |       | 7.77       |                |       |               | 5.72       |   |   |

 

| **2005**         | ** ** | ** **                               | ** ** | ** ** | ** ** | **High Close** | ** ** | **Low Close** | ** ** |
|------------------|------------|------------------------------------------|------------|------------|------------|---------------------|------------|--------------------|------------|
| First  Quarter:  |       | January 1 -  March 31, 2005    |       |       | $          | 5.72                |       |               |       | $ | 3.47 |   |   |
| Second  Quarter: |       | April 1 -  June 30, 2005       |       |       | 4.18       |                |       |               | 2.55       |   |   |
| Third  Quarter:  |       | July 1 -  September 30, 2005   |       |       | 5.67       |                |       |               | 4.12       |   |   |
| Fourth  Quarter: |       | October 1 -  December 31, 2005 |       |       | 6.02       |                |       |               | 4.58       |   |   |

 

| **2006**        | ** ** | ** **                               | ** ** | ** ** | ** ** | **High Close** | ** ** | **Low Close** | ** ** |
|-----------------|------------|------------------------------------------|------------|------------|------------|---------------------|------------|--------------------|------------|
| First  Quarter: |       | January 1 -  February 28, 2006 |       |       | $          | 5.57                |       |               |       | $ | 4.52 |   |   |
|                 |            |                                          |            |            |            |                     |            |                    |            |  |  |  |  |  |  |

 

***Approximate Number of Equity Security Holders***

As of December 31,2005, there were approximately 883 record holders of our Common Stock.

***Dividends***

Wehave never paid a cash dividend on our Common Stock and we intend to continueto retain earnings, if any, to finance future growth. Accordingly, we do notanticipate paying cash dividends to holders of Common Stock in the foreseeablefuture.

***Equity Compensation Plan Information***

Informationregarding our equity compensation plans will be contained in our definitiveProxy Statement with respect to our Annual Meeting of Shareholders under thecaption “Compensation—Equity Compensation Plan Information,” and isincorporated by reference into this report. All of our equity compensationplans have been approved by our shareholders.

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**Item 6.        SelectedConsolidated Financial Data**

Thefollowing selected consolidated financial data should be read in conjunctionwith “Management’s Discussion and Analysis of Financial Condition and Resultsof Operations” and the Consolidated Financial Statements and the notes theretoincluded elsewhere in this report.

| ** **                                                                            | ** ** | **Year ended December 31,**                         | ** ** |
|---------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                            | ** ** | **2001**                                                           | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                                                                            | ** ** | **(in thousands, except per share data)** | ** ** |
| **Consolidated Statements of  Operations Data:**                                      |       |                                                               |       |   |   |   |   |   |   |   |   |
| Net revenues:                                                                         |       |                                                               |       |   |   |   |   |   |   |   |   |
| Product revenues—unrelated parties                                               |       | $                                                                  | 168,593    |   | $ | 100,620 |   | $ | 86,549 |   | $ | 180,234 |   | $ | 157,499 |   |
| Product revenues—related parties                                                 |       | 90,025                                                             |       | 143,401 |   | 169,980 |   | 224,497 |   | 236,597 |   |
| License revenues—unrelated parties                                               |       | 35,412                                                             |       | 30,637 |   | 38,512 |   | 44,311 |   | 35,226 |   |
| License revenues—related parties                                                 |       | —                                                             |       | — |   | — |   | 156 |   | 1,577 |   |
| Total net revenues                                                                    |       | 294,030                                                            |       | 274,658 |   | 295,041 |   | 449,198 |   | 430,899 |   |
| Cost of revenues                                                                      |       | 248,161                                                            |       | 206,246 |   | 218,775 |   | 322,093 |   | 353,128 |   |
| Gross profit                                                                          |       | 45,869                                                             |       | 68,412 |   | 76,266 |   | 127,105 |   | 77,771 |   |
| Operating expenses:                                                                   |       |                                                               |       |   |   |   |   |   |   |   |   |
| Research and development                                                              |       | 50,380                                                             |       | 47,069 |   | 43,144 |   | 46,904 |   | 49,030 |   |
| Sales and marketing                                                                   |       | 26,794                                                             |       | 25,498 |   | 22,272 |   | 28,295 |   | 28,620 |   |
| General and administrative                                                            |       | 17,855                                                             |       | 17,097 |   | 14,398 |   | 18,292 |   | 23,926 |   |
| Other                                                                                 |       | 1,346                                                              |       | — |   | 37,849 |   | 7,375 |   | 2,945 |   |
| Total operating expenses                                                              |       | 96,375                                                             |       | 89,664 |   | 117,663 |   | 100,866 |   | 104,521 |   |
| Income (loss)  from operations                                                        |       | (50,506                                                            | )          | (21,252 | ) | (41,397 | ) | 26,239 |   | (26,750 | ) |
| Interest and  other income                                                            |       | 7,449                                                              |       | 3,225 |   | 2,996 |   | 2,295 |   | 1,790 |   |
| Interest and  other expense                                                           |       | (437                                                               | )          | (242 | ) | (350 | ) | (281 | ) | (266 | ) |
| Impairment of  equity investments                                                     |       | (3,274                                                             | )          | (7,757 | ) | — |   | (509 | ) | (2,240 | ) |
| Income (loss)  before provision for (benefit from) income taxes and minority interest |       | (46,768                                                            | )          | (26,026 | ) | (38,751 | ) | 27,744 |   | (27,466 | ) |
| Provision for  (benefit from) income taxes                                            |       | (17,772                                                            | )          | (10,931 | ) | 26,416 |   | 3,906 |   | 2,449 |   |
| Minority interest                                                                     |       | —                                                             |       | — |   | — |   | (90 | ) | (77 | ) |
| Net income (loss)                                                                     |       | $                                                                  | (28,996    | ) | $ | (15,095 | ) | $ | (65,167 | ) | $ | 23,929 |   | $ | (29,838 | ) |
| Net income (loss)  per share—basic                                               |       | $                                                                  | (0.32      | ) | $ | (0.16 | ) | $ | (0.69 | ) | $ | 0.25 |   | $ | (0.29 | ) |
| Net income (loss)  per share—diluted                                             |       | $                                                                  | (0.32      | ) | $ | (0.16 | ) | $ | (0.69 | ) | $ | 0.24 |   | $ | (0.29 | ) |
| **Consolidated  Balance Sheet Data:**                                                 |       |                                                               |       |   |   |   |   |   |   |   |   |
| Total assets                                                                          |       | $                                                                  | 446,760    |   | $ | 440,606 |   | $ | 396,361 |   | $ | 502,331 |   | $ | 477,837 |   |
| Long-term  obligations                                                                |       | $                                                                  | 1,793      |   | $ | 1,873 |   | $ | 1,423 |   | $ | 1,307 |   | $ | 2,627 |   |
| Shareholders’ equity                                                             |       | $                                                                  | 391,411    |   | $ | 381,851 |   | $ | 331,497 |   | $ | 375,984 |   | $ | 379,833 |   |

 

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**Item 7.**                        Management’sDiscussion and Analysis of Financial Condition and Results of Operations

Except for the historicalinformation contained herein, the following discussion contains forward-lookingstatements that involve risks and uncertainties. All forward-looking statementsincluded in this document are based on information available to us on the datehereof, and we assume no obligation to update any such forward-lookingstatements. Our actual results could differ materially from those discussed. Factorsthat could cause or contribute to such differences include, but are not limitedto, those discussed in Part I, Item 1A. “Risk Factors,” as well as thosediscussed elsewhere in this report.

***Overview***

We are a leading supplier of flash memory semiconductordevices addressing the needs of high volume applications. We believe ourproprietary flash memory technology, SuperFlash, offers superior performance toother flash memory solutions. In addition, we believe SuperFlash has benefitsthat include high reliability, fast, fixed erase time, the ability to be scaledto a smaller size and a low-cost manufacturing process. Our products areproduced to meet the needs of a wide range of digital consumer, networking,wireless communications and Internet computing markets. Our product offeringsinclude standard flash products, application specific memory products, embeddedcontrollers and mass data storage products. Our memory devices have densitiesranging from 256 Kbit to 64 Mbit and are generally used for the storage ofprogram code. Our flash embedded microcontrollers support concurrent flashread-while-write operations using In-Application Programming, or IAP. Our massdata storage products are used for storing images, music and other data indevices such as digital cameras and MP3 players.

One of our key initiatives is the active development of our non-memorybusiness. Our objective is to transform SST from a pure-play in flash to a multi-product linecompany. We continue to execute on our plan to achieve, by mid-2008,30%  revenue contribution from non-memoryproducts, which includes embedded controllers, NAND controller based products,smart card ICs and radio frequency ICs and modules. During 2005, weachieved 16.0% product revenue contribution from non-memory products.**We believethat non-memory products represent an area in which we have significantcompetitive advantages and can yield profitable revenue with higher and morestable gross margins than our memory products in the long run.

The semiconductor industry has historically beencyclical, characterized by periodic changes in business conditions caused byproduct supply and demand imbalance. When the industry experiences downturns,they often 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 the average selling prices of our productsas a result of the industry-wide oversupply and excessive inventory in themarket in the second half of 2004 and the first half of 2005. Although we haveseen strengthening of market demand in the second half of 2005, our businesscould be further harmed by industry-wide prolonged downturns in the future.

Our product sales are made primarily using short-termcancelable purchase orders. The quantities actually purchased by the customer,as well as shipment schedules, are frequently revised to reflect changes in thecustomer’s needs and in our supply of products. Accordingly, our backlog ofopen purchase orders at any given time is not a meaningful indicator of futuresales. Changes in the amount of our backlog do not necessarily reflect a correspondingchange in the level of actual or potential sales.

We derived 90.0%, 86.0% and 87.6% of our net productrevenues during 2003, 2004 and 2005, respectively, from product shipments toAsia. Additionally, substantially all of our wafer suppliers and packaging andtesting subcontractors are located in Asia.

29

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Shipments to our top ten end customers, which excludetransactions through stocking representatives and distributors, accounted for37.7%, 29.1% and 27.2% of our net product revenues in 2003, 2004 and 2005,respectively.

No single end customer, which we define as originalequipment manufacturers, or OEMs, original design manufacturers, or ODMs,contract electronic manufacturers, or CEMs, or end users, represented 10.0% ormore of our net product revenues during 2003, 2004 and 2005.

We out-source our end customer service logistics inAsia to Silicon Professional Technology Ltd., or SPT, which supports ourcustomers in Taiwan, China and other Southeast Asia countries. SPT providesforecasting, planning, warehousing, delivery, billing, collection and otherlogistic functions for us in these regions. SPT is a wholly-owned subsidiary ofone of our stocking representatives in Taiwan, Professional Computer TechnologyLimited, or PCT. Please see a description of our relationship with PCT under “RelatedParty Transactions.”  Products shipped toSPT are accounted for as our inventory held at our logistics center, andrevenue is recognized when the products have been delivered and are consideredas a sale to our end customers by SPT. For the years ended December 31,2003, 2004 and 2005, SPT serviced end customer sales accounting for 64.2%,52.9% and 58.5% of our net product revenues recognized. As of December 31,2003, 2004 and 2005, SPT represented 73.4%, 55.1% and 69.6% of our net accountsreceivable, respectively.

We ship products to, andhave accounts receivable from, OEMs, ODMs, CEMs, stocking representatives,distributors, and our logistics center. Our stocking representatives,distributors and logistics center reship our products to our end customers,including OEMs, ODMs, CEMs and end users. Shipments, by us or our logisticcenter, to our top three stocking representatives for reshipment accounted for29.9%, 34.0% and 40.3% of our product shipments in 2003, 2004 and 2005,respectively. In addition, the same three stocking representatives solicitedsales for 32.8%, 25.1% and 18.3% of our product shipments to end users in 2003,2004 and 2005, respectively for which they received a commission.

***Results of Operations: Years Ended December 31,2003, 2004 and 2005***

**Net Revenues**

| ** **            | ** ** | **Year Ended December 31,** | ** ** | **Increase (Decrease)** | ** ** | **Increase (Decrease)** | ** ** |
|-----------------------|------------|--------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **            | ** ** | **2003**                                   | ** ** | **2004**                     | ** ** | **2005**                     | ** ** | **2003 vs. 2004** | ** ** | **2004 vs. 2005** | ** ** |
| Product revenues      |       | $                                          | 256,529    |                         | $          | 404,731                      |       | $ | 394,096 |   | $ | 148,202 |   | 57.8 | % | $ | (10,635 | ) | (2.6 | )% |
| Technology  licensing |       | 38,512                                     |       | 44,467                       |       | 36,803                       |       | 5,955 |   | 15.5 | % | (7,664 | ) | (17.2 | )% |
| Total net revenues    |       | $                                          | 295,041    |                         | $          | 449,198                      |       | $ | 430,899 |   | $ | 154,157 |   | 52.2 | % | $ | (18,299 | ) | (4.1 | )% |

 

Net revenues for 2005decreased $18.3 million, or 4.1%, from the prior year largely as a result of a24.5% decrease in the average selling prices of our products due to industryoversupply and heavy competition over the first half of 2005. This decrease wasoffset by a 43.0% increase in unit shipments from the first to the second halfof 2005. In addition to the decrease in the average selling prices of ourproducts, we recognized lower up-front fees from our licensees due to thetiming of new license agreements and milestone completions from existingagreements. Net revenues for 2004 increased $154.2 million, or 52.2%, comparedto 2003 due to increased unit shipments and average selling prices as well asincreased license and royalty revenues.

30

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*Product Revenues*

Thefollowing charts and discussion are based on our reportable segments describedin Note 16 of the Notes to the Consolidated Financial Statements.****

| ** **   | ** ** | **Year Ended December 31,** | ** ** | **Increase (Decrease)** | ** ** | **Increase (Decrease)** | ** ** |
|--------------|------------|--------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **   | ** ** | **2003**                                   | ** ** | **2004**                     | ** ** | **2005**                     | ** ** | **2003 vs. 2004** | ** ** | **2004 vs. 2005** | ** ** |
| SMPG revenue |       | $                                          | 166,776    |                         | $          | 269,376                      |       | $ | 205,234 |   | $ | 102,600 |   | 61.5 | % | $ | (64,142 | ) | (23.8 | )% |
|              |            |                                            |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

SMPG net revenuesdecreased $64.1 million, or 23.8%, for 2005 compared to 2004. SMPG revenuedecreased year over year due to both a 1.8% decrease in unit shipments and a22.7% decrease in the average selling price of SPMG products due to industryoversupply and heavy competition over the past year. However, we began toexperience stronger demand and improved pricing in the second half of 2005 withshipments increasing 31.0% over the first half of 2005. SMPG net revenuesincreased 61.5% in 2004 from 2003. Increased market demand and product mix ledto a 26.9% increase in units shipped in 2004 over 2003 with a 28.7% increase inthe average selling price.

*ASPG*

| ** **   | ** ** | **Year Ended December 31,** | ** ** | **Increase (Decrease)** | ** ** | **Increase (Decrease)** | ** ** |
|--------------|------------|--------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **   | ** ** | **2003**                                   | ** ** | **2004**                     | ** ** | **2005**                     | ** ** | **2003 vs. 2004** | ** ** | **2004 vs. 2005** | ** ** |
| ASPG Revenue |       | $                                          | 60,481     |                         | $          | 90,126                       |       | $ | 154,709 |   | $ | 29,645 |   | 49.0 | % | $ | 64,583 |   | 71.7 | % |
|              |            |                                            |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

ASPG revenue increased$64.6 million, or 71.7%, for 2005 compared to 2004. The increase was largely aresult of record unit shipments, increasing 112.2% year-over-year attributableto serial flash products and media controllers as well as  our smartcard business acquired through theEmosyn acquisition in 2004. ASPG net revenues increased 49.0% in 2004 from2003. Increased market demand and the acquired smartcard business led to asubstantial increase in units shipped in 2004 over 2003.

*SPG*

| ** **  | ** ** | **Year Ended December 31,** | ** ** | **Increase (Decrease)** | ** ** | **Increase (Decrease)** | ** ** |
|-------------|------------|--------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **  | ** ** | **2003**                                   | ** ** | **2004**                     | ** ** | **2005**                     | ** ** | **2003 vs. 2004** | ** ** | **2004 vs. 2005** | ** ** |
| SPG revenue |       | $                                          | 29,272     |                         | $          | 44,636                       |       | $ | 30,954 |   | $ | 15,364 |   | 52.5 | % | $ | (13,682 | ) | (30.7 | )% |
|             |            |                                            |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

SPG revenue decreased from2004 to 2005 by 30.7%. Unit shipments and average selling prices fell by 15.7%and 12.9%, respectively. These decreases were mainly due to significant pricingpressures we experienced over the past year as a result of industry oversupplyand heavy competition. Revenue increased in 2004 from 2003 by 52.5% due to a 5.8%increase in shipments and a 34.3% increase in average selling prices.

*SCC*

| ** **  | ** ** | **Year Ended December 31,** | ** ** | **Increase (Decrease)** | ** ** | **Increase (Decrease)** | ** ** |
|-------------|------------|--------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **  | ** ** | **2003**                                   | ** ** | **2004**                     | ** ** | **2005**                     | ** ** | **2003 vs. 2004** | ** ** | **2004 vs. 2005** | ** ** |
| SCC Revenue |       |                                       | $          | —                       |       |                         | $          | 593 |   | $ | 3,199 |   | $593 |   | N/A |   | $ | 2,606 |   | 439.5 | % |
|             |            |                                            |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

SCC revenue increased $2.6million for 2005 due to the full year’s inclusion of SCC in 2005. Shipments ofSCC products generally saw sequential increases during each quarter of 2005,however, revenue fluctuated during the year as pricing pressures eroded averageselling prices. There was no segment revenue for the year ended December 31,2003 as the SCC segment was purchased from G-Plus in November 2004.

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*Technology Licensing Revenue*

| ** **            | ** ** | **Year Ended December 31,** | ** ** | **Increase (Decrease)** | ** ** | **Increase (Decrease)** | ** ** |
|-----------------------|------------|--------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **            | ** ** | **2003**                                   | ** ** | **2004**                     | ** ** | **2005**                     | ** ** | **2003 vs. 2004** | ** ** | **2004 vs. 2005** | ** ** |
| Technology  licensing |       | $                                          | 38,512     |                         | $          | 44,467                       |       | $ | 36,803 |   | $ | 5,955 |   | 15.5 | % | $ | (7,664 | ) | (17.2 | )% |
|                       |            |                                            |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Revenues from royaltiesand license fees decreased during 2005 from 2004 by $7.7 million. The decreaseyear over year was mainly due to the timing of milestone completion on new andexisting licensees. The increase from 2003 to 2004 is due to increased licensefees.

**Gross Profit**

| ** **                         | ** ** | **Year Ended December 31,** | ** ** | **Increase (Decrease)** | ** ** | **Increase (Decrease)** | ** ** |
|------------------------------------|------------|--------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                         | ** ** | **2003**                                   | ** ** | **2004**                     | ** ** | **2005**                     | ** ** | **2003 vs. 2004** | ** ** | **2004 vs. 2005** | ** ** |
| Product gross  profit              |       | $                                          | 37,754     |                         | $          | 82,638                       |       | $ | 40,968 |   | $ | 44,884 |   | 118.9 | % | $ | (41,670 | ) | (50.4 | )% |
| Product gross  margin              |       | 14.7                                       | %          | 20.4                         | %          | 10.4                         | %          |   |   |   |   |   |   |   |   |
| Technology  licensing gross profit |       | 38,512                                     |       | 44,467                       |       | 36,803                       |       | 5,955 |   | 15.5 | % | (7,664 | ) | (17.2 | )% |
| Technology  licensing gross margin |       | 100.0                                      | %          | 100.0                        | %          | 100.0                        | %          |   |   |   |   |   |   |   |   |
| Total gross  profit                |       | $                                          | 76,266     |                         | 127,105    |                         | 77,771     |   | 50,839 |   | 66.7 | % | (49,334 | ) | (38.8 | )% |
| Total gross margin                 |       | 25.8                                       | %          | 28.3                         | %          | 18.0                         | %          |   |   |   |   |   |   |   |   |
|                                    |            |                                            |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Both gross profit and gross margin decreased in 2005compared to 2004. Industry oversupply and heavy competition in the first halfof 2005 were the major contributors to the decreases and contributed to a 24.5%decrease in the average selling price of our products. In addition, werecognized lower up-front fees from our licensees due to the timing of newlicense agreements and milestone completions from existing agreements.

During the 2005 we experienced market softness duringthe first two quarters of the year with upwards trends in the second half.Units shipped in the second half of 2005 grew more than 40% over the first halfand during the fourth quarter of 2005, unit shipments set a new record of morethan 2 million units per calendar day, including an 8% increase from ourprevious record achieved in the third quarter of 2005. We also experiencedshipment records in many high volume applications, including DVD recorders, DVDrewritable drives, MP3 players, digital TVs, desktop and notebook PCs, harddisk drives, printers and LCD monitors. We are continuing to drivemanufacturing cost reductions through the transition to smaller geometries.Substantially all  new wafer starts arenow in 0.25 micron and 0.18 micron geometries and we are in the process ofintensively developing 0.13 micron and 0.12 micron process technologies forhigh density serial flash and a low cost 16 megabit product that are targetedfor production in the second half of 2006. While our near term cost structurefor 16 megabits and above densities is mainly determined by our 0.18 microninventory, we believe that with our cost reduction efforts using more advanced0.12 micron technology, we will begin to realize benefits during the later partof 2006.

Gross profit was $127.1 million, or 28.3% of netrevenues, in 2004 and $76.3 million, or 25.8% of net revenues, in 2003. Theincrease in gross profit in 2004 when compared to 2003 is primarily due toimproved manufacturing costs achieved by transitioning manufacturing technologyto smaller geometries, the sale of previously reserved inventory, increases inaverage selling prices and unit shipments by 16.2% and 35.3%, respectively, aswell as increased revenues from technology licensing, offset by a net increaseof $28.5 million in our provision for inventory and adverse purchasecommitments over the 2003 provision.

Gross margin for unrelated party shipments was 14.2%while gross margin for related party shipments was 7.9%. The primary reason forthe difference in gross margin is that the majority of our high volume 

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customer shipments are inAsia and are serviced  through SPT, ourlogistics center. For more information related to SPT, please also see Part I,Item IA. “Risk Factors—Business Risks—We depend on Silicon ProfessionalTechnology Ltd., or SPT, our logistics center, to support many of our customersin Asia” on page 14.

*SMPG*

| ** **        | ** ** | **Year Ended December 31,** | ** ** | **Increase (Decrease)** | ** ** | **Increase (Decrease)** | ** ** |
|-------------------|------------|--------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **        | ** ** | **2003**                                   | ** ** | **2004**                     | ** ** | **2005**                     | ** ** | **2003 vs. 2004** | ** ** | **2004 vs. 2005** | ** ** |
| SMPG gross profit |       | $                                          | 21,428     |                         | $          | 48,352                       |       | $ | 6,510 |   | $ | 26,924 |   | 125.6 | % | $ | (41,842 | ) | (86.5 | )% |
| SMPG gross margin |       | 12.8                                       | %          | 17.9                         | %          | 3.2                          | %          |   |   |   |   |   |   |   |   |
|                   |            |                                            |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

SMPG gross margins for2005 decreased from 2004. The decrease in gross margin is primarily driven byprice erosion as a result of industry over-supply and severe competitionbeginning in the second half of 2004 and continuing through the first half of2005. We also experienced excessive inventory build late in 2004 and early 2005as a result of the downturn in the market. The increase in revenue in 2004compared to 2003 was the result of both an increase in unit shipments of 26.9%and an increase in average selling prices of 28.7%.

*ASPG*

| ** **        | ** ** | **Year Ended December 31,** | ** ** | **Increase (Decrease)** | ** ** | **Increase (Decrease)** | ** ** |
|-------------------|------------|--------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **        | ** ** | **2003**                                   | ** ** | **2004**                     | ** ** | **2005**                     | ** ** | **2003 vs. 2004** | ** ** | **2004 vs. 2005** | ** ** |
| ASPG gross profit |       | $                                          | 11,544     |                         | $          | 21,792                       |       | $ | 33,780 |   | $ | 10,248 |   | 88.8 | % | $ | 11,988 |   | 55.0 | % |
| ASPG gross margin |       | 19.1                                       | %          | 24.2                         | %          | 21.8                         | %          |   |   |   |   |   |   |   |   |
|                   |            |                                            |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

ASPG gross profitincreased for 2005 compared to 2004 due to the increase in the number of unitsshipped, especially in serial flash products and media controllers, however,gross margin decreased primarily due to a 19.3 % decrease in the averageselling price of ASPG products. There was some price improvement during thefourth quarter as the market strengthened and prices stabilized. ASPG grossprofit for 2004 increased by $10.2 million compared to 2003 due to an 80.6%increase in the number of units shipped, although our average selling pricedecreased by 18.4%.

*SPG*

| ** **       | ** ** | **Year Ended December 31,** | ** ** | **Increase (Decrease)** | ** ** | **Increase (Decrease)** | ** ** |
|------------------|------------|--------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **       | ** ** | **2003**                                   | ** ** | **2004**                     | ** ** | **2005**                     | ** ** | **2003 vs. 2004** | ** ** | **2004 vs. 2005** | ** ** |
| SPG gross profit |       | $                                          | 4,782      |                         | $          | 12,706                       |       | $ | 2,792 |   | $ | 7,924 |   | 165.7 | % | $ | (9,914 | ) | (78.0 | )% |
| SPG gross margin |       | 16.3                                       | %          | 28.5                         | %          | 9.0                          | %          |   |   |   |   |   |   |   |   |
|                  |            |                                            |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

SPG gross profit and grossmargin decreased from 2004 to 2005. Price erosion as a result of industryover-supply and heavy competition caused the downturn in this sector whichbegan in the fourth quarter of 2004. For 2004 compared to 2003, gross profitincreased $7.9 million due a 5.8% increase in units shipped and a 34.3%increase in average selling price.

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*SCC*

| ** **       | ** ** | **Year Ended December 31,** | ** ** | **Increase (Decrease)** | ** ** | **Increase (Decrease)** | ** ** |
|------------------|------------|--------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **       | ** ** | **2003**                                   | ** ** | **2004**                     | ** ** | **2005**                     | ** ** | **2003 vs. 2004** | ** ** | **2004 vs. 2005** | ** ** |
| SCC gross profit |       |                                       | —     |                         |       | $                            | (212       | ) | $ | (28 | ) | $ | (12 | ) | N/A |   | $ | 184 |   | (86.8 | )% |
| SCC gross margin |       |                                       | —     |                         |       | (35.8                        | )%         | (0.9 | )% |   |   |   |   |   |   |   |   |
|                  |            |                                            |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The SCC segment remained insignificant during 2005 and we do not expect itssignificance to change until late 2006. The SCC segment was created through theacquisition of G-Plus in November 2004, and, as a result, there was noprior year comparable activity. 

For other factors thatcould affect our gross profit, please also see Part I, Item IA. “RiskFactors—Business Risks—We incurred material inventory valuation adjustments in2003, 2004 and 2005, and we may incur additional significant inventory valuationadjustments in the future.”

**Operating Expenses**

| ** **                | ** ** | **Year Ended December 31,** | ** ** | **Increase (Decrease)** | ** ** | **Increase (Decrease)** | ** ** |
|---------------------------|------------|--------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                | ** ** | **2003**                                   | ** ** | **2004**                     | ** ** | **2005**                     | ** ** | **2003 vs. 2004** | ** ** | **2004 vs. 2005** | ** ** |
| Research and  development |       | $                                          | 43,144     |                         | $          | 46,904                       |       | $ | 49,030 |   | $ | 3,760 |   | 8.7 | % | $ | 2,126 |   | 4.5 | % |
| Percent of revenue        |       | 14.6                                       | %          | 10.4                         | %          | 11.4                         | %          |   |   |   |   |   |   |   |   |
|                           |            |                                            |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

*Research anddevelopment*

Research and developmentexpenses include costs associated with the development of new products,enhancements to existing products, quality assurance activities and occupancycosts. These costs consist primarily of employee salaries and benefits and thecost of materials such as wafers and masks. Research and development expensesincreased 4.5% from 2004 to 2005 mainly due to a $4.0 million increase insalaries and wages related to an increase in headcount from the acquisitions,partially offset by a $1.8 million decrease in profit sharing. Research anddevelopment expenses increased by 8.7% from 2003 to 2004 primarily due toincreases in wafer, mask and evaluation part expenses of $2.0 million due tothe completion of certain technology projects during 2004, and increasedheadcount related expenses of $2.2 million due to profit sharing payments andincreased headcount. We expect research and development expenses will continueto increase in absolute dollars.

*Sales and Marketing*

| ** **           | ** ** | **Year Ended December 31,** | ** ** | **Increase (Decrease)** | ** ** | **Increase (Decrease)** | ** ** |
|----------------------|------------|--------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **           | ** ** | **2003**                                   | ** ** | **2004**                     | ** ** | **2005**                     | ** ** | **2003 vs. 2004** | ** ** | **2004 vs. 2005** | ** ** |
| Sales and  marketing |       | $                                          | 22,272     |                         | $          | 28,295                       |       | $ | 28,620 |   | $ | 6,023 |   | 27.0 | % | $ | 325 |   | 1.1 | % |
| Percent of revenue   |       | 7.5                                        | %          | 6.3                          | %          | 6.6                          | %          |   |   |   |   |   |   |   |   |
|                      |            |                                            |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Sales and marketingexpenses consist of commissions, headcount and related costs, as well as traveland other related costs. Sales and marketing expenses were relatively flat for2005 compared to 2004. Salaries and wage increases of $1.8 million were mostlyoffset by decreases in commission expense of $1.7 million. The increase insales and marketing expenses from 2003 to 2004 by 27.0% was primarily due toincreased headcount related costs of $2.4 million from bonus and profit sharingpayments and increased headcount, increased commission expense of $1.6 milliondue to increased sales and increased logistic center fees and other marketingexpenses. We expect sales and marketing expenses will increase in absolutedollars as we continue to expand our sales and marketing efforts. In addition,fluctuations in revenues will cause fluctuations in sales and marketingexpenses as it impacts our commission expense.

34

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*General and Administrative*

| ** **                  | ** ** | **Year Ended December 31,** | ** ** | **Increase (Decrease)** | ** ** | **Increase (Decrease)** | ** ** |
|-----------------------------|------------|--------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                  | ** ** | **2003**                                   | ** ** | **2004**                     | ** ** | **2005**                     | ** ** | **2003 vs. 2004** | ** ** | **2004 vs. 2005** | ** ** |
| General and  administrative |       | $                                          | 14,398     |                         | $          | 18,292                       |       | $ | 23,926 |   | $ | 3,894 |   | 27.0 | % | $ | 5,634 |   | 30.8 | % |
| Percent of revenue          |       | 4.9                                        | %          | 4.1                          | %          | 5.6                          | %          |   |   |   |   |   |   |   |   |
|                             |            |                                            |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

General and administrativeexpenses consist of salaries and related costs for administrative, executiveand finance personnel, recruiting costs, professional services and legal feesand allowances for doubtful accounts. The increase from 2004 to 2005 waslargely due to increased accounting expenses and outside consulting fees of $3.2million associated with Sarbanes-Oxley compliance work and a one-time increasein contingent tax consulting fees from a tax refund project, increased salariesand benefits of $1.6 million related to increased headcount and increasedamortization of acquired intangible assets of $1.8 million and was partiallyoffset by decreased  bad debt expense of$1.2 million. We will continue to have costs associated with Sarbanes-Oxleycompliance although we anticipate these will stabilize in 2006. The increase ingeneral and administrative expenses from 2003 to 2004 by 27.0% was primarilydue to increases in accounting and outside consulting fees of $2.0 million dueto the increase costs of complying with Sarbanes-Oxley reporting, headcountrelated expenses of $1.3 million due to profit sharing payments and increasedheadcount, and bad debt expenses of $597 thousand. We anticipate that generaland administrative expenses will increase in absolute dollars as we scale ourfacilities, infrastructure, and headcount to support our overall expectedgrowth. 

*Other Operating Expenses*

| ** **                | ** ** | **Year Ended December 31,** | ** ** | **Increase (Decrease)** | ** ** | **Increase (Decrease)** | ** ** |
|---------------------------|------------|--------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                | ** ** | **2003**                                   | ** ** | **2004**                     | ** ** | **2005**                     | ** ** | **2003 vs. 2004** | ** ** | **2004 vs. 2005** | ** ** |
| Other operating  expenses |       | $                                          | 37,849     |                         | $          | 7,375                        |       | $ | 2,945 |   | $ | (30,474 | ) | (80.5 | )% | $ | (4,430 | ) | (60.1 | )% |
| Percent of revenue        |       | 12.8                                       | %          | 1.6                          | %          | 0.7                          | %          |   |   |   |   |   |   |   |   |
|                           |            |                                            |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

For 2005, other operatingexpenses of $2.9 million were related to expensed in-process research anddevelopment in conjunction with the acquisition of Actrans and the remainingminority interest in Emosyn and the settlement of our patent litigation casewith Atmel. In 2004, these expenses were comprised of $5.9 million related tothe write off of in-process research and development relating to theacquisition of Emosyn and G-Plus and a $1.5 million period charge related to anoperating lease for an abandoned building. In 2003, other operating expenseswere $37.8 million, which related entirely to the Atmel litigation settlement. 

*Interest and other income*

| ** **                   | ** ** | **Year Ended December 31,** | ** ** | **Increase (Decrease)** | ** ** | **Increase (Decrease)** | ** ** |
|------------------------------|------------|--------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                   | ** ** | **2003**                                   | ** ** | **2004**                     | ** ** | **2005**                     | ** ** | **2003 vs. 2004** | ** ** | **2004 vs. 2005** | ** ** |
| Other income  (expense), net |       | $                                          | 2,996      |                         | $          | 2,295                        |       | $ | 1,790 |   | $ | (701 | ) | (23.4 | )% | $ | (505 | ) | (22.0 | )% |
| Percent of revenue           |       | 1.0                                        | %          | 0.5                          | %          | 0.4                          | %          |   |   |   |   |   |   |   |   |
|                              |            |                                            |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Other income and expensefor 2003, 2004 and 2005 included mainly interest and dividend income on ourcash and investments. Interest and other income decreased from 2004 to 2005 andfrom 2003 to 2004 primarily due to decreased realized gains from the sale ofsome of our investments. 

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*Interest and other expense*

| ** **         | ** ** | **Year Ended December 31,** | ** ** | **Increase (Decrease)** | ** ** | **Increase (Decrease)** | ** ** |
|--------------------|------------|--------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **         | ** ** | **2003**                                   | ** ** | **2004**                     | ** ** | **2005**                     | ** ** | **2003 vs. 2004** | ** ** | **2004 vs. 2005** | ** ** |
| Interest expense   |       | $                                          | 350        |                         | $          | 281                          |       | $ | 266 |   | $ | (69 | ) | (19.7 | )% | $ | (15 | ) | (5.3 | )% |
| Percent of revenue |       | 0.1                                        | %          | 0.1                          | %          | 0.1                          | %          |   |   |   |   |   |   |   |   |
|                    |            |                                            |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Interest expense remainedrelatively low for 2003, 2004 and 2005 since we did not have significantoutstanding debt.

*Impairment ofequity investments*

During 2005 and 2004 werecorded impairment charges on our equity investments of $2.2 million and $509thousand, respectively. There were no impairments during 2003. During thefourth quarter of 2005, we wrote down one of our investments, Advanced ChipEngineering Technology, or ACET, since ACET issued a secondary round of equityfunding at a lower per share price than our carrying value. Consequently, werecorded an impairment charge of $2.2 million on our existing investment. As ofDecember 31, 2005, the recorded value of our investment in ACET was $1.8million. During 2003, one of our investments, Insyde, saw a significant declinein the market value of their stock. We recognized a $509 thousand loss from theimpairment of our investment in Insyde because its stock price had declinedbelow the acquisition cost for more than six months. The impairment wasconsidered to be “other-than-temporary” in nature, thus the investment valuewas permanently written down to reflect the fair value.

**Provisionfor (Benefit from) Income Taxes**

We maintained a full valuation allowance on our netdeferred tax assets as of December 31, 2005. The valuation allowance wasdetermined in accordance with the provisions of Statement of FinancialAccounting Standards No. 109, or SFAS No. 109, “Accounting for IncomeTaxes,” which requires an assessment of both positive and negative evidencewhen determining whether it is more likely than not that deferred tax assetsare recoverable; such assessment is required on a jurisdiction by jurisdictionbasis. Cumulative losses incurred by us in the U.S. in recent years representedsufficient negative evidence under SFAS No. 109 and accordingly, a fullvaluation allowance was recorded against U.S. deferred tax assets. We intend tomaintain a full valuation allowance on the U.S. deferred tax assets untilsufficient positive evidence exists to support reversal of the valuationallowance.

Our tax provision for 2005 was $2.4 million on apre-tax loss of $27.5 million consisting primarily of foreign withholding taxesand foreign income taxes.

In 2004, our income taxexpense was $3.9 million on net income before tax of $27.7 million. During2004, we maintained a full valuation allowance on our net deferred tax assets.In 2003, we implemented an international tax structure, which in conjunctionwith the full valuation allowance, will mean that going forward we will recorda tax expense as a result of foreign tax withholding and alternative minimumtax until such time that the valuation allowance against the deferred tax assetis no longer required.

**Segment Reporting**

Our operations involve the design, development,manufacturing, marketing and technical support of our nonvolatile memorytechnology and products. We offer low to medium density devices that target abroad range of existing and emerging applications in the digital consumer,networking, wireless communications and Internet computing markets. Ourproducts are differentiated based upon attributes such as density, voltage,access speed, package and predicted endurance. We also license our technologyfor use in non-competing applications.

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We manage our business in five reportable segments:the Standard Memory Product Group, or SMPG, the Application Specific ProductGroup, or ASPG, the Special Product Group, or SPG, the SST CommunicationsCorporation Products, or SCC, and Technology Licensing. We do not allocateamortization expense, operating expenses, interest and other income, interestexpense, impairment of equity investments and provision for or benefit fromincome taxes to any of these segments for internal reporting purposes, as we donot believe that allocating these expenses are material in evaluating abusiness unit’s performance.

SMPG includes our standard flash memory productfamilies: the Multi-Purpose Flash, or MPF, family and the Multi-Purpose FlashPlus, or MPF+, family. These product families allow us to produce productsoptimized for cost and functionality to support a broad range of mainstream applicationsthat use nonvolatile memory products. Effective July 1, 2003, wetransferred the Small Sector Flash, or SSF, family from SMPG to SPG. EffectiveJanuary 1, 2004, we transferred the last MTP series of products from SMPGto SPG. Accordingly, our segment revenues.

ASPG includes Concurrent SuperFlash, Serial Flash,Firmware Hub, or FWH, and Low Pin Count, or LPC, flash products. These productsare designed to address specific applications such as cellular phones, harddisk drives and PCs. ASPG also includes flash embedded controllers such the ATAflash disk controller to consumer, industrial and mass data storageapplications. We acquired a majority ownership of Emosyn on September 10,2004. On April 15, 2005, we acquired the remaining minority interest ofEmosyn. As a result of the acquisition of the remaining minority interest, themanagement of Emosyn’s products was integrated into ASPG. Effective for thesecond quarter of 2005, Emosyn is no longer considered its own reportablesegment by us and Emosyn’s flash memory based smart-card IC’s are now includedin ASPG. These products are used primarily in cell phone applications andinclude such benefits of use as lower power consumption, long term dataretention and high endurance of data access. Our segment revenues and grossmargin information have been reclassified for presentation purposes as if thetransfer occurred as of September 10, 2004.

SPG includes ComboMemory, ROM/RAM Combos, the SmallSector Flash, or SSF, family, Multi-Time Programmable, or MTP, family,FlashFlex51 microcontrollers and other special flash products. These productsare used in applications requiring low power and a small form factor such ascellular phones, wireless modems, MP3 players, pagers and personal digitalorganizers. Effective July 1, 2003, we transferred the SSF family fromSMPG to SPG. Effective January 1, 2004, we transferred the last MTP seriesof products from SMPG to SPG. Accordingly, our segment revenues and grossprofit information have been reclassified for presentation purposes as if thetransfer occurred as of January 1, 2003.

SCC includes RF transmitter, receiver, synthesizer,power amplifier and switch products. These products provide end-to-end RFsolutions to enable wireless multimedia and broadband networking applications. Weformed SST Communications Corporation and acquired the operations of G-Plus on November 5,2004. The segment data is reflected from this date forward.

Technology Licensing includes both license fees androyalties.

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**Related Party Transactions**

Thefollowing table is a summary of our related party revenues and purchases (inthousands): 

| ** **                                                | ** ** | **Year Ended**             | ** ** |
|-----------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                | ** ** | **December 31, 2005** | ** ** |
| ** **                                                | ** ** | **Revenues**                    | ** ** | **Purchases** | ** ** |
| Silicon  Technology Co., Ltd                              |       | $                               | 3,711      |   |   | $ | — |   |   |
| Apacer  Technology, Inc. & related entities |       | 2,180                           |       |   | — |   |   |
| Professional  Computer Technology Limited                 |       | —                          |       |   |   |   |   |
| Silicon  Professional Technology Ltd                      |       | 230,706                         |       |   |   |   |   |
| Grace  Semiconductor Manufacturing Corp                   |       | 1,577                           |       |   | 45,373 |   |   |
| King Yuan  Electronics Company, Limited                   |       | —                          |       |   | 34,882 |   |   |
| Powertech  Technology, Incorporated                       |       | —                          |       |   | 15,111 |   |   |
|                                                      |       | $                               | 238,174    |   |   | $ | 95,366 |   |   |

 

| ** **                                                | ** ** | **Year Ended**             | ** ** |
|-----------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                | ** ** | **December 31, 2004** | ** ** |
| ** **                                                | ** ** | **Revenues**                    | ** ** | **Purchases** | ** ** |
| Silicon  Technology Co., Ltd                              |       | $                               | 7,943      |   | $ | — |   |
| Apacer  Technology, Inc. & related entities |       | 2,359                           |       | 707 |   |
| Silicon Professional  Technology Ltd                      |       | 214,195                         |       | — |   |
| Grace  Semiconductor Manufacturing Corp                   |       | 156                             |       | 59,278 |   |
| King Yuan  Electronics Company, Limited                   |       | —                          |       | 38,248 |   |
| Powertech  Technology, Incorporated                       |       | —                          |       | 14,718 |   |
|                                                      |       | $                               | 224,653    |   | $ | 112,951 |   |

 

| ** **                                                | ** ** | **Year Ended**             | ** ** |
|-----------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                | ** ** | **December 31, 2003** | ** ** |
| ** **                                                | ** ** | **Revenues**                    | ** ** | **Purchases** | ** ** |
| Silicon  Technology Co., Ltd                              |       | $                               | 3,615      |   |   | $ | — |   |   |
| Apacer  Technology, Inc. & related entities |       | 1,555                           |       |   | 2,361 |   |   |
| Silicon  Professional Technology Ltd                      |       | 164,810                         |       |   | — |   |   |
| Grace  Semiconductor Manufacturing Corp                   |       | —                          |       |   | 12 |   |   |
| King Yuan  Electronics Company, Limited                   |       | —                          |       |   | 19,659 |   |   |
| Powertech  Technology, Incorporated                       |       | —                          |       |   | 9,280 |   |   |
|                                                      |       | $                               | 169,980    |   |   | $ | 31,312 |   |   |

 

The following table is a summary of our related partyaccounts receivable and accounts payable and accruals (in thousands): 

| ** **                                         | ** ** | **December 31, 2004** | ** ** | **December 31, 2005**          | ** ** |
|----------------------------------------------------|------------|---------------------------------|------------|------------------------------------------|------------|
| ** **                                         | ** ** | **Trade  Accounts  Receivable** | ** ** | **Accounts  Payable and  Accruals** | ** ** | **Trade  Accounts  Receivable** | ** ** | **Accounts  Payable and  Accruals** | ** ** |
| Silicon  Technology Co., Ltd.                      |       |                            | $          | 322                                      |       |   |   | $ | — |   |   |   | $ | 370 |   |   |   | $ | — |   |   |
| Apacer  Technology, Inc. and related entities |       |                            | 458        |                                     |       |   | 3230 |   |   |   | 237 |   |   |   | — |   |   |
| Professional  Computer Technology Limited          |       |                            | —     |                                     |       |   | 72 |   |   |   | — |   |   |   | 123 |   |   |
| Silicon  Professional Technology Ltd.              |       |                            | 32,037     |                                     |       |   | 694 |   |   |   | 53,785 |   |   |   | 846 |   |   |
| Grace  Semiconductor Mfg. Corp                     |       |                            | 156        |                                     |       |   | 17,227 |   |   |   | 1,466 |   |   |   | 4,949 |   |   |
| King Yuan  Electronics Company, Limited            |       |                            | —     |                                     |       |   | 13,702 |   |   |   | — |   |   |   | 10,004 |   |   |
| Powertech  Technology, incorporated                |       |                            | —     |                                     |       |   | 3,867 |   |   |   | — |   |   |   | 5,945 |   |   |
|                                               |       |                            | $          | 32,973                                   |       |   |   | $ | 35,882 |   |   |   | $ | 55,858 |   |   |   | $ | 21,867 |   |   |

 

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In 1996, we acquired a 14% interest in SiliconTechnology Co., Ltd., or Silicon Technology, a privately held Japanese company,for $939 thousand in cash. Bing Yeh, our President, CEO and Chairman of ourBoard of Directors, is also a member of Silicon Technology’s board of directors.We acquired the interest in Silicon Technology in order to provide a presencefor our products in Japan. We now have our own office in Japan, althoughSilicon Technology continues to sell our products. At December 31, 2005,our investment, which is carried at cost, represented 8.7% of the outstanding equityof Silicon Technology. Our sales to Silicon Technology were made at prevailingmarket prices and the payment terms are consistent with the payment termsextended to our other customers. We are not obligated to provide SiliconTechnology with any additional financing.

In 2000, we acquired a 10% interest in ApacerTechnology Inc, or Apacer, for $9.9 million in cash. Apacer, a privately heldTaiwanese company and a related entity of Acer, is a memory module manufacturer.Bing Yeh, our President, CEO and Chairman of our Board of Directors, is also amember of Apacer’s board of directors. In 2001, we invested an additional $2.1million in Apacer. In August 2002, wemade an additional investment of $181 thousand. The investment waswritten down to $4.4 million during 2002. At December 31, 2005, ourinvestment represented 9.5% of the outstanding equity of Apacer. Our sales tothe related Acer entities were made at prevailing market prices and the paymentterms are consistent with the payment terms extended to our other customers. Ourpurchases from Apacer are made pursuant to purchase orders at prevailing marketprices. We do not have a long-term contract with Apacer to supply us withproducts. If Apacer were to terminate its relationship with us, we believe thatwe would be able to procure the necessary products from other productionsubcontractors. We are not obligated to provide Apacer with any additionalfinancing.

In 2000, we acquired a 15% interest in ProfessionalComputer Technology Limited, or PCT, a Taiwanese company, for $1.5 million incash. Bing Yeh, our President, CEO and Chairman of our Board of Directors, isalso a member of PCT’s board of directors. PCT is one of our stockingrepresentatives. In May 2002, we made an additional investment of $179 thousandin PCT. During 2003, PCT completed an initial public offering on the TaiwanStock Exchange and we sold a portion of our holdings. Under Taiwan securityregulations, a certain number of shares must be held in a central custody andare restricted from sale for a period of time. The shares available for salewithin one year are carried at the quoted market price and included inlong-term available-for-sale investments in the balance sheet as of December 31,2005. Shares required to be held in custody for greater than a one year periodare carried at cost and included in equity investments. In February 2004,we purchased $1.7 million of PCT’s European convertible bonds. As of December 31,2005, the value of the stock and convertible bond investment recorded aslong-term available-for-sale is valued at $7.7 million and the restrictedportion of the investment carried at cost is recorded at $807 thousand. At December 31,2005 our investment represented 11.5% of the outstanding equity and 13.2% ofthe European convertible bonds of PCT.

PCT and its subsidiary, Silicon Professional AllianceCorporation, or SPAC, earn commissions for point-of-sales transactions to itscustomers. Commissions to PCT and SPAC are paid at the same rate as all of ourother stocking representatives in Asia. In 2003, 2004 and 2005 we paid salescommissions of $1.2 million, $579 thousand and $315 thousand,respectively, to PCT and SPAC. Shipments, by us or our logistics center, to PCTand SPAC for reshipment accounted for 27.3%, 31.3% and 38.9% of our productshipments in 2003, 2004 and 2005. In addition, PCT and SPAC solicited sales,for which they earned a commission, for 12.0%, 3.3% and 2.0% of our shipmentsto end users in 2003, 2004 and 2005, respectively.

PCT has established a separate company andwholly-owned subsidiary, Silicon Professional Technology, Ltd., or SPT, toprovide forecasting, planning, warehousing, delivery, billing, collection andother logistic functions for us in Taiwan. SPT now services substantially allof our end customers based in Taiwan, China and other Southeast Asia countries.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. We pay SPTa fee based on a percentage of 

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revenue for each productsold through SPT to our end customers. The fee paid to SPT covers the cost ofwarehousing and insuring inventory and accounts receivable, personnel costsrequired to maintain logistics and information technology functions and thecosts to perform billing and collection of accounts receivable. SPT receivesextended payment terms and is obligated to pay us whether or not they havecollected the accounts receivable.

We do not have any long-term contracts with SPT, PCTor SPAC, and SPT, PCT or SPAC may cease providing services to us at any time. IfSPT, PCT or SPAC were to terminate their relationship with us we wouldexperience a delay in reestablishing warehousing, logistics and distributionfunctions which would harm our business. We are not obligated to provide SPT,PCT or SPAC with any additional financing.

In 2000, we acquired a 1% interest in King YuanElectronics Company, Limited, or KYE, a Taiwanese company, which is aproduction subcontractor, for $4.6 million in cash. A member of our managementteam holds a supervisor position at KYE. The role and responsibilities of asupervisor are defined and governed by Corporate Law in Taiwan. The investmentwas made in KYE in order to strengthen our relationship with KYE. During 2001,KYE completed an initial public offering on the Taiwan Stock Exchange. Accordingly,the investment has been included in long-term available-for-sale investments inthe balance sheet as of December 31, 2004 and 2005. The investment waswritten down to $1.3 million during 2001 and is valued at $4.3 million as of December 31,2005 based on the quoted market price.  At December 31, 2005, our investmentrepresented 0.4% of the outstanding equity of KYE. Our purchases from KYE aremade pursuant to purchase orders at prevailing market prices. We do not have along-term contract with KYE to supply us with services. If KYE were toterminate its relationship with us, we believe that we would be able to procurethe necessary services from other production subcontractors. We are notobligated to provide KYE with any additional financing.

In 2000, we acquired a 3% interest in PowertechTechnology, Incorporated, or PTI, a Taiwanese company, which is a productionsubcontractor, for $2.5 million in cash. Bing Yeh, our President, CEO andChairman of our Board of Directors, is also a member of PTI’s board ofdirectors. The investment was made in PTI in order to strengthen ourrelationship with PTI. During 2003, PTI completed an initial public offering onthe Taiwan Stock Exchange and we sold a portion of our holdings. Under Taiwansecurity regulations, a certain number of shares must be held in a centralcustody and are restricted from sale for a period of time. The shares availablefor sale within one year are carried at the quoted market price and included inlong-term available-for-sale investments in the balance sheet as of December 31,2004 and 2005. Shares required to be held in custody for greater than a oneyear period are carried at cost and included in equity investments. In August 2004,we invested $723 thousand cash in PTI shares available for sale. As of December 31,2005, the value of the investment recorded as long-term available-for-sale isvalued at $26.5 million and the restricted portion of the investment carried atcost is recorded at $445 thousand. At December 31, 2005, our investmentrepresented 2.4% of the outstanding equity of PTI. During the first quarterof  2006, we sold four million common sharesof PTI for a net gain of $12.2 million. We hold 5.5 million shares of PTI as ofMarch 3, 2006. Refer to Note 19 of the Consolidated FinancialStatements. Our purchases from and sales to PTI are made at prevailing marketprices. We do not have a long-term contract with PTI to supply us with services.If PTI were to terminate its relationship with us, we believe that we would beable to procure the necessary services from other production subcontractors. Weare not obligated to provide PTI with any additional financing.

We have invested $83.2 million in GSMC, a CaymanIslands company, which owns a wafer foundry subsidiary, Grace, in Shanghai,China.  Bing Yeh, our President, CEO andChairman of our Board of Directors, is also a member of GSMC’s board ofdirectors. In addition, a member of our management team holds one supervisorposition at GSMC. The role and responsibilities of a supervisor are defined andgoverned by Corporate Law in the Cayman Islands. This investment is carried atcost. GSMC has a wholly owned subsidiary, Shanghai Grace SemiconductorManufacturing Corporation, or Grace, which is a wafer foundry company withoperations in China. Grace began to manufacture our products in late 2003. Wedo 

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not have a long-termcontract with Grace to supply us with products. At December 31, 2005, ourinvestment represented 9.8% of the outstanding equity of GSMC.

In 2002, we acquired a 6% interest in Insyde SoftwareCorporation, or Insyde, a Taiwanese company, for $964 thousand in cash. BingYeh, our President, CEO and Chairman of our Board of Directors, is also amember of Insyde’s board of directors. During 2003, Insyde completed an initialpublic offering on the Taiwan Stock Exchange. Under Taiwan securityregulations, a certain number of shares must be held in a central custody andare restricted from sale for a period of time. The shares available for salewithin one year are carried at the quoted market price and included in long-termavailable-for-sale investments in the balance sheet as of December 31,2004 and 2005. Shares required to be held in custody for greater than a oneyear period are carried at cost and included in equity investments. In January 2004,we invested an additional $133 thousand cash in Insyde’s convertible bonds. Thestock investment was written down $509 thousand during 2004. Refer to Note 13of these Notes to the Consolidated Financial Statements. At December 31,2005, our investment represented 6.2% of the outstanding equity and 6.3% of theconvertible bonds of Insyde.

In June 2004, we acquired a 9% interest inAdvanced Chip Engineering Technology, or ACET, a privately held Taiwanesecompany for $4.0 million cash. ACET, a related entity of KYE, is a productionsubcontractor. Chen Tsai, our Senior Vice President of Worldwide BackendOperations, is also a member of ACET’s board of directors. During 2005, werecorded a $2.2 million impairment charge related to our investment in ACET.ACET is in the process of raising an additional round of equity financing at alower per share cost than our current basis. Consequently, our investment wasovervalued. Refer to Note 13 of the Consolidated Financial Statements. At December 31,2005 our investment, which is carried at cost, represented 9.4% of theoutstanding equity of ACET.

In November 2004, weacquired a 30% interest in Nanotech Corporation, or Nanotech, a privately heldCayman Island company, for $3.8 million cash. Nanotech, a development stagecompany, has a wholly owned subsidiary which is in the process of establishingfoundry operations in China. Bing Yeh, our President, CEO and Chairman of ourBoard of Directors, is also a member of Nanotech’s board of directors. TsuyoshiTaira, a member of our Board of Directors, also invested in this round offinancing. We are not obligated to provide Nanotech with any additionalfinancing. During 2005, we loaned Nanotech $225,000. At December 31, 2005our investment, which is accounted for under the equity method, represented 29%of the outstanding equity of Nanotech.

**Critical Accounting Estimates**

Our criticalaccounting estimates are as follows:

·       Revenuerecognition;

·       Allowancefor sales returns;

·       Allowancefor doubtful accounts;

·       Allowancefor excess and obsolete inventory and lower of cost or market;

·       Warrantyaccrual;

·       Litigationcosts;

·       Valuationof equity investments;

·       Provisionfor adverse purchase commitments; and

·       Accountingfor income taxes.

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*Revenuerecognition.*   Sales to direct customers andforeign stocking representatives are recognized net of an allowance forestimated returns. When product is shipped to direct customers or stockingrepresentatives, or by our distributors or SPT to end users, prior torecognizing revenue, we also require that evidence of the arrangement exists,the price is fixed or determinable and collection is reasonably assured. Legaltitle generally passes to our customers at the time our products are shipped. Paymentterms typically range from 30 to 65 days. Sales to distributors are madeprimarily under arrangements allowing price protection and the right of stockrotation on merchandise unsold. Because of the uncertainty associated withpricing concessions and future returns, we defer recognition of such revenues,related costs of revenues and related gross profit until the merchandise issold by the distributor. Products shipped to SPT are accounted for as ourinventory held at our logistics center, and revenue is recognized when theproducts have been delivered and are considered as a sale to our end customersby SPT.

Most of our technology licenses provide for thepayment of up-front license fees and continuing royalties based on productsales. For license and other arrangements for technology that we are continuingto enhance and refine, and under which we are obligated to provide unspecifiedenhancements, revenue is recognized over the lesser of the estimated periodthat we have historically enhanced and developed refinements to the technology,approximately two to three years (the upgrade period), or the remaining portionof the upgrade period from the date of delivery, provided all specifiedtechnology and documentation has been delivered, the fee is fixed ordeterminable and collection of the fee is reasonably assured. From time totime, we reexamine the estimated upgrade period relating to licensed technologyto determine if a change in the estimated upgrade period is needed. Revenuefrom license or other technology arrangements where we are not continuing toenhance and refine technology or are not obligated to provide unspecifiedenhancements is recognized upon delivery, if the fee is fixed or determinableand collection of the fee is reasonably assured.

Royalties received under these arrangements during theupgrade period are recognized as revenue based on the ratio of the elapsedportion of the upgrade period to the estimated upgrade period. The remainingportions of the royalties are recognized ratably over the remaining portion ofthe upgrade period. Royalties received after the upgrade period has elapsed arerecognized when reported to us.

If we make different judgments or utilize differentestimates in relation to the estimated period of technology enhancement anddevelopment, the amount and timing of our license and royalty revenues could bematerially different.

*Allowancefor sales returns.*   We maintain allowances forsales returns for estimated product returns by our customers. We estimate ourallowance for sales returns based on our historical return experience, currenteconomic trends, changes in customer demand, known returns we have not receivedand other estimates. The allowance for sales returns was $1.3 million,$2.0 million and $1.6 million as of December 31, 2003, 2004 and2005, respectively. If we make different judgments or utilize differentestimates, the amount and timing of our revenue could be materially different.

*Allowancefor doubtful accounts.*   We maintain allowance fordoubtful accounts for estimated losses from the inability of our customers tomake required payments. We evaluate our allowance for doubtful accounts basedon the aging of our accounts receivable, the financial condition of our customersand their payment history, our historical write-off experience and otherestimates. If we were to make different judgments of the financial condition ofour customers or the financial condition of our customers were to deteriorate,resulting in an impairment of their ability to make payments, additionalallowances may be required. The allowance for doubtful accounts was $1.1 million,$1.2 million and $758 thousand as of December 31, 2003, 2004 and2005, respectively.

*Allowancefor excess and obsolete inventory and lower of cost or market.*   Ourinventories are stated at the lower of cost (determined on a first-in,first-out basis) or market value. We typically plan our production andinventory levels based on internal forecasts of customer demand, which arehighly 

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unpredictable andfluctuate substantially. The value of our inventory is dependent on ourestimate of future average selling prices, and, if our projected averageselling prices are over estimated, we may be required to reduce our inventory valueto reflect the lower of cost or market. Our inventories include high technologyparts and components that are specialized in nature or subject to rapidtechnological obsolescence. We maintain allowance for inventory for potentiallyexcess and obsolete inventories and those inventories carried at costs that arehigher than their market values. We review on-hand inventory includinginventory held at the logistic center for potential excess, obsolete and lowerof cost or market exposure and adjust the level of inventory reserveaccordingly. Some of our customers have requested that we ship them productthat has a finished goods date of manufacture that is less than one year old.In the event that this becomes a common requirement, it may be necessary for usto provide for an additional allowance for our on-hand finished goods inventorywith a date of manufacture of greater than one year old, which could result inadditional inventory write-downs. Our allowance for excess and obsoleteinventories includes an allowance for our on-hand finished goods inventory witha date of manufacture of greater than two years old and for certain productswith a date of manufacture of greater than one year old. For the obsoleteinventory analysis, we review inventory items in detail and consider date code,customer base requirements, known product defects, planned or recent productrevisions, end of life plans and diminished market demand. If we determine thatmarket conditions are less favorable than those currently projected bymanagement, such as an unanticipated decline in average selling prices ordemand not meeting our expectations, additional inventory write-downs may berequired. The allowance for excess and obsolete inventories and lower of costor market was $11.2 million, $32.2 million and $50.0 million asof December 31, 2003, 2004 and 2005, respectively.

*Warrantyaccrual.**  *Ourproducts are generally subject to warranty and we provide for the estimatedfuture costs of repair, replacement or customer accommodation upon shipment ofthe product in the accompanying statements of operations. Our warranty accrualis estimated based on historical claims compared to historical revenues andassumes that we will replace products subject to a claim. For new products, weuse our historical percentage for the appropriate class of product. Shouldactual product failure rates differ from our estimates, revisions to theestimated warranty liability would be required. The recorded value of ourwarranty accrual was $187 thousand, $3.8 million and $803 thousandas of December 31, 2003, 2004 and 2005, respectively.

*Litigationcosts.*   From time to time, we are also involvedin legal actions arising in the ordinary course of business. We have incurredcertain costs associated with defending these matters. There can be noassurance that shareholder class action complaints, shareholder derivativecomplaints or other third party assertions will be resolved without costlylitigation, in a manner that is not adverse to our financial position, resultsof operations or cash flows or without requiring royalty payments in the futurewhich may adversely impact gross margins. As of December 31, 2005, noestimate can be made of the possible loss or possible range of loss associatedwith the resolution of these contingencies. If additional information becomesavailable such that we estimate that there is a possible loss or possible rangeof loss associated with these contingencies, then we would record the minimumestimated liability, which could materially impact our results of operationsand financial position.

*Valuationof equity investments.**  *Wehold minority interests in companies having operations in the semiconductorindustry. We record an investment impairment charge when we believe aninvestment has experienced a decline in value that is other than temporary. Futureadverse changes in market conditions or poor operating results of underlyinginvestments could result in losses or an inability to recover the carryingvalue of the investments, thereby possibly requiring an impairment charge inthe future. The recorded value of our equity investments was $70.1 million,$121.7 million and $135.2 million as of December 31, 2003, 2004and 2005, respectively.

*Provisionfor adverse purchase commitments.*   We maintain aprovision for adverse purchase commitments for in process orders at our vendorswhen there is a lower of cost or market valuation against 

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our on-hand inventory. Onceproduction has begun against our purchase orders, we are committed to purchasingthe inventory or, if we cancel the order, we are liable for all costs incurredup to the time of cancellation. If we have written down our on-hand inventoryof the ordered product for lower of cost or market valuations, we must considerthe impact to in process inventory at our vendor. We evaluate our in processorders to determine the impact of canceling the order and the impact ofpurchasing the inventory at a cost higher than the estimated current marketvalue. If we determine that market conditions become less favorable than thosecurrently projected by management, such as an unanticipated decline in averageselling prices or demand not meeting our expectations, additional inventorywrite-downs may be required when the inventory is purchased. The recordedprovision for adverse purchase commitments was $538 thousand, $8.3 millionand $1.8 million as of December 31, 2003, 2004 and 2005,respectively.

*Accounting for incometaxes.*   During the third quarter of 2003 werecorded a charge to establish a full valuation allowance against our deferredtax assets offset by a reduction in income tax payable as a result of areassessment of expected liabilities for 2003 and certain exposures. Accordingly,for 2003 we recorded an income tax expense of $26.4 million. During thefourth quarter of 2003, we maintained a full valuation allowance on our netdeferred tax assets. The valuation allowance was determined in accordance withthe provisions of Statement of Financial Accounting Standards No. 109, or SFAS No. 109,“Accounting for Income Taxes,” which requires an assessment of both positiveand negative 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. 109and accordingly, a full valuation allowance was recorded against U.S. deferredtax assets. We intend to maintain a full valuation allowance on the U.S.deferred tax assets until sufficient positive evidence exists to supportreversal of the valuation allowance. During 2004 and 2005, we maintained a fullvaluation allowance on our deferred tax assets. At December 31, 2004 and2005 the valuation allowance against our deferred tax assets was $27.2 millionand $39.5 million, respectively.

**Liquidityand Capital Resources**

| ** **                   | ** ** | **Year Ended** | ** ** |
|------------------------------|------------|---------------------|------------|
| ** **                   | ** ** | **Dec 31,**    | ** ** | **Dec 31,** | ** ** | **Dec 31,** | ** ** |
| ** **                   | ** ** | **2003**            | ** ** | **2004** | ** ** | **2005** | ** ** |
| Cash provided by  (used in): | ** ** | ** **          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Operating  activities        |       | $                   | 7,554      |   | $ | (13,992 | ) | $ | (16,495 | ) |
| Investing  activities        |       | $                   | 10,180     |   | $ | (26,012 | ) | $ | 52,799 |   |
| Financing Activities         |       | $                   | 4,285      |   | $ | (8,881 | ) | $ | 5,713 |   |

* *

*Operatingactivities.*   The major contributing factors toour use of operating cash over the past twelve months are the reduction oftrade payables and accruals of $30.6 million, as a result of paymentsmainly for prior inventory related purchases, increased trade receivables of$20.4 million due to increased shipment volumes in the second half of theyear offset by reductions in inventories and other assets of $4.9 millionand $4.0 million, respectively. Although we had a net loss of $29.8 millionfor the year ended December 31, 2005, the net loss was offset by non-cashcharges, primarily related to a provision for inventory of $37.3 millionand depreciation and amortization expense of $10.0 million.

For 2004, our primary use of cash was for inventorypurchases. Cash used in operating activities included an increase in inventoryof $133.6 million to support increased sales activities and forecastcustomer demands, a $7.1 million increase in trade receivables fromunrelated parties due to increased revenues and increases in other assets anddeferred revenues of $4.3 million. Cash generated from operatingactivities included a net income of $23.9 million, a decrease in tradereceivables from related parties of $8.1 million due mainly to decreasedpayment terms with our logistic center, SPT, an increase in related andunrelated trade accounts payable of $37.8 million due to increasedpurchases of inventories, 

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and an increase in accruedexpenses and other liabilities of $7.5 million. Non-cash adjustmentsrelated to a provision for excess and obsolete inventories, write down ofinventory to market and adverse purchase commitments of $35.9 million,depreciation and amortization expense of $7.4 million, in-process researchand development of $5.9 million, a provision for sales returns anddoubtful accounts of $2.2 million and a $1.5 million operating leaseimpairment charge.

For 2003, our primary source of operating cash flowwas the timing of inventory purchases and payments to our vendors and serviceproviders, offset by the payment of $37.8 million to Atmel. Cash generatedfrom operating activities included decreases in inventories of $29.5 milliondue to increased sales, which reduced the amount of inventory held, and othercurrent and non-current assets of $18.3 million, increases in tradeaccounts payable from related and unrelated parties of $12.4 million dueto increased strategic purchasing of certain products, increases in deferredrevenue of $1.0 million and non-cash related adjustments of $37.9 million.Non-cash adjustments related to $7.7 million of depreciation andamortization, $6.7 million of inventory valuation adjustments, $22.3 milliondecrease in net deferred tax assets and $1.3 million of tax benefit fromemployee stock plans, offset by a $228 thousand charge to expense forprovision for doubtful accounts. Working capital uses of cash included a netloss of $65.2 million, increases in trade accounts receivable from relatedand non-related parties of $19.9 million due to increased revenue at theend of 2003.

*Investingactivities.*   The primary source of cash frominvesting activities came from the net sales, maturities and purchases ofavailable-for-sale investments which provided cash of $67.0 million,offset by the use of cash for other investing activities, mainly theacquisition of Actrans and the remaining minority interest in Emosyn as well aspurchases of fixed assets to support our operations. During 2004, our investingactivities used cash of $26.0 million primarily due to investments inequity securities of GSMC, ACET, Nanotech, PCT, PTI and Insyde of $33.2 million,$4.0 million, $3.8 million, $1.7 million, $723 thousand and$133 thousand, respectively, and the acquisitions of Emosyn and G-Pluswhich used cash of $16.0 million and $4.6 million, respectively. Investingactivities also used cash for purchases of available for sale investments andrestricted cash of $47.6 million and purchases of property and equipmentof $8.0 million. Sales and maturities of available for sale investmentsprovided cash from investing activities of $91.9 million. Our investingactivities provided cash of $10.2 million during 2003, primarily due to atotal of $12.0 million cash from the excess sales and maturities ofavailable-for-sale investments and restricted cash over the purchases of suchinvestments, offset by $1.8 million invested in capital expenditures.

*Financingactivities.*   Cash generated from financingactivities for the year ended December 31, 2005 primarily related to theborrowing against the line of credit of $3.0 million and the issuance ofcommon stock under the employee stock purchase plan and the exercise ofemployee stock options.. During 2004, the repurchase of our common stock usedcash of $14.9 million and the issuance of shares of common stock issuedunder our employee stock purchase plan and the exercise of employee stockoptions provided cash of $5.5 million. Repayment of loans used cash of$393 thousand and minority interest capital contributions provided cash of$820 thousand. During 2003, the cash provided was primarily from $4.5 millionof common stock issued under our employee stock purchase plan and the exerciseof employee stock options, offset by $250 thousand in loan repayments.

Principal sources ofliquidity at December 31, 2005 consisted of $78.4 million of cash, cashequivalents, and short-term and long-term available-for-sale investments.

*ContractualObligations and Commitments*

*PurchaseCommitments.*   As of December 31, 2005, wehad outstanding purchase commitments with our foundry vendors of $51.7 millionfor delivery in 2006. We have recorded a liability of $1.8 million foradverse purchase commitments.

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*LeaseCommitments.*   We have long-term, non-cancelablebuilding lease commitments. In 2004, we recorded charges to other operatingexpense of $1.5 million relating to operating leases for an unoccupiedbuilding. These charges represent the estimated difference between the totaldiscounted future sublease income and our discounted lease commitments relatingto these buildings.

Future payments due under building lease, purchasecommitments and other contractual obligations as of December 31, 2005 (in thousands):

| ** **            | ** ** | ** ** | ** ** | **Less than** | ** ** | ** **                     | ** ** | ** **                     | ** ** | **More than** | ** ** |
|-----------------------|------------|------------|------------|--------------------|------------|--------------------------------|------------|--------------------------------|------------|--------------------|------------|
| ** **            | ** ** | **Total**  | ** ** | **1 year**    | ** ** | **1 - 3 years** | ** ** | **3 - 5 years** | ** ** | **5 years**   | ** ** |
| Notes payable         |       | $          | 39         |               |       | $                              | 39         |                           |       |               | $          | — |   |   |   | $ | — |   |   |   | $ | — |   |   |
| Capital leases        |       | 3,910      |       |               | 2,200      |                           |       |                           | 1,710      |               |       |   | — |   |   |   | — |   |   |
| Operating leases      |       | 14,657     |       |               | 3,626      |                           |       |                           | 6,722      |               |       |   | 4,246 |   |   |   | 63 |   |   |
| Purchase  commitments |       | 51,696     |       |               | 51,696     |                           |       |                           | —     |               |       |   | — |   |   |   | — |   |   |
| Total                 |       | $          | 70,302     |               |       | $                              | 57,561     |                           |       |               | $          | 8,432 |   |   |   | $ | 4,246 |   |   |   | $ | 63 |   |   |

 

*Credit Facilities*

On August 11, 2005, we entered into a 1-yearloan and security agreement with Cathay Bank, a U.S. bank, for a $35.0 millionrevolving line of credit, all of which was available to us as of December 31,2005. 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 interestrate for the line of credit is 1% below the prime rate reported from time totime by the Wall Street Journal, Western Edition (7.25% at December 31,2005). The line of credit is collateralized by substantially all of the assetsof SST other than intellectual property. The agreement contains certainfinancial covenants, including the levels of qualifying accounts receivable andinventories, which could limit the availability of funds under the agreement. There were no borrowings under this line as of December 31,2005.

On July 16, 2004, weentered into a 2-year loan agreement with Cathay Bank, a U.S. bank, for a$3.0 million revolving line of credit. The interest rate for the line ofcredit is 3.475% per annum. The line of credit is collateralized by a $3.0 millioncertificate of deposit which is included in non-current other assets. Thecertificate of deposit matures in July 2006 and carries an interest rateof 2.6% per annum. As of December 31, 2004, there were no borrowings underthis line of credit. As of December 31, 2005, we had borrowed $3.0 millionunder our line of credit.

*Off Balance SheetArrangements.*

At December 31, 2004and 2005, we did not have any off-balance sheet arrangements or relationshipswith unconsolidated entities or financial partnerships, such as entities oftenreferred to as structured finance or special purposes entities, which aretypically established for the purpose of facilitating off-balance sheetarrangements or other contractually narrow or limited purposes.

*Operating CapitalRequirements.*

We believe that ourcash balances, together with funds we expect to generate from operations, willbe sufficient to meet our projected working capital and other cash requirementsthrough at least the next twelve months. However, there can be no assurancethat future events will not require us to seek additional borrowings or capitaland, if so required, that such borrowing or capital will be available onacceptable terms. Factors that could affect our short-term and long-term cashused or generated from operations and as a result, our need to seek additionalborrowings or capital include:

·       theaverage selling prices of our products;

·       customerdemand for our products;

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·       theneed to secure future wafer production capacity from our suppliers;

·       thetiming of significant orders and of license and royalty revenue;

·       merger,acquisition or joint venture projects;

·       investmentsin strategic business partners;

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

·       theoutcome of ongoing litigation.

Please also see Part I,Item 1A. “Risk Factors—Business Risks—Our operating results fluctuatesignificantly, and an unanticipated decline in revenues may disappointsecurities analysts or investors and result in a decline in our stock price.”

**Recent Accounting Pronouncements**

In December 2004, the FASB issued SFAS 123R(revised 2004), or SFAS 123R, “Share Based Payment.” SFAS 123R is arevision of FASB 123 and supersedes APB No. 25. SFAS 123R establishesstandards for the accounting for transactions in which an entity exchanges itsequity instruments for good or services or incurs liabilities in exchange forgoods or services that are based on the fair value of the entity’s equityinstruments. SFAS 123R focuses primarily on accounting for transactions inwhich an entity obtains employee services in share-based payment transactions. SFAS 123Rrequires an entity to measure the cost of employee services received inexchange for an award of equity instruments based on the grant-date fair valueof the award over the period during which an employee is required to provideservice for the award. The grant-date fair value of employee share options andsimilar instruments must be estimated using option-pricing models adjusted fo rthe unique characteristics of those instruments unless observable market pricesfor the same or similar instruments are available. In addition, SFAS 123Rrequires that a public entity measure the cost of employee services received inexchange for an award of liability instruments based on its current fair valueand that the fair value of that award will be remeasured subsequently at eachreporting date through the settlement date. SFAS 123R allows for either modifiedprospective recognition of compensation expense or retrospective recognition. Weplan to apply the modified prospective recognition method. In April 2005,the SEC adopted a new rule that amends the compliance dates of SFAS 123R.The effective date of SFAS 123R for us is the first interim period of 2006.We have determined the adoption of SFAS 123R will result in amounts thatare similar to the current pro forma disclosures under SFAS 123, andexpect the adoption to have a significant adverse impact on our consolidatedoperating expenses.

In March 2005, the SEC issued Staff AccountingBulletin No. 107, or SAB 107. SAB 107 includes interpretive guidance forthe initial implementation of SFAS 123R. We expect to apply the principlesof SAB 107 in conjunction with the adoption of SFAS 123R.

In May 2005, the FASB issued SFAS No. 154,“Accounting Changes and Error Corrections”, or SFAS 154. SFAS 154replaces APB Opinion No. 20 “Accounting Changes” and SFAS No. 3,Reporting Accounting Changes in Interim Financial Statements”. SFAS 154requires retrospective application to prior periods’ financial statements ofchanges in accounting principles, unless it is impractical to determine eitherthe period-specific effects or the cumulative effect of the change. We do notexpect the adoption of SFAS No. 154 to have a material impact on ourconsolidated financial statements.

In September 2005,the FASB ratified Emerging Issues Task Force Issue No. 04-13, “Accounting for Purchases and Sales ofInventory 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 

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(counterparties) beviewed as a single nonmonetary transaction within the scope of APB OpinionNo. 29, “Accounting forNonmonetary Transactions”*,*or**APB 29, and FinancialAccounting Standard No. 153, “Exchangesof Nonmonetary Assets, an Amendment of APB 29”*,*or SFAS 153, and (b) if nonmonetarytransactions within the scope of APB 29 and FAS 153 involveinventory, are there any circumstances under which the transactions should berecognized at fair value. The pronouncement is effective for new inventoryarrangements entered into, or modifications or renewals of existing inventoryarrangements occurring in interim or annual reporting periods beginning after March 15,2006. We do not expect that this pronouncement will have a material effect on ourconsolidated financial statements.

**Item 7A.**                Quantitativeand Qualitative Disclosures about Market Risk

We are exposed to risks associated with foreignexchange rate fluctuations due to our international manufacturing and salesactivities. These exposures may change over time as business practices evolveand could negatively impact our operating results and financial condition. Currently,we do not hedge these foreign exchange rate exposures. All of our sales aredenominated in U.S. dollars. An increase in the value of the U.S. dollarrelative to foreign currencies could make our products more expensive andtherefore reduce the demand for our products. Such a decline in the demandcould reduce revenues and/or result in operating losses. In addition, adownturn in the economies of China, Japan or Taiwan could impair the value ofour equity investments in companies with operations in these countries. If weconsider the value of these companies to be impaired, we will write off, orexpense, some or all of our investments. In 2001, we wrote down our investmentin KYE by $3.3 million to $1.3 million due to an other than temporarydecline in its market value. As of December 31, 2005, the market value ofour KYE investment was $4.3 million based on the quoted market price. Inthe third quarter of 2002, we wrote down our investment in Apacer, a privatelyheld memory module manufacturer located in Taiwan, by $7.8 million due toa other than temporary decline in its value. As of December 31, 2005, therecorded value of our Apacer investment was $4.4 million. During 2004, wewrote down our investment in Insyde by $509 thousand because Insyde’sstock price had declined below our cost basis on a other-than-temporary basis.During 2005, we wrote down our investment in ACET by $2.2 million sinceACET issued a secondary round of equity funding at a lower per share price thanour carrying value. As of December 31, 2005, the recorded value of ourinvestment in ACET was $1.8 million.

At any time, fluctuations in interest rates couldaffect interest earnings on our cash, cash equivalents and short-terminvestments, or the fair value of our investment portfolio. A 10% move ininterest rates as of December 31, 2005 would have an immaterial effect onour financial position, results of operations and cash flows. Currently, we donot hedge these interest rate exposures. As of December 31, 2005, thecarrying value of our available-for-sale investments approximated fair value. Thetable below presents the carrying value and related weighted average interestrates for our unrestricted and restricted cash, cash equivalents andavailable-for-sale investments as of December 31, 2005 (in thousands):

| ** **                                                 | ** ** | **Carrying** | ** ** | **Interest** | ** ** |
|------------------------------------------------------------|------------|--------------|------------|--------------|------------|
| ** **                                                 | ** ** | **Value**    | ** ** | **Rate**     | ** ** |
| Short-term  available-for-sale investments—fixed rate |       | $            | 1,008      |         |       | 2.9 | % |   |
| Cash and cash  equivalents—variable rate              |       | 77,382       |       |         | 0.2        | % |   |
|                                                       |       | $            | 78,390     |         |       | 0.2 | % |   |

 

**Item 8.**                        ConsolidatedFinancial Statements and Supplementary Data

The consolidated financialstatements are included in a separate section of this Annual Report.

***Supplementary Data: Selected Consolidated QuarterlyData***

Thefollowing table presents our unaudited consolidated statements of operationsdata for each of the eight quarters in the period ended December 31, 2005.In our opinion, this information has been presented 

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on the same basis as the audited consolidatedfinancial statements included in a separate section of this report, and allnecessary adjustments, consisting only of normal recurring adjustments, havebeen included in the amounts below to present fairly the unaudited quarterlyresults when read in conjunction with the audited consolidated financialstatements and related notes. The operating results for any quarter should notbe relied upon as necessarily indicative of results for any future period. Weexpect our quarterly operating results to fluctuate in future periods due to avariety of reasons, including those discussed in Part I, Item 1A. “RisksFactors.”

| ** **                                | ** ** | **Quarter Ended**                                             | ** ** |
|-------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                | ** ** | **March 31,**                                                 | ** ** | **June 30,** | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
| ** **                                | ** ** | **2005**                                                           | ** ** | **2005** | ** ** | **2005** | ** ** | **2005** | ** ** |
| ** **                                | ** ** | **(in thousands, except per share data)** | ** ** |
| Net revenues:                             |       |                                                               |       |   |   |   |   |   |   |   |   |   |   |
| Product revenues                          |       | $                                                                  | 79,270     |   | $ | 84,882 |   |   | $ | 107,724 |   |   |   | $ | 122,220 |   |   |
| License revenues                          |       | 7,045                                                              |       | 8,417 |   |   | 10,348 |   |   |   | 10,993 |   |   |
| Total net revenues                        |       | $                                                                  | 86,315     |   | $ | 93,299 |   |   | $ | 118,072 |   |   |   | $ | 133,213 |   |   |
| Gross profit                              |       | $                                                                  | 12,593     |   | $ | 11,262 |   |   | $ | 19,145 |   |   |   | $ | 34,771 |   |   |
| Income (loss)  from operations            |       | $                                                                  | (13,414    | ) | $ | (18,864 | ) |   | $ | (5,470 | ) |   |   | $ | 10,998 |   |   |
| Net Income (loss)                         |       | $                                                                  | (13,897    | ) | $ | (19,587 | ) |   | $ | (4,794 | ) |   |   | $ | 8,440 |   |   |
| Net Income (loss)  per share—basic   |       | $                                                                  | (0.14      | ) | $ | (0.19 | ) |   | $ | (0.05 | ) |   |   | $ | 0.08 |   |   |
| Net income (loss) per  share—diluted |       | $                                                                  | (0.14      | ) | $ | (0.19 | ) |   | $ | (0.05 | ) |   |   | $ | 0.08 |   |   |

 

| ** **                                | ** ** | **Quarter Ended**                                             | ** ** |
|-------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                | ** ** | **March 31,**                                                 | ** ** | **June 30,** | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
| ** **                                | ** ** | **2004**                                                           | ** ** | **2004** | ** ** | **2004** | ** ** | **2004** | ** ** |
| ** **                                | ** ** | **(in thousands, except per share data)** | ** ** |
| Net revenues:                             |       |                                                               |       |   |   |   |   |   |   |   |   |   |   |
| Product revenues                          |       | $                                                                  | 91,370     |   | $ | 115,571 |   |   | $ | 101,260 |   |   |   | $ | 96,530 |   |   |
| License revenues                          |       | 13,063                                                             |       | 12,958 |   |   | 10,912 |   |   |   | 7,534 |   |   |
| Total net revenues                        |       | $                                                                  | 104,433    |   | $ | 128,529 |   |   | $ | 112,172 |   |   |   | $ | 104,064 |   |   |
| Gross profit                              |       | $                                                                  | 38,151     |   | $ | 48,767 |   |   | $ | 39,584 |   |   |   | $ | 603 |   |   |
| Income (loss)  from operations            |       | $                                                                  | 15,421     |   | $ | 23,396 |   |   | $ | 14,752 |   |   |   | $ | (27,330 | ) |   |
| Net Income (loss)                         |       | $                                                                  | 14,233     |   | $ | 22,099 |   |   | $ | 14,522 |   |   |   | $ | (26,925 | ) |   |
| Net Income (loss)  per share—basic   |       | $                                                                  | 0.15       |   | $ | 0.23 |   |   | $ | 0.15 |   |   |   | $ | (0.28 | ) |   |
| Net income (loss) per  share—diluted |       | $                                                                  | 0.14       |   | $ | 0.22 |   |   | $ | 0.15 |   |   |   | $ | (0.28 | ) |   |

 

We recorded an operating lease impairment of $1.5 millionrelating to an operating lease for an abandoned building in the second quarterof 2004. We expensed the in-process research and development resulting from theacquisitions of Emosyn and G-Plus in the amount of $1.7 million and $4.2 millionin the third and fourth quarters of 2004, respectively. We recorded a provisionof adverse purchase commitments of $2.6 million and $5.4 million inthe third and fourth quarters, respectively. In the fourth quarter of 2004, werecorded an $18.3 million valuation adjustment against inventory forpotentially excess and obsolete inventories and those inventories carried atcosts that are higher than their market values.

We recorded inventoryvaluation adjustments of $10.8 million,$12.9 million, $8.4 millionand $5.2 million in the first, second, third and fourth quarters of 2005,respectively due to a decline in the pricing of several of our productsWe recorded a $2.9 millioncharge related to in-process R&D expense involving the acquisition of Actransand the settlement of the Atmel patent litigation case in the secondquarter of 2005. In the fourth quarter of 2005, we recorded an asset impairmentcharge of $2.2 million relating to one of our equity investments****due to a subsequent lower-priced round of equity financingby the investee.

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**Item 9.**                        Changesin and Disagreements with Accountants on Accounting and Financial Disclosure

Not applicable.

**Item9A.     Controls and Procedures**

**Disclosure Controls and Procedures**

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

Our management, with the participationof the Chief Executive Officer and Chief Financial Officer, conducted anevaluation of the effectiveness of our disclosure controls and procedures (asdefined in the Exchange Act Rules 13a-15(e) and 15d-15(e)) as of December 31,2005. 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 December 31, 2005. 

**Management’sReport on Internal Control over Financial Reporting**

Management is responsible for establishing andmaintaining adequate internal control over financial reporting, as such term isdefined in Exchange Act Rule 13a-15(f). Our internal control over financialreporting is a process designed to provide reasonable assurance regarding thereliability of financial reporting and the preparation of financial statementsfor external purposes in accordance with generally accepted accountingprinciples. Our internal control over financial reporting includes thosepolicies and procedures that: (i) pertain to the maintenance of records that,in reasonable detail, accurately and fairly reflect the transactions anddispositions of our assets; (ii) provide reasonable assurance that transactionsare recorded as necessary to permit preparation of financial statements inaccordance with U. S. generally accepted accounting principles, and that ourreceipts and expenditures are being made only in accordance with authorizationsof our management and directors, and (iii) provide reasonable assuranceregarding prevention or timely detection of unauthorized acquisition, use ordisposition our assets that could have a material effect on the financialstatements. 

Because of its inherent limitations, internal controlover financial reporting may not prevent or detect misstatements. Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate. 

Our management assessed the effectiveness of ourinternal control over financial reporting as of December 31, 2005. In makingits assessment of internal control over financial reporting, our managementused the criteria established in *Internal Control—IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission (COSO). Based on our evaluation under the criteria setforth in Internal Control—Integrated Framework, our management concluded thatour internal control over financial reporting was effective as ofDecember 31, 2005.

Management’s assessment ofthe effectiveness of our internal control over financial reporting as ofDecember 31, 2005 has been audited by PricewaterhouseCoopers LLP, anindependent registered public accounting firm, as stated in their report whichappears herein. 

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**Changesin Internal Control Over Financial Reporting**

During the fourthquarter of 2005, we completed the remediation of our systems of internalcontrol to address material weaknesses identified as of December 31, 2004. Weimplemented the following remediation steps to address such materialweaknesses:

·       Wehired additional accounting and finance staff.

·       Wecontinued to enhance training programs for our accounting and financepersonnel. 

·       Wesupplemented our internal accounting and finance personnel with third partyexperts regarding selected accounting and tax matters.

During the fourth quarter of 2005, we completed ourtesting and concluded that these newly implemented controls were effective andtherefore this material weakness has been remediated.

Except as discussed above,there have been no changes in our internal control over financial reportingduring the quarter ended December 31, 2005 that have materially affected or arereasonably likely to materially affect our internal control over financialreporting, as defined in Exchange Act Rule 13a-15(f).

**Item 9B.**               OtherInformation

On December 21, 2004,we were notified by the Enforcement Office of the Securities and ExchangeCommission that it was conducting an informal inquiry regarding trading ofshares of our common stock prior to our December 20, 2004 announcement ofupdated guidance for our financial results for the fourth quarter of 2004. Theinquiry involves trading in shares of our common stock by a former executiveofficer, a director of SST, two current employees and one former employee. In September 2005,the Enforcement Office issued a subpoena compelling the testimony of the formerexecutive officer. We have and continue to cooperate with the EnforcementOffice.

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**PART III**

**Item 10.**                 Directorsand Executive Officers of the Registrant

The information requiredby this item will be contained in our definitive Proxy Statement with respectto our 2006 Annual Meeting of Shareholders under the captions “Election ofDirectors,” “Security Ownership of Certain Beneficial Owners and Management—Compliancewith the Reporting Requirement of Section 16(a),” “Audit Committee,” “Nominatingand Corporate Governance Committee,” and “Code of Conduct,” and areincorporated by reference into this report. The information relating to ourexecutive officers is contained in Part I, Item 1 of this report.

**Item 11.**                 ExecutiveCompensation

The information requiredby this item will be contained in our definitive Proxy Statement with respectto our 2006 Annual Meeting of Shareholders under the caption “Compensation—Compensationof Officers,” and is incorporated by reference into this report.

**Item 12.**                 SecurityOwnership of Certain Beneficial Owners and Management and Related ShareholderMatters

The information requiredby this item will be contained in our definitive Proxy Statement with respectto our 2006 Annual Meeting of Shareholders under the captions “SecurityOwnership of Certain Beneficial Owners and Management” and “Compensation—EquityCompensation Plan Information,” and are incorporated by reference into thisreport.

**Item 13.**                 CertainRelationships and Related Transactions

The information requiredby this item will be contained in our definitive Proxy Statement with respectto our 2006 Annual Meeting of Shareholders under the caption “CertainTransactions,” and is incorporated by reference into this report. Please alsosee “Management’s Discussion and Analysis of Financial Condition and Results ofOperations—Related Party Transactions.”

**Item 14.**                 PrincipalAccountant Fees and Services

The information required by this item will becontained in our definitive Proxy Statement with respect to our 2006 AnnualMeeting of Shareholders under the caption “Ratification of Selection ofIndependent Registered Public Accounting Firm” and is incorporated by referenceinto this report.

52

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**PART IV**

**Item 15. Exhibits and Financial Statement Schedule**

(a)(1)   ConsolidatedFinancial Statements.   The index to the consolidated financial statementsis found on page 49 of this Report.

     (2)   Financial Statement Schedule.   Financial statement schedule NumberII is included.

     (3)   Exhibits.   See Exhibit Index in part (b), below.

(b)   Indexto Exhibits.

| Exhibit   Number   | ** ** | ** **                                                                                                                       | ** ** | **Description of Document** | ** ** |
|--------------------|------------|----------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
|   3.1(1) |       | Bylaws of Silicon Storage Technology, Inc., as   amended.                                                                   |       |
|   3.2(2) |       | Restated   Articles of Incorporation of SST, dated November 3, 1995.                                                        |       |
|   3.3(3) |       | Certificate of   Amendment of the Restated Articles of Incorporation of SST, dated   June 30, 2000.                         |       |
|   3.4(4) |       | Certificate of   Designation of Series A Junior Participating Preferred Stock.                                              |       |
|   4.1    |       | Reference is   made to Exhibits 3.1 to 3.4.                                                                                      |       |
|   4.2(5) |       | Specimen Stock   Certificate of SST.                                                                                             |       |
|   4.3(6) |       | Rights Agreement   between SST and American Stock Transfer and Trust Co., dated May 4,   1999.                              |       |
|   4.4(7) |       | Amendment   No. 1 to Rights Agreement between SST and American Stock Transfer and   Trust Co., dated October 28, 2000. |       |
| 10.1(8)+           |       | 1995 Equity   Incentive Plan and related agreements.                                                                             |       |
| 10.2(9)+           |       | 1995 Employee   Stock Purchase Plan.                                                                                             |       |
| 10.3(10)+          |       | 1995   Non-Employee Director’s Stock Option Plan, as amended, and related form of   stock option agreement.                 |       |
| 10.4(11)+          |       | Profit Sharing   Plan.                                                                                                           |       |
| 10.5(12)           |       | Lease Agreement   between SST and Sonora Court Properties, dated May 4, 1993, as amended.                                   |       |
| 10.6(13)           |       | Lease Agreement   between SST and Coast Properties, dated May 4, 1995, as amended.                                          |       |
| 10.8(14)           |       | Lease Amendment,   dated March 4, 1998, between SST and Sonora Court Properties.                                            |       |
| 10.9(15)           |       | Lease Amendment,   dated March 4, 1998, between SST and Coast Properties.                                                   |       |
| 10.11(16)          |       | Second Amendment   to Lease, dated September 13, 1999, between SST and Coast Properties.                                    |       |
| 10.12(17)          |       | Lease Agreement   between SST and Bhupinder S. Lehga and Rupinder K. Lehga, dated   November 15, 1999.                      |       |
| 10.13(18)          |       | Lease Agreement   between SST and The Irvine Company, dated November 22, 1999.                                              |       |
| 10.14(19)          |       | Sunnyvale   Industrials Net Lease Agreement, dated June 26, 2000.                                                           |       |
| 10.15(20)          |       | Non-Employee   Director Cash Retainer Program.                                                                                   |       |

53

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| Exhibit   Number | ** ** | ** **                                                                                                                                                                                                      | ** ** | **Description of Document** | ** ** |
|------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| 10.16(21)+       |       | Consulting   Agreement, dated May 11, 2005 and effective May 16, 2005, by and   between SST and Isao Nojima.                                                                                          |       |
| 10.17(22)        |       | Loan and   Security Agreement, dated August 11, 2005, by and among Cathay Bank,   SST and certain subsidiaries of SST.                                                                                     |       |
| 21.1             |       | Subsidiaries of   SST.                                                                                                                                                                                          |       |
| 23.1             |       | Consent of   PricewaterhouseCoopers LLP, Independent Registered Public Accounting Firm.                                                                                                                         |       |
| 24.1             |       | Power of   Attorney is contained on the signature page.                                                                                                                                                         |       |
| 31.1             |       | Certification   required by Rule 13a-14(a).                                                                                                                                                                |       |
| 31.2             |       | Certification   required by Rule 13a-4(a).                                                                                                                                                                 |       |
| 32.1             |       | Certification of   President and Chief Executive Officer, as required by Rule 13a-14(b) 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) and Section 1350 of Chapter 63 of Title 18 of   the United States Code (18 U.S.C. 1350).* |       |

----

             *  The certifications attached as Exhibit 32.1and Exhibit 32.2 accompany the Annual Report on Form 10-K, arenot deemed filed with the Securities and Exchange Commission and are not to beincorporated by reference into any filing of the Company under the SecuritiesAct of 1933, as amended, or the Securities Exchange Act of 1934, as amended(whether made before or after the date of the Form 10-K),irrespective of any general incorporation language contained in such filing.

         +  Management contract, compensatory   plan or arrangement.

          1.  Filed as Exhibit 3.1 to our QuarterlyReport on Form 10-Q for the quarter ended June 30, 2004, filed August 5,2004 and incorporated by reference herein.

          2.  Filed as Exhibit 3.4 to our RegistrationStatement on Form S-1, as amended, File No. 33-97802,filed on October 5, 1995, and incorporated by reference herein.

          3.  Filed as Exhibit 3.5 to our QuarterlyReport on Form 10-Q for the quarter ended June 30, 2000, filedon August 7, 2000, and incorporated by reference herein.

          4.  Filed as Exhibit 99.3 to our CurrentReport on Form 8-K filed on May 18, 1999, and incorporated byreference herein.

          5.  Filed as Exhibit 4.2 to our RegistrationStatement on Form S-1, as amended, File No. 33-97802,filed on November 3, 1995, and incorporated by reference herein.

          6.  Filed as Exhibit 99.2 to our CurrentReport on Form 8-K filed on May 18, 1999, and incorporated byreference herein.

          7.  Filed as Exhibit 3.6 to our Annual Reporton Form 10-K for the year ended December 31, 2000, as amended,filed on March 30, 2001, and incorporated by reference herein.

          8.  Filed as amended as Exhibit 99.1 to ourRegistration Statement on Form S-8, File No. 333-108345,filed on August 29, 2003, and incorporated by reference herein.

54

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          9.  Filed as amended as Exhibit 99.3 to ouron Form S-8, File No. 333-108345 filed on August 29,2003, and incorporated by reference herein.

   10.  Filed as amended as Exhibit 10.3 to our Current Report on Form 8-K,filed on April 21, 2005, and incorporated by reference herein.

   11.  Filed as Exhibit 10.5 to our Registration Statement on Form S-1,as amended, File No. 33-97802, filed on October 5, 1995, andincorporated by reference herein.

   12.  Filed as Exhibit 10.6 to our Registration Statement on Form S-1,as amended, File No. 33-97802, filed on October 5, 1995, andincorporated by reference herein.

   13.  Filed as Exhibit 10.7 to our Registration Statement on Form S-1,as amended, File No. 33-97802, filed on October 5, 1995, andincorporated by reference herein.

   14.  Filed as Exhibit 10.17 to our Quarterly Report on Form 10-Qfor the quarter ended June 30, 1998, filed on August 14, 1998, andincorporated by reference herein.

   15.  Filed as Exhibit 10.18 to our Quarterly Report on Form 10-Qfor the quarter ended June 30, 1998, filed on August 14, 1998, andincorporated by reference herein.

   16.  Filed as Exhibit 10.23 to our Annual Report on Form 10-Kfor the year ended December 31, 1999, as amended, filed on February 24,2000, and incorporated by reference herein.

   17.  Filed as Exhibit 10.24 to our Annual Report on Form 10-Kfor the year ended December 31, 1999, as amended, filed on February 24,2000, and incorporated by reference herein.

   18.  Filed as Exhibit 10.25 to our Annual Report on Form 10-Kfor the year ended December 31, 1999, as amended, filed on February 24,2000, and incorporated by reference herein.

   19.  Filed as Exhibit 10.28 to our Quarterly Report on Form 10-Qfor the quarter ended June 30, 2000, filed on August 7, 2000, andincorporated by reference herein.

   20.  Filed as Exhibit 10.15 to our Current Report on Form 8-Kfiled on April 21, 2005, and incorporated by reference herein.

   21.  Filed as Exhibit 10.16 to our Current Report on Form 8-Kfiled on May 20, 2005, and incorporated by reference herein.

   22.  Filed as Exhibit 10.17 to our Current Report on Form 8-Kfiled on August 15, 2005 and incorporated by reference herein.

 

55

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the Registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized, in the City of Sunnyvale,County of Santa Clara, State of California, on the 16th day of March, 2006. 
|        |   | SILICON STORAGE TECHNOLOGY,  INC.                                              |
|--------|--------|--------------------------------------------------------------------------------|
|   | By:    | /s/ BING YEH                                                                   |
|   |   | Bing Yeh  President and Chief Executive Officer  (Principal Executive Officer) |

 

Pursuant to therequirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the Registrant and in thecapacities and on the dates indicated.

**POWER OF ATTORNEY**

**KNOW ALL PERSONS BY THESE PRESENTS,**that each person whose signature appears belowconstitutes and appoints Bing Yeh and Arthur O. Whipple, and each or any one of them, his true and lawfulattorney-in-fact and agent, with full power of substitution andre-substitution, for him and in his name, place and stead, in any and allcapacities, to sign any and all amendments to this report, and to file thesame, with all exhibits thereto, and other documents in connection therewith,with the Securities and Exchange Commission, granting unto said attorneys-in-factand agents, and each of them, full power and authority to do and perform eachand every act and thing requisite and necessary to be done in connectiontherewith, as fully to all intents and purposes as he might or could do inperson, hereby ratifying and confirming all that said attorneys-in-fact andagents, or any of them, or their or his substitutes or substitute, may lawfullydo or cause to be done by virtue hereof.
|                        | **Signature** | ** **                                           | ** ** |                     | **Title** | ** ** | ** ** |  | **Date** | ** ** |
|------------------------|---------------|------------------------------------------------------|------------|---------------------|-----------|------------|------------|--|----------|------------|
| /s/ BING YEH           |          | President, Chief  Executive Officer and Chairman of  |       | March 16, 2006 |
| Bing  Yeh              |          | the Board (Principal Executive Officer)              |       |                |
| /s/ ARTHUR O.  WHIPPLE |          | Vice President,  Finance and Chief Financial Officer |       | March 16, 2006 |
| Arthur  O. Whipple     |          | (Principal Financial and Accounting Officer)         |       |                |
| /s/ YAW WEN HU         |          | Director                                             |       | March 16, 2006 |
| Yaw  Wen Hu            |          |                                                 |       |                |
| /s/ TSUYOSHI TAIRA     |          | Director                                             |       | March 16, 2006 |
| Tsuyoshi  Taira        |          |                                                 |       |                |
| /s/ RONALD CHWANG      |          | Director                                             |       | March 16, 2006 |
| Ronald  Chwang         |          |                                                 |       |                |
| /s/ YASUSHI CHIKAGAMI  |          | Director                                             |       | March 16, 2006 |
| Yasushi  Chikagami     |          |                                                 |       |                |
| /s/ TERRY NICKERSON    |          | Director                                             |       | March 16, 2006 |
| Terry Nickerson        |          |                                                 |       |                |

 

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**SILICON STORAGE TECHNOLOGY, INC. AND SUBSIDIARIESINDEX TO CONSOLIDATEDFINANCIAL STATEMENTS**
| Item                                                                                  | ** ** | ** ** | ** ** | **Page** |
|---------------------------------------------------------------------------------------|------------|------------|------------|----------|
| Report of Independent Registered Public Accounting  Firm                              |       |       | 58         |     |
| Consolidated  Balance Sheets                                                          |       |       | 60         |     |
| Consolidated Statements of Operations                                                 |       |       | 61         |     |
| Consolidated Statements of Shareholders’ Equity and  Comprehensive Income (Loss) |       |       | 62         |     |
| Consolidated Statements of Cash Flows                                                 |       |       | 63         |     |
| Notes to Consolidated Financial Statements                                            |       |       | 64         |     |
| Schedule II                                                                           |       |       | 96         |     |

 

 

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**Reportof Independent Registered Public Accounting Firm**

To the Board of Directors and Stockholders ofSilicon Storage Technology, Inc.:

We have completedintegrated audits of Silicon Storage Technology, Inc.’s 2005 and 2004consolidated financial statements and of its internal control over financialreporting as of December 31, 2005, and an audit of its 2003 consolidatedfinancial statements in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Our opinions, based on our audits,are presented below.

**Consolidatedfinancial statements and financial statement schedule**

In our opinion, theconsolidated financial statements listed in the index appearing under Item 15(a)(1)present fairly, in all material respects, the financial position of SiliconStorage Technology, Inc. and its subsidiaries at December 31, 2005 and 2004,and the results of their operations and their cash flows for each of the threeyears in the period ended December 31, 2005 in conformity with accountingprinciples generally accepted in the United States of America. In addition, inour opinion, the financial statement schedule listed in the index appearingunder Item 15(a)(2) presents fairly, in all material respects, the informationset forth therein when read in conjunction with the related consolidatedfinancial statements. These financial statements and financial statementschedule are the responsibility of the Company’s management. Our responsibilityis to express an opinion on these financial statements and financial statementschedule based on our audits. We conducted our audits of these statements inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether the financial statements are free ofmaterial misstatement. An audit of financial statements includes examining, ona test basis, evidence supporting the amounts and disclosures in the financialstatements, assessing the accounting principles used and significant estimatesmade by management, and evaluating the overall financial statementpresentation. We believe that our audits provide a reasonable basis for ouropinion.

**Internalcontrol over financial reporting**

Also, in our opinion, management’s assessment,included in Management's Report on Internal Control over Financial Reportingappearing under Item 9A, that the Company maintained effective internal controlover financial reporting as of December 31, 2005 based on criteria establishedin *Internal Control—Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commission(COSO), is fairly stated, in all material respects, based on those criteria.Furthermore, in our opinion, the Company maintained, in all material respects,effective internal control over financial reporting as of December 31, 2005,based on criteria established in *Internal Control—IntegratedFramework* issued by the COSO. The Company’s management is responsiblefor maintaining effective internal control over financial reporting and for itsassessment of the effectiveness of internal control over financial reporting.Our responsibility is to express opinions on management’s assessment and on theeffectiveness of the Company’s internal control over financial reporting basedon our audit. We conducted our audit of internal control over financialreporting in accordance with the standards of the Public Company AccountingOversight Board (United States). Those standards require that we plan andperform the audit to obtain reasonable assurance about whether effectiveinternal control over financial reporting was maintained in all materialrespects. An audit of internal control over financial reporting includes obtainingan understanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operatingeffectiveness of internal control, and performing such other procedures as weconsider necessary in the circumstances. We believe that our audit provides areasonable basis for our opinions. 

58

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A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. Acompany’s internal control over financial reporting includes those policies andprocedures that (i) pertain to the maintenance of records that, in reasonabledetail, accurately and fairly reflect the transactions and dispositions of theassets of the company; (ii) provide reasonable assurance that transactions arerecorded as necessary to permit preparation of financial statements in accordancewith generally accepted accounting principles, and that receipts andexpenditures of the company are being made only in accordance withauthorizations of management and directors of the company; and (iii) providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use, or disposition of the company’s assets that could have amaterial effect on the financial statements. 

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements. Also, projections of any evaluation of effectiveness tofuture periods are subject to the risk that controls may become inadequatebecause of changes in conditions, or that the degree of compliance with thepolicies or procedures may deteriorate.

/s/ PricewaterhouseCoopersLLP

San Jose, CaliforniaMarch 16, 2006

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**SILICONSTORAGE TECHNOLOGY, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS(in thousands)**

| ** **                                                                                                                                                        | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                        | ** ** | **2004**              | ** ** | **2005**              | ** ** |
| **ASSETS**                                                                                                                                                        |       |                  |       |                  |       |   |   |   |   |
| Current assets:                                                                                                                                                   |       |                  |       |                  |       |   |   |   |   |
| Cash and cash equivalents                                                                                                                                         |       |                  | $          | 35,365                |       |   |   | $ | 77,382 |   |   |
| Short-term available-for-sale investments                                                                                                                         |       |                  | 68,628     |                  |       |   | 1,008 |   |   |
| Trade accounts receivable—unrelated parties, net of  allowance for doubtful accounts of $1,189 at December 31, 2004 and $758  at December 31, 2005 |       |                  | 25,206     |                  |       |   | 21,378 |   |   |
| Trade accounts receivable—related parties                                                                                                                    |       |                  | 32,973     |                  |       |   | 55,858 |   |   |
| Inventories, net                                                                                                                                                  |       |                  | 156,618    |                  |       |   | 108,343 |   |   |
| Other current assets                                                                                                                                              |       |                  | 16,049     |                  |       |   | 13,109 |   |   |
| Total current assets                                                                                                                                              |       |                  | 334,839    |                  |       |   | 277,078 |   |   |
| Property and equipment, net                                                                                                                                       |       |                  | 16,620     |                  |       |   | 19,415 |   |   |
| Long-term available-for-sale investments                                                                                                                          |       |                  | 23,094     |                  |       |   | 39,057 |   |   |
| Equity investments, GSMC                                                                                                                                          |       |                  | 83,150     |                  |       |   | 83,150 |   |   |
| Equity investments, others                                                                                                                                        |       |                  | 15,413     |                  |       |   | 12,962 |   |   |
| Goodwill                                                                                                                                                          |       |                  | 15,600     |                  |       |   | 29,637 |   |   |
| Intangible assets, net                                                                                                                                            |       |                  | 9,767      |                  |       |   | 11,816 |   |   |
| Other assets                                                                                                                                                      |       |                  | 3,848      |                  |       |   | 4,722 |   |   |
| Total assets                                                                                                                                                      |       |                  | $          | 502,331               |       |   |   | $ | 477,837 |   |   |
| **LIABILITIES**                                                                                                                                                   |       |                  |       |                  |       |   |   |   |   |
| Current  liabilities:                                                                                                                                             |       |                  |       |                  |       |   |   |   |   |
| Notes payable, current portion                                                                                                                                    |       |                  | $          | 705                   |       |   |   | $ | 39 |   |   |
| Borrowing under line of credit facility                                                                                                                           |       |                  | —     |                  |       |   | 3,000 |   |   |
| Trade accounts payable-unrelated parties                                                                                                                          |       |                  | 53,273     |                  |       |   | 48,660 |   |   |
| Trade accounts payable-related parties                                                                                                                            |       |                  | 35,882     |                  |       |   | 21,867 |   |   |
| Accrued expenses and other liabilities                                                                                                                            |       |                  | 30,593     |                  |       |   | 17,318 |   |   |
| Deferred revenue                                                                                                                                                  |       |                  | 2,388      |                  |       |   | 4,493 |   |   |
| Total current liabilities                                                                                                                                         |       |                  | 122,841    |                  |       |   | 95,377 |   |   |
| Other liabilities                                                                                                                                                 |       |                  | 1,307      |                  |       |   | 2,627 |   |   |
| Minority interest                                                                                                                                                 |       |                  | 2,199      |                  |       |   | — |   |   |
| Total liabilities                                                                                                                                                 |       |                  | 126,347    |                  |       |   | 98,004 |   |   |
| Commitments (Note  4) and Contingencies (Note 5)                                                                                                                  |       |                  |       |                  |       |   |   |   |   |
| **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: 97,358 shares at  December 31, 2004 and 102,827 shares at December 31, 2005                                                     |       |                  | 358,578    |                  |       |   | 377,027 |   |   |
| Accumulated other comprehensive income                                                                                                                            |       |                  | 16,542     |                  |       |   | 31,780 |   |   |
| Retained earnings (accumulated deficit)                                                                                                                           |       |                  | 864        |                  |       |   | (28,974 | ) |   |
| Total shareholders’ equity                                                                                                                                   |       |                  | 375,984    |                  |       |   | 379,833 |   |   |
| Total liabilities  and shareholders’ equity                                                                                                                  |       |                  | $          | 502,331               |       |   |   | $ | 477,837 |   |   |

 

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

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**SILICON STORAGE TECHNOLOGY, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTSOF OPERATIONS (in thousands, except per share data)**

| ** **                                                                            | ** ** | **Year ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                            | ** ** | **2003**                                   | ** ** | **2004** | ** ** | **2005** | ** ** |
| Net revenues:                                                                         |       |                                       |       |   |   |   |   |
| Product revenues—unrelated parties                                               |       | $                                          | 86,549     |   | $ | 180,234 |   | $ | 157,499 |   |
| Product revenues—related parties                                                 |       | 169,980                                    |       | 224,497 |   | 236,597 |   |
| License revenues—unrelated parties                                               |       | 38,512                                     |       | 44,311 |   | 35,226 |   |
| License revenues—related parties                                                 |       | —                                     |       | 156 |   | 1,577 |   |
| Total net revenues                                                                    |       | 295,041                                    |       | 449,198 |   | 430,899 |   |
| Cost of revenues:                                                                     |       |                                       |       |   |   |   |   |
| Cost of revenues—unrelated parties                                               |       | 73,398                                     |       | 135,331 |   | 135,188 |   |
| Cost of revenues—related parties                                                 |       | 145,377                                    |       | 186,762 |   | 217,940 |   |
| Total cost of revenues                                                                |       | 218,775                                    |       | 322,093 |   | 353,128 |   |
| Gross profit                                                                          |       | 76,266                                     |       | 127,105 |   | 77,771 |   |
| Operating expenses:                                                                   |       |                                       |       |   |   |   |   |
| Research and development                                                              |       | 43,144                                     |       | 46,904 |   | 49,030 |   |
| Sales and marketing                                                                   |       | 22,272                                     |       | 28,295 |   | 28,620 |   |
| General and administrative                                                            |       | 14,398                                     |       | 18,292 |   | 23,926 |   |
| Other (Note 5 and Note 12)                                                            |       | 37,849                                     |       | 7,375 |   | 2,945 |   |
| Total operating expenses                                                              |       | 117,663                                    |       | 100,866 |   | 104,521 |   |
| Income (loss)  from operations                                                        |       | (41,397                                    | )          | 26,239 |   | (26,750 | ) |
| Interest and  other income                                                            |       | 2,996                                      |       | 2,295 |   | 1,790 |   |
| Interest and  other expense                                                           |       | (350                                       | )          | (281 | ) | 266 | ) |
| Impairment of  equity investments                                                     |       | —                                     |       | (509 | ) | (2,240 | ) |
| Income (loss)  before provision for (benefit from) income taxes and minority interest |       | (38,751                                    | )          | 27,744 |   | (27,466 | ) |
| Provision for  (benefit from) income taxes                                            |       | 26,416                                     |       | 3,906 |   | 2,449 |   |
| Minority interest                                                                     |       | —                                     |       | (91 | ) | (77 | ) |
| Net income (loss)                                                                     |       | $                                          | (65,167    | ) | $ | 23,929 |   | $ | (29,838 | ) |
| Net income (loss) per share—basic                                                |       | $                                          | (0.69      | ) | $ | 0.25 |   | $ | (0.29 | ) |
| Shares used in per share calculation—basic                                       |       | 94,723                                     |       | 95,756 |   | 101,369 |   |
| Net income (loss) per share—diluted                                              |       | $                                          | (0.69      | ) | $ | 0.24 |   | $ | (0.29 | ) |
| Shares used in  per share calculation—diluted                                    |       | 94,723                                     |       | 99,143 |   | 101,369 |   |

 

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

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**SILICON STORAGE TECHNOLOGY, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTSOF SHAREHOLDERS’ EQUITYAND COMPREHENSIVE INCOME (LOSS) (in thousands)**

| ** **                                                                          | ** ** | ** **            | ** ** | ** **       | ** ** | **Retained**      | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------------------------|------------|-----------------------|------------|------------------|------------|-------------------|------------|-----------------|------------|------------|------------|
| ** **                                                                          | ** ** | ** **            | ** ** | ** **       | ** ** | **Earnings**      | ** ** | **Other**       | ** ** | ** ** | ** ** |
| ** **                                                                          | ** ** | **Common Stock** | ** ** | **(Accumulated** | ** ** | **Comprehensive** | ** ** | ** **      | ** ** |
| ** **                                                                          | ** ** | **Shares**            | ** ** | **Amount**       | ** ** | **Deficit)**      | ** ** | **Income**      | ** ** | **Total**  | ** ** |
| Balances,  December 31, 2002                                                        |       | 93,295                |       | $                | 339,598    |              |       | $               | 42,102     |       |       |   | $ | 151 |   |   | $ | 381,851 |   |
| Issuance of shares of common stock under employee  stock purchase and option plans  |       | 2,033                 |       | 4,535            |       |              | —     |            |       |       | —     |   |   | 4,535 |   |
| Tax benefit from exercise of stock options                                          |       | —                |       | 1,251            |       |              | —     |            |       |       | —     |   |   | 1,251 |   |
| Net loss                                                                            |       | —                |       | —           |       |              | (65,167    | )               |       |       | —     |   |   |   |   |
| Unrealized gain on available for sale securities                                    |       | —                |       | —           |       |              | —     |            |       |       | 9,027      |   |   |   |   |
| Comprehensive loss                                                                  |       | —                |       | —           |       |              | —     |            |       |       | —     |   |   | (56,140 | ) |
| Balances,  December 31, 2003                                                        |       | 95,328                |       | $                | 345,384    |              |       | $               | (23,065    | )          |       |   | $ | 9,178 |   |   | $ | 331,497 |   |
| Repurchase of shares of common stock                                           |       | (2,574                | )          | (14,853          | )          |              |       |            |       |       |       |   |   | (14,853 | ) |
| Issuance of shares of common stock for acquisition  of G-Plus, Inc                  |       | 3,030                 |       | 22,074           |       |              |       |            |       |       |       |   |   | 22,074 |   |
| Issuance of shares of common stock under employee  stock purchase and option plans  |       | 1,574                 |       | 5,545            |       |              | —     |            |       |       | —     |   |   | 5,545 |   |
| Tax benefit from exercise of stock options.                                         |       | —                |       | 428              |       |              | —     |            |       |       | —     |   |   | 428 |   |
| Net income                                                                          |       | —                |       | —           |       |              | 23,929     |            |       |       | —     |   |   |   |   |
| Unrealized gain on available for sale securities                                    |       | —                |       | —           |       |              | —     |            |       |       | 7,337      |   |   |   |   |
| Cumulative translation adjustment                                                   |       | —                |       | —           |       |              | —     |            |       |       | 27         |   |   |   |   |
| Comprehensive income.                                                               |       | —                |       | —           |       |              | —     |            |       |       | —     |   |   | 31,293 |   |
| Balances,  December 31, 2004.                                                       |       | 97,358                |       | $                | 358,578    |              |       | $               | 864        |       |       |   | $ | 16,542 |   |   | $ | 375,984 |   |
| Issuance of shares of common stock for acquisition  of Actrans, Inc.                |       | 4,358                 |       | 14,722           |       |              | —     |            |       |       | —     |   |   | 14,722 |   |
| Issuance of shares of common stock under employee  stock purchase and option plans. |       | 1,111                 |       | 3,727            |       |              | —     |            |       |       | —     |   |   | 3,727 |   |
| Net loss                                                                            |       | —                |       | —           |       |              | (29,838    | )               |       |       | —     |   |   |   |   |
| Unrealized gain on available for sale securities                                    |       | —                |       | —           |       |              | —     |            |       |       | 15,259     |   |   |   |   |
| Cumulative translation adjustment                                                   |       | —                |       | —           |       |              | —     |            |       |       | (21        | ) |   |   |   |
| Comprehensive income                                                                |       | —                |       | —           |       |              | —     |            |       |       | —     |   |   | (14,600 | ) |
| Balances, December 31,  2005                                                        |       | 102,827               |       | $                | 377,027    |              |       | $               | (28,974    | )          |       |   | $ | 31,780 |   |   | $ | 379,833 |   |

 

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

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**SILICONSTORAGE TECHNOLOGY, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTSOF CASH FLOWS (in thousands)**

| ** **                                                                                                  | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                  | ** ** | **2003**                                   | ** ** | **2004** | ** ** | **2005** | ** ** |
| Cash flows from operating activities:                                                                       |       |                                       |       |   |   |   |   |
| Net income (loss)                                                                                           |       | $                                          | (65,167    | ) | $ | 23,929 |   | $ | (29,838 | ) |
| Adjustments to reconcile net income (loss) to net  cash used in operating activities:                       |       |                                       |       |   |   |   |   |
| Depreciation  andamortization.                                                                              |       | 7,696                                      |       | 7,445 |   | 9,956 |   |
| Purchased in process  research and development                                                              |       | —                                     |       | 5,896 |   | 1,661 |   |
| Provision (credits) for  doubtful accounts receivable                                                       |       | 228                                        |       | 825 |   | (424 | ) |
| Provision for sales  returns                                                                                |       | 316                                        |       | 1,347 |   | 2,051 |   |
| Provision for excess and  obsolete inventories, write-down of inventories and adverse purchase  commitments |       | 6,670                                      |       | 35,883 |   | 37,304 |   |
| Deferred income taxes                                                                                       |       | 22,318                                     |       | — |   | — |   |
| Loss in equity interest                                                                                     |       | —                                     |       | 93 |   | 481 |   |
| Impairment loss on equity  investment                                                                       |       | —                                     |       | 509 |   | 2,240 |   |
| Impairment loss on  operating lease                                                                         |       | —                                     |       | 1,479 |   | — |   |
| (Gain) loss on disposal  of equipment                                                                       |       | 114                                        |       | (33 | ) | 74 |   |
| Gain on sale of equity  investments                                                                         |       | (649                                       | )          | — |   | — |   |
| Tax benefit from employee  stock stock plans                                                                |       | 1,251                                      |       | 428 |   | — |   |
| Minority interest                                                                                           |       | —                                     |       | (91 | ) | (77 | ) |
| Changes in operating assets and liabilities:                                                                |       |                                       |       |   |   |   |   |
| Trade accounts  receivable—unrelated parties                                                           |       | (3,931                                     | )          | (7,113 | ) | 2,101 |   |
| Trade accounts  receivable—related parties                                                             |       | (15,972                                    | )          | 8,080 |   | (22,480 | ) |
| Inventories                                                                                                 |       | 29,507                                     |       | (133,622 | ) | 4,906 |   |
| Other current and  non-current assets                                                                       |       | 18,318                                     |       | (3,045 | ) | 4,037 |   |
| Trade accounts  payable—unrelated parties                                                              |       | 8,365                                      |       | 12,422 |   | (6,729 | ) |
| Trade accounts payable—related  parties                                                                |       | 4,045                                      |       | 25,354 |   | (14,015 | ) |
| Accrued expenses and  other liabilities                                                                     |       | (6,535                                     | )          | 7,464 |   | (9,847 | ) |
| Deferred revenue                                                                                            |       | 980                                        |       | (1,242 | ) | 2,105 |   |
| Net provided by (cash  used) in operating activities                                                        |       | 7,554                                      |       | (13,992 | ) | (16,495 | ) |
| Cash flows from investing activities:                                                                       |       |                                       |       |   |   |   |   |
| Acquisitions, net of cash                                                                                   |       | —                                     |       | (18,443 | ) | (7,406 | ) |
| Investments in equity  securities                                                                           |       | —                                     |       | (43,839 | ) | (333 | ) |
| Purchase of property and  equipment                                                                         |       | (1,806                                     | )          | (8,042 | ) | (6,443 | ) |
| Proceeds from sale of  equipment                                                                            |       | —                                     |       | 33 |   | 4 |   |
| Purchases of  available-for-sale investments                                                                |       | (72,659                                    | )          | (47,590 | ) | (22,026 | ) |
| Sales and maturities of  available-for-sale and equity investments                                          |       | 84,645                                     |       | 91,869 |   | 89,003 |   |
| Net cash provided by  (used in) investing activities                                                        |       | 10,180                                     |       | (26,012 | ) | 52,799 |   |
| Cash flows from financing activities:                                                                       |       |                                       |       |   |   |   |   |
| Debt repayments                                                                                             |       | (250                                       | )          | (393 | ) | (439 | ) |
| Borrowing against line of  credit                                                                           |       | —                                     |       | — |   | 3,000 |   |
| Capital lease payments                                                                                      |       | —                                     |       | — |   | (575 | ) |
| Issuance of shares of  common stock                                                                         |       | 4,535                                      |       | 5,545 |   | 3,727 |   |
| Repurchase of common  stock                                                                                 |       | —                                     |       | (14,853 | ) | — |   |
| Minority interest:  capital contribution in cash                                                            |       | —                                     |       | 820 |   | — |   |
| Net cash provided by  (used in) financing activities                                                        |       | 4,285                                      |       | (8,881 | ) | 5,713 |   |
| Net increase  (decrease) in cash and cash equivalents                                                       |       | 22,019                                     |       | (48,885 | ) | 42,017 |   |
| Cash and cash  equivalents at beginning of period                                                           |       | 62,231                                     |       | 84,250 |   | 35,365 |   |
| Cash and cash  equivalents at end of period                                                                 |       | $                                          | 84,250     |   | $ | 35,365 |   | $ | 77,382 |   |
| Supplemental disclosure of cash flow information:                                                           |       |                                       |       |   |   |   |   |
| Cash received for  interest                                                                                 |       | $                                          | 2,813      |   | $ | 2,146 |   | $ | 1,571 |   |
| Cash paid for  interest                                                                                     |       | $                                          | 127        |   | $ | 82 |   | $ | 122 |   |
| Net cash paid for  (received from) income taxes                                                             |       | $                                          | (8,224     | ) | $ | 2,798 |   | $ | 2,623 |   |
| Common stock  issued in connection with acquisitions                                                        |       | $                                          | —     |   | $ | 22,074 |   | $ | 14,722 |   |

 

During the year ended December 31, 2005, weissued approximately 4.4 million shares of common stock in connection with theacquisition of Actrans Inc. During the year ended December 31, 2004, weissued approximately 3.0 million shares of common stock in connection with theacquisition of G-Plus.

The accompanyingnotes are an integral part of these consolidated financial statements.

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**SILICON STORAGE TECHNOLOGY, INC. AND SUBSIDIARIESNOTES TO THECONSOLIDATED FINANCIAL STATEMENTS**

**1. Natureof Operations and Summary of Significant Accounting Policies:**

***Nature of Operations:***

Silicon Storage Technology, Inc.(SST, us or we) is a leading supplier of flash memory semiconductor devices forthe digital consumer, networking, wireless communications and Internetcomputing markets. Flash memory is a form of non-volatile memory that allowselectronic systems to retain information when the system is turned off. Flashmemory is now used in hundreds of millions of consumer electronics andcomputing products annually. We also produce and sell other semiconductorproducts including smart cards, SIM cards, radio frequency, RF, poweramplifiers and transceivers and memory controllers. We license our SuperFlashtechnology to other companies for non-competing applications. Our products areused in personal computers, personal computer peripheral devices, consumerelectronics and communications devices. Our products are sold to manufacturerslocated primarily in Asia.

***Use of Estimates in Preparation of the FinancialStatements:***

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 could differ from those estimates.

***Risks, Uncertainties and Concentrations:***

Our sales are concentrated in the nonvolatile memoryclass of the semiconductor memory industry, which is highly competitive andrapidly changing. Significant technological changes in the industry, changes incustomer requirements, changes in product costs and selling prices, or theemergence of competitor products with new capabilities or technologies couldaffect our operating results adversely. We currently buy all wafers and die, anintegral component of our products, from outside suppliers and we are dependenton third party subcontractors to assemble and test our products. Failure bythese suppliers to satisfy our requirements on a timely basis at competitiveprices could cause us to suffer manufacturing delays, a possible loss ofrevenues, or higher than anticipated costs of revenues, any of which could havea severe adverse affect on our operating results.

We out-source our end customer service logistics inAsia to Silicon Professional Technology Ltd., or SPT, which supports ourcustomers in Taiwan, China and other Southeast Asia countries. SPT provides forecast,planning, warehousing, delivery, billing, collection and other logisticfunctions for us in these regions. SPT is a wholly-owned subsidiary of one ofour stocking representatives in Taiwan, Professional Computer TechnologyLimited, or PCT. Products shipped to SPT are accounted for as our inventoryheld at our logistics center, and revenue is recognized when the products havebeen delivered and are considered as a sale to our end customers by SPT. Forthe years ended December 31, 2003, 2004 and 2005, SPT serviced endcustomer sales accounting for 64.2%, 52.9% and 58.5%, respectively, of our netproduct revenues recognized. Further description of our relationships with PCTand SPT are in Note 16 of these Notes to the Consolidated Financial Statements.

We ship products to, and have accounts receivablefrom, original equipment manufacturers, or OEMs; original design manufacturers,or ODMs; contract electronic manufacturers, or CEMs; stocking representatives;distributors; and our logistics center. Our stocking representatives,distributors and 

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logistics center reshipour products to our end customers, including OEMs, ODMs, CEMs and end users. Shipments,by us or our logistics center, to our top three stocking representatives forreshipment accounted for 29.9%, 34.0% and 40.3% of our product shipments in2003, 2004 and 2005, respectively. In addition, the same three stockingrepresentatives solicited sales for 32.8%, 25.1% and 18.3% of our shipments toend users in 2003, 2004 and 2005, respectively, for which they received acommission. Our stocking representatives and distributors could discontinuetheir relationship with us or discontinue selling our products at any time. Theloss of our relationship with any of our stocking representatives ordistributors could harm our operating results by impairing our ability to sellour products to our end customers. Our logistics center, SPT, may ceaseproviding services to us at any time. If SPT were to terminate theirrelationship with us we would experience a delay in reestablishing warehousing,logistics and distribution functions, which could impair our ability to collectaccounts receivable from SPT and may harm our business.

We derived 90.0%, 86.0% and 87.6% of our net productrevenues from Asia during 2003, 2004 and 2005, respectively.

In addition, substantially all of our wafer suppliersand packaging and testing subcontractors are located in Asia. Any kind ofeconomic, political or environmental instability in this region of the worldcan have a severe negative impact on our operating results due to the largeconcentration of our production and sales activities in this region.

Our revenues may be impacted by our ability to obtainadequate wafer supplies from our foundries. 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 in qualifying new products and in ramping-up newproduct production and we could experience these delays in the future. We arealso subject to the risks of service disruptions, raw material shortages andprice****increases by our foundries. Suchdisruptions, shortages and price increases could harm our operating results.

We depend onindependent subcontractors to assemble and test our products. Our reliance onthese subcontractors involves the following significant risks:

·       reducedcontrol over delivery schedules and quality;

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

·       difficultiesselecting and integrating new subcontractors;

·       limitedwarranties on products supplied to us;

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

·       potentialmisappropriation of our intellectual property.

These risks may lead to increased costs, delayedproduct delivery or loss of competitive advantage, which would harm ourprofitability and customer relationships.

It should be noted that we may be greatly impacted bythe political, economic and military conditions in Taiwan. Taiwan and China arecontinuously engaged in political disputes and both countries continue toconduct military exercises in or near the other’s territorial waters andairspace. Such disputes may continue and even escalate, resulting in an economicembargo, a disruption in shipping or even military hostilities. This couldseverely harm our business by interrupting or delaying production or shipmentof our product. Any kind of activity of this nature or even rumors of suchactivity could severely and negatively impact our operations, revenues,operating results, and stock price.

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Our corporate headquartersare located in California near major earthquake faults. In addition, some ofour suppliers are located near fault lines. In the event of a major earthquakeor other natural disaster near our headquarters, our operations could be harmed.Similarly, a major earthquake or other natural disaster, such as a typhoon,near one or more of our major suppliers, like the earthquakes in September 1999and March 2002 or the typhoons in September 2001 and July 2005that occurred in Taiwan, could potentially disrupt the operations of thosesuppliers, which could then limit the supply of our products and harm ourbusiness.

***Basis of Consolidation:***

The consolidated financialstatements include the accounts of SST and our wholly-owned and majority-ownedsubsidiaries after elimination of inter-company balances and transactions. Thefunctional currency of SST and all its subsidiaries, except SST China, is theUnited States dollar. The functional currency of SST China is the Chinese Yuan.

***Foreign Currency Transactions:***

Monetary accountsmaintained in currencies other than the United States dollar are re-measuredusing the foreign exchange rate at the balance sheet date. Operational accountsand non-monetary balance sheet accounts are measured and recorded at the ratein effect at the date of the transactions. The effects of foreign currencyre-measurement are reported in current operations. The effect of foreigncurrency re-measurement was not significant in fiscal years 2003, 2004 or 2005.

***Financial Instruments:***

Cash equivalents are highly liquid investments withoriginal or remaining maturities of three months or less as of the dates ofpurchase. Highly liquid investments included in cash equivalents are classifiedas available-for-sale and are carried at cost, which approximates fair value.Cash equivalents present insignificant risk of changes in value because ofinterest rate changes. We maintain substantially all of our cash balances withthree major financial and/or brokerage institutions domiciled in the UnitedStates and we have not experienced any material losses relating to theseinvestment instruments.

Short and long-term investments, which are comprisedof federal, state and municipal government obligations,  foreign and public corporate debt securitiesand listed equity securities, are classified as available-for-sale and carriedat fair value, based on quoted market prices, with the unrealized gains orlosses, net of tax, reported in Shareholders’ Equity as Other ComprehensiveIncome. The cost of debt securities is adjusted for amortization of premiumsand accretion of discounts to maturity, both of which are included in interestincome. Realized gains and losses are recorded on the specific identificationmethod. Realized gains and losses were not material in 2004 and 2005.

The carrying amounts reported for cash and cashequivalents, accounts receivable, accounts payable and accrued expenses areconsidered to approximate fair values based upon the short maturities of thosefinancial instruments. The fair value of available-for-sale investments is setforth in Note 2 of these Notes to the Consolidated Financial Statements.

Financial instruments that potentially subject us toconcentrations of credit risks comprise, principally, cash, cash equivalents,investments and trade accounts receivable. We invest our excess cash inaccordance with our investment policy, which has been approved by our Board ofDirectors and reviewed periodically. We perform credit evaluations of newcustomers and require those without positive, established histories to pay inadvance, upon delivery or through letters of credit. Otherwise, we do notrequire collateral of our customers, and maintain allowances for potentialcredit losses. As of December 31, 2004 and 2005, SPT represented 55.1% and69.6% of our net accounts receivable, respectively.

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We have acquired interestsin Japanese and Taiwanese companies and a Cayman Islands company operating inChina. See Note 17 of these Notes to the Consolidated Financial Statements. Someof these companies are privately held and it was not practicable to estimatethe fair value of the investments in the issued and untraded common stock. Investmentsin privately held companies are included in “Equity investments” in the balancesheet and are carried at cost. When a decline in value is other than temporarythe cost basis of the securities are reduced to their estimated fair value. Someof the Taiwanese companies are public companies and their stock is traded onthe Taiwan Stock Exchange. Under Taiwan security regulations, a certain numberof shares must be held in central custody subsequent to an initial publicoffering and are restricted from sale for a period of time. Shares required tobe held in custody for greater than a one year period are carried at cost andrecorded as equity investments. The unrestricted shares and the sharesavailable for sale within one year from the balance sheet date are carried atquoted market price and included in long-term available for sale investments,with unrealized gains and losses reported as a separate component ofshareholders’ equity. If a loss is other than temporary, it is reported as an “Impairmentof equity investments.”  See Note 13 ofthese Notes to the Consolidated Financial Statements. Cash dividends and otherdistributions of earnings from the investees, if any, are included in otherincome when declared.

***Accounts Receivable***

The allowance for doubtfulaccounts is based on an assessment of the collectibility of customer accounts.We review the allowance by considering factors such as historical experience,credit quality, age of the accounts receivable balances, and current economicconditions that may affect a customer’s ability to pay.

***Inventories:***

Inventories are stated at the lower of cost(determined on a first-in, first-out basis) or market value. We typically planour production and inventory levels based on internal forecasts of customerdemand, which are highly unpredictable and can fluctuate substantially. Thevalue of our inventory is dependent on our estimate of future average sellingprices, and, if our projected average selling prices are not realized, we maybe required to adjust our inventory value to reflect the lower of cost ormarket. Due to the large number of units in our inventory, even a small changein average selling prices could result in a significant adjustment and have asignificant impact on our financial position and results of operations. Ourinventories include high technology parts and components that are specializedin nature or subject to rapid technological obsolescence. Some of our customershave requested that we ship them product that has a finished goods date ofmanufacture that is less than one year old. 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 old, which could result in a significant adjustmentand could harm our financial results. We review on-hand inventory includinginventory held at the logistic center for potential excess, obsolete and lowerof cost or market exposure and adjust the level of inventory reserveaccordingly. Our allowance for excess and obsolete inventories includes anallowance for our on hand finished goods inventory with a date of manufactureof greater than two years old and for certain products with a date ofmanufacture of greater than one year old. For the obsolete inventory analysis,we review 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. While we have programs to minimizethe required inventories on hand and we consider technological obsolescencewhen estimating allowances for potentially excess and obsolete inventories andthose required to reduce recorded amounts to market values, it is reasonablypossible that such estimates could change in the near term. Such changes inestimates could have a significant impact on our financial position and resultsof operations.

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Inventory valuationadjustments to cost of sales and adverse purchase commitments amounted to $6.7million in 2003, $35.9 million in 2004 and $37.3 million in 2005.

***Property and Equipment:***

Property and equipment arestated at cost and depreciated using the straight-line method over estimateduseful lives of three to seven years, except for building for which the usefullife is forty years. See Note 3 of these Notes to the Consolidated FinancialStatements.

***Goodwill and Intangible Assets:***

Goodwill and intangibleswere acquired in acquisitions in 2004 and 2005. Statement of Financial AccountingStandards No. 142, “Goodwill and Other Intangible Assets”, or SFAS 142,requires goodwill to be tested for impairment on an annual basis and betweenannual tests in certain circumstances, and written down when impaired. Noimpairment of goodwill has been identified since the date of acquisition. Furthermore,SFAS 142 requires purchased intangible assets other than goodwill to beamortized over their useful lives unless these lives are determined to beindefinite. Purchased intangible assets are carried at cost less accumulatedamortization. Amortization is computed using the straight-line method over theestimated useful lives of one to five years. No impairment of intangibles hasbeen identified since the date of acquisition.

***Long-Lived Assets:***

Long-lived assets includeproperty and equipment, equity investments and intangible assets. Wheneverevents or changes in circumstances indicate that the carrying amounts oflong-lived assets may not be recoverable, we estimate the future cash flows,undiscounted and without interest charges, expected to result from the use ofthose assets and their eventual disposition. If the sum of the expected futurecash flows is less than the carrying amount of those assets, we recognize animpairment loss based on the excess of the carrying amount over the fair valueof the assets.

***Revenue Recognition:***

Sales to direct customers and foreign stockingrepresentatives are recognized net of an allowance for estimated returns. Whenproduct is shipped to direct customers or stocking representatives, or by ourdistributors or SPT to end users, prior to recognizing revenue, we require thatevidence of the arrangement exists, the price is fixed or determinable andcollection of the resulting receivable is reasonably assured. Sales todistributors are made primarily under arrangements allowing price protectionand the right of stock rotation on unsold merchandise. Because of theuncertainty associated with pricing concessions and future returns, we deferrecognition of such revenues, related costs of revenues and related grossprofit until the merchandise is sold by the distributor. Products shipped toSPT are accounted for as our inventory held at our logistics center and revenueis recognized when the products have been delivered and are considered as asale to our end customers by SPT.

For license and other arrangements for technology thatwe are continuing to enhance and refine and under which we are obligated toprovide unspecified enhancements, revenue is recognized over the lesser of theestimated period that we have historically enhanced and developed refinementsto the technology, approximately two to three years (the upgrade period), orthe remaining portion of the upgrade period from the date of delivery, providedall specified technology and documentation has been delivered, the fee is fixedor determinable and collection of the fee is reasonably assured. From time totime, we re-examine the estimated upgrade period relating to licensedtechnology to determine if a change in the estimated upgrade period is needed. Revenuefrom license or other technology arrangements where we are not 

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continuing to enhance andrefine technology or are not obligated to provide unspecified enhancements isrecognized upon delivery, if the fee is fixed or determinable and collection ofthe fee is reasonably assured.

Royalties received underthese arrangements during the upgrade period are recognized as revenue based onthe ratio of the elapsed portion of the upgrade period to the estimated upgradeperiod. The remaining portions of the royalties are recognized ratably over theremaining portion of the upgrade period. Royalties received after the upgradeperiod has elapsed are recognized when reported to us, which generallycoincides with the receipt of payment.

***Research and Development:***

Research and developmentexpenses are charged to operations as incurred.

***Income Taxes:***

Deferred tax assets andliabilities are determined based on the difference between the financialstatement and tax bases of assets and liabilities using enacted tax rates ineffect for the year in which the differences are expected to affect taxableincome. Valuation allowances are established when necessary to reduce deferredtax assets to the amounts expected to be realized.

***Computation of Net Income (Loss) Per Share:***

We have computed andpresented net income (loss) per share under two methods, basic and diluted.Basic net income (loss) per share is computed by dividing net income (loss) bythe weighted average number of common shares outstanding for the period. Dilutednet income (loss) per share is computed adjusting the net income (loss) by thepotential minority interests and dividing by the sum of the weighted averagenumber of common shares outstanding and potential common shares. Thecalculation of diluted net income (loss) per share excludes potential commonstock if the effect is anti-dilutive. Potential common stock shares consist ofcommon stock options, computed using the treasury stock method based on theaverage stock price for the period.

***Stock-based Compensation:***

Wehave employee stock benefit plans, which are described more fully in Note 9, “Stock-basedCompensation.”  We account forstock-based compensation using the intrinsic value method. No compensation costhas been recognized for the stock option plans or the employee stock purchaseplan. Had compensation cost for these plans been determined based on the fairvalue at the grant date of the awards, our net income (loss) and net income(loss) per share for 2003, 2004 and 2005 would have been as follows (inthousands, except per share amounts): 

| ** **                                                                                                                              | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                                              | ** ** | **2003**                                   | ** ** | **2004** | ** ** | **2005** | ** ** |
| Net income (loss)  reported                                                                                                             |       | $                                          | (65,167    | ) | $ | 23,929 |   | $ | (29,838 | ) |
| Deduct: total  stock based employee compensation expense determined under fair value method for  all awards, net of related tax effects |       | (7,601                                     | )          | (9,036 | ) | (8,612 | ) |
| Pro forma net  income (loss)                                                                                                            |       | $                                          | (72,768    | ) | $ | 14,893 |   | $ | (38,450 | ) |
| Basic income (loss) per share                                                                                                           |       |                                       |       |   |   |   |   |
| Pro forma                                                                                                                               |       | $                                          | (0.69      | ) | $ | 0.25 |   | $ | (0.38 | ) |
| Dilute income  (loss) per share                                                                                                         |       |                                       |       |   |   |   |   |
| Pro forma                                                                                                                               |       | $                                          | (0.69      | ) | $ | 0.24 |   | $ | (0.38 | ) |

 

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The weighted average fair value of options grantedunder the Equity Incentive Plan and the Directors’ Plan during 2003, 2004 and2005 was $8.57, $8.15 and $4.24.

The weighted averagevaluation of rights granted under the employee stock purchase plan during 2003,2004 and 2005 was $1.82, $6.54 and $3.91, respectively, per share.

***Comprehensive Income (Loss):***

Comprehensive income(loss) is defined as the change in equity of a business enterprise during aperiod from transactions and other events and circumstances from non-ownersources. Comprehensive income (loss) includes unrealized gains and losses onavailable-for-sale investments, net of tax, and cumulative translationadjustments. Other comprehensive income (loss) is presented in the Statement ofShareholders’ Equity and Comprehensive Income (Loss).

***Reclassifications:***

Certain amounts in the2003 consolidated financial statements have been reclassified to conform to thecurrent year presentation. These reclassifications have no impact on ourpreviously reported net losses. Specifically, we reclassified certain auctionrate securities from cash equivalents to short-term investments where interestrates reset in less than 90 days but have a maturity date longer than 90 days. Thereclassifications had the effect of increasing net cash provided by investingactivities by $1.1 million for the year ended December 31, 2003.

***Recent Accounting Pronouncements:***

In December 2004, the FASB issued SFAS 123R(revised 2004), or SFAS 123R, “Share Based Payment.”  SFAS 123R is a revision of FASB 123 andsupersedes APB No. 25. SFAS 123R establishes standards for the accountingfor transactions in which an entity exchanges its equity instruments for goodor services or incurs liabilities in exchange for goods or services that arebased on the fair value of the entity’s equity instruments. SFAS 123R focusesprimarily on accounting for transactions in which an entity obtains employeeservices in share-based payment transactions. SFAS 123R requires an entity tomeasure the cost of employee services received in exchange for an award ofequity instruments based on the grant-date fair value of the award over theperiod during which an employee is required to provide service for the award. Thegrant-date fair value of employee share options and similar instruments must beestimated using option-pricing models adjusted for the unique characteristicsof those instruments unless observable market prices for the same or similarinstruments are available. In addition, SFAS 123R requires that a public entitymeasure the cost of employee services received in exchange for an award ofliability instruments based on its current fair value and that the fair valueof that award will be remeasured subsequently at each reporting date throughthe settlement date. SFAS 123R allows for either modified prospectiverecognition of compensation expense or retrospective recognition. We plan toapply the modified prospective recognition method. In April 2005, the SECadopted a new rule that amends the compliance dates of SFAS 123R. Theeffective date of SFAS 123R for us is the first interim period of 2006. We havedetermined  the adoption of SFAS 123Rwill result in amounts that are similar to the current pro forma disclosuresunder SFAS 123 and expect the adoption to have a significant adverse impact onour consolidated operating expenses.

In March 2005, the SEC issued Staff AccountingBulletin No. 107, or SAB 107. SAB 107 includes interpretive guidance forthe initial implementation of SFAS 123R. We expect to apply the principles ofSAB 107 in conjunction with the adoption of FAS 123R.

In May 2005, the FASB issued SFAS No. 154, “AccountingChanges and Error Corrections”, or SFAS 154. SFAS 154 replaces APB OpinionNo. 20 “Accounting Changes” and SFAS No. 3, Reporting AccountingChanges in Interim Financial Statements”. SFAS 154 requires retrospectiveapplication to 

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prior periods’ financialstatements of changes in accounting principles, unless it is impractical todetermine either the period-specific effects or the cumulative effect of thechange. We do not expect the adoption of SFAS No. 154 to have a materialimpact on our consolidated financial statements.

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

**2. Available-for-Sale Investments:**

Thefair value of available-for-sale investments, including restrictedavailable-for-sale investments, as of December 31, 2005 were as follows(in thousands):

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

 

Contractual maturity datesof our available-for-sale investments for debt securities are in 2006. Allof these securities are classified as current as they are expected to berealized in cash or sold or consumed during the normal operating cycle of ourbusiness. At December 31, 2005 the balance of these investments was $1.0million.

The unrealized gain as of December 31, 2005 isrecorded in accumulated other comprehensive income, net of zero tax.

Market values were determined for each individualsecurity in our investment portfolio. The declines in value of the governmentbonds and notes primarily relate to changes in the interest rates and areconsidered temporary in nature. With respect to our foreign listed equitysecurities, our policy is to review our equity holdings on a regular basis toevaluate whether or not such securities have experienced a other than temporarydecline in fair value. Our policy includes, but is not limited to, reviewingeach company’s cash position, earnings and revenue outlook, stock priceperformance over the past six months, liquidity, management and ownership. Ifwe believe that an other-than-temporary decline in value exists, it is ourpolicy to write down these investments to the market value and record therelated write-down in our consolidated statement of operations.

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Thefair value of available-for-sale investments as of December 31, 2004 wereas follows (in thousands):

| ** **                                                | ** ** | **Amortized  Cost** | ** ** | **Unrealized  Gain** | ** ** | **Unrealized  Loss** | ** ** | **Fair  Value** | ** ** |
|-----------------------------------------------------------|------------|---------------------|------------|----------------------|------------|----------------------|------------|-----------------|------------|
| Corporate bonds  and notes                                |       |                | $          | 106                  |       |                 |       | $               | —     |   |   |   | $ | — |   |   | $ | 106 |   |
| Government bonds  and notes                               |       |                | 78,625     |                 |       |                 | —     |            |       |   | (69 | ) |   | 78,556 |   |
| Foreign listed  equity securities                         |       |                | 6,509      |                 |       |                 | 16,977     |            |       |   | (393 | ) |   | 23,093 |   |
| Total bonds,  notes and equity securities                 |       |                | $          | 85,240               |       |                 |       | $               | 16,977     |   |   |   | $ | (462 | ) |   | 101,755 |   |
| Less amounts  classified as cash equivalents              |       | (10,033             | )          |
| Total short and  long-term available-for-sale investments |       | $                   | 91,722     |                 |

 

Contractual maturity datesof our available-for-sale investments for debt securities range from 2005to 2039. All of these securities are classified as current as they are expectedto be realized in cash or sold or consumed during the normal operating cycle ofour business. At December 31, 2004 the balance of these investments was$68.6 million.

The unrealized gain as of December 31,2004 was recorded in accumulated other comprehensive income, net of zero tax.

**3. BalanceSheet Detail (in thousands):**

Tradeaccounts receivable comprise:

| ** **                       | ** ** | **December 31,** | ** ** |
|----------------------------------|------------|-----------------------|------------|
| ** **                       | ** ** | **2004**              | ** ** | **2005** | ** ** |
| Trade Accounts  Receivable       |       | $                     | 61,377     |   | $ | 79,571 |   |
| Allowance for  sales returns     |       | (2,009                | )          | (1,577 | ) |
| Allowance for  doubtful accounts |       | (1,189                | )          | (758 | ) |
|                             |       | $                     | 58,179     |   | $ | 77,236 |   |

 

Inventories,net, comprise: 

| ** **                         | ** ** | **December 31,** | ** ** |
|------------------------------------|------------|-----------------------|------------|
| ** **                         | ** ** | **2004**              | ** ** | **2005** | ** ** |
| Raw materials                      |       | $                     | 86,355     |   | $ | 65,404 |   |
| Work in process                    |       | 4,151                 |       | 6,491 |   |
| Finished goods                     |       | 60,520                |       | 29,450 |   |
| Inventory held at  logistic center |       | 5,592                 |       | 6,998 |   |
|                               |       | $                     | 156,618    |   | $ | 108,343 |   |

 

Othercurrent assets comprise:

| ** **             | ** ** | **December 31,** | ** ** |
|------------------------|------------|-----------------------|------------|
| ** **             | ** ** | **2004**              | ** ** | **2005** | ** ** |
| Refundable income  tax |       | $                     | 6,035      |   | $ | 5,776 |   |
| Other current  assets  |       | 10,014                |       | 7,333 |   |
|                   |       | $                     | 16,049     |   | $ | 13,109 |   |

 

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Propertyand Equipment comprise:

| ** **                     | ** ** | **December 31,** | ** ** | **Estimated  Useful** | ** ** |
|--------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                     | ** ** | **2004**              | ** ** | **2005**              | ** ** | **Lives** | ** ** |
| Land                           |       | $                     | 959        |                  | $          | 959 |   |   |   |
| Building                       |       | 1,532                 |       | 2,786                 |       | Forty  years |   |
| Equipment                      |       | 17,662                |       | 17,430                |       | Four  years |   |
| Computer and  design hardware  |       | 13,684                |       | 14,205                |       | Three  years |   |
| Software                       |       | 13,254                |       | 15,724                |       | Three  years |   |
| Vehicles                       |       | 29                    |       | 47                    |       | Five  years |   |
| Furniture and  fixtures        |       | 2,072                 |       | 1,973                 |       | Seven  years |   |
| Leasehold  improvements        |       | 8,695                 |       | 8,037                 |       | (1) |   |
|                           |       | 57,887                |       | 61,161                |       |   |   |
| Less accumulated  depreciation |       | 41,461                |       | 42,463                |       |   |   |
|                           |       | 16,426                |       | 18,698                |       |   |   |
| Construction in  progress      |       | 194                   |       | 717                   |       |   |   |
|                           |       | $                     | 16,620     |                  | $          | 19,415 |   |   |   |

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(1)          Seven years or remaininglease term, whichever is less

Depreciation expense was $7.7 million, $6.6 millionand $6.1 million for 2003, 2004 and 2005, respectively.

Accruedliabilities comprise:

| ** **                              | ** ** | **December 31,  2004** | ** ** | **December 31,  2005** | ** ** |
|-----------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| Accrued  compensation and related items |       |                        | $          | 6,829                       |       |   |   | $ | 5,934 |   |   |
| Accrued adverse  purchase commitments   |       |                        | 8,330      |                        |       |   | 1,752 |   |   |
| Accrued commission                      |       |                        | 2,198      |                        |       |   | 2,762 |   |   |
| Accrued income  tax payable             |       |                        | 2,038      |                        |       |   | 1,319 |   |   |
| Accrued warranty                        |       |                        | 3,826      |                        |       |   | 803 |   |   |
| Other accrued  liabilities              |       |                        | 7,372      |                        |       |   | 4,748 |   |   |
|                                    |       |                        | $          | 30,593                      |       |   |   | $ | 17,318 |   |   |

 

Our technology license agreements generally include anindemnification clause that indemnifies the licensee against liability anddamages (including legal defense costs) arising from any claims of patent,copyright, trademark or trade secret infringement by our proprietary technology.The terms of these guarantees approximate the terms of the technology licenseagreements, which typically range from five to ten years. Our current licenseagreements expire from 2006 through 2014. The maximum possible amount of futurepayments we could be required to make, if such indemnifications were requiredon all of these agreements, is $40.7million. We have not recorded anyliabilities as of December 31, 2005 related to these indemnities as nosuch claims have been made or asserted.

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Accruedwarranty:

| ** **                                  | ** ** | **Year Ended  December 31,** | ** ** |
|---------------------------------------------|------------|----------------------------------------|------------|
| ** **                                  | ** ** | **2004**                               | ** ** | **2005** | ** ** |
| Beginning balance                           |       | $                                      | 187        |   | $ | 3,826 |   |
| Provisions for  warranty                    |       | 4,834                                  |       | 2,270 |   |
| Change in  estimate of prior period accrual |       | —                                 |       | (1,342 | ) |
| Consumption of  reserves                    |       | (1,195                                 | )          | (3,951 | ) |
| Ending balance                              |       | $                                      | 3,826      |   | $ | 803 |   |

 

Our products are generallysubject to warranty and we provide for the estimated future costs of repair,replacement or customer accommodation upon shipment of the product in theaccompanying statements of operations. Our warranty accrual is estimated basedon historical claims compared to historical revenues and assumes that we haveto replace products subject to a claim. For new products, we use our historicalpercentage for the appropriate class of product. The increase in the consumptionof the reserve for the year ended December 31, 2005 compared to the prioryear relates mainly to the rescreening work related to two specific customers,which was fully reserved for as of December 31, 2004. The work wascompleted during the year ended December 31, 2005 and, consequently, werevised our estimate and decreased provisions for warranty by $1.3 million .

**4. Commitments**

We lease our corporate facilities under non-cancelableoperating leases that expire in 2006 through 2012. The leases requireescalating monthly payments over their terms and, therefore, periodic rentexpense is being recognized on a straight-line basis. Under the terms of theleases, we are responsible for maintenance costs, including real propertytaxes, utilities and other costs. Rent expense was $5.5 million, $5.0 millionand $4.2 million in 2003, 2004 and 2005, respectively.

During 2001 and the second quarter of 2004, werecorded charges to other operating expense of $756 thousand and $1.5 million,respectively, relating to operating leases for two unoccupied buildings. Thesecharges represent the fair value of the liability determined by reducing theremaining lease commitment by the estimated sublease income relating to thesetwo buildings. At December 31, 2003, 2004 and 2005, payments made havereduced the recorded liability to $270 thousand, $976 thousand and $4 thousand,respectively.

Futureminimum lease payments at December 31, 2005 are as follows (in thousands):

| ** **                               | ** ** | **Capital  Lease** | ** ** | **Operating  Lease** | ** ** |
|------------------------------------------|------------|--------------------|------------|----------------------|------------|
| 2006                                     |       | $                  | 2,200      |                 |       | $ | 3,626 |   |   |
| 2007                                     |       | 1,710              |       |                 | 3,409      |   |   |
| 2008                                     |       | —             |       |                 | 3,313      |   |   |
| 2009                                     |       | —             |       |                 | 3,315      |   |   |
| 2010                                     |       | —             |       |                 | 931        |   |   |
| Thereafter                               |       | —             |       |                 | 63         |   |   |
|                                     |       | $                  | 3,910      |                 |       | $ | 14,657 |   |   |
| Less: Imputed  interst                   |       | (143               | )          |                 |       |   |   |
| Present value of minimum  lease payments |       | $                  | 3,767      |                 |       |   |   |   |

 

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**5. Contingencies:**

In January 1996, Atmel Corporation filed suitagainst SST alleging that we infringed six U.S. patents. We successfully movedfor summary judgment on two of the six asserted patents in September 1997.In January 2001, Atmel withdrew its allegation that we infringed anotherpatent. On May 7, 2002, a judgment was entered against us in the amount of$36.5 million based on a jury’s finding that we infringed two of the threeremaining patents. We appealed the judgment on July 16, 2002. On September 12,2003, the Court of Appeals upheld the jury’s verdict. On November 18,2003, the Court of Appeals denied our request for a rehearing, and in December 2003we paid Atmel $37.8 million to satisfy the judgment plus statutory interestaccrued during the appeals. The payment was recorded as other operating expensein the year ending December 31, 2003. In addition, on June 28, 2004we paid $247 thousand of legal related expenses incurred by Atmel pursuant tothe court order.

The third patent remaining in the case, the ‘903patent, expired in September 2001. The trial court has held that, if it isfound to be valid, certain of our products infringed that patent. A trial todetermine whether the ‘903 patent is invalid began on July 29, 2002. On August 5,2002 the jury announced that it was unable to reach a verdict on our invaliditydefense, and a mistrial was declared. Atmel requested a new trial, but theCourt stayed the matter until after our appeal of the earlier judgment isresolved. A new trial on the invalidity of the ‘903 patent was scheduled for August 1,2005, but on June 30, 2005 we signed an agreement with Atmel to settle thelitigation. Under the terms of that agreement, Atmel released us and ourcustomers from any liability under the ‘903 patent and agreed to dismiss the suitwith prejudice in return for a settlement payment. On July 27, 2005, theCourt entered an Order dismissing the case.

In January and February 2005, multipleputative shareholder class action complaints were filed against SST and certaindirectors and officers, in the United States District Court for the NorthernDistrict of California, following our announcement of anticipated financialresults for the fourth quarter of 2004. On March 24, 2005, the putativeclass actions were consolidated under the caption *In re Silicon Storage Technology, Inc., Securities Litigation,*Case No. C 05 00295 PJH (N.D. Cal.). On May 3, 2005, the HonorablePhyllis J. Hamilton appointed the “Louisiana Funds Group,” consisting of theLouisiana School Employees’ Retirement System and the Louisiana DistrictAttorneys’ Retirement System, to serve as lead plaintiff and the law firms ofPomeranz Haudek Block Grossman & Gross LLP and Berman DeValerio PeaseTabacco Burt & Pucillo to serve as lead counsel and liason counsel,respectively, for the class. The lead plaintiff filed a Consolidated Amended Class ActionComplaint 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 to dismiss the complaint on September 16,2005. Plaintiff served an opposition to the motion to dismiss on November 4,2005. Our reply in further support of the motion to dismiss was filed on December 19,2005. On January 18, 2006, the Court heard arguments on the motion todismiss. On March 10, 2006, the Court granted our motion to dismiss theconsolidated amended complaint, with leave to file an amended complaint.Pursuant to the Court’s Order, any amended complaint must be filed no laterthat April 14, 2006. We intend to take all appropriate action in responseto these lawsuits. The impact related to the outcome of these matters isundeterminable at this time.

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

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From time to time, we arealso involved in other legal actions arising in the ordinary course of business.We have accrued certain costs associated with defending these matters. Therecan be no assurance that the shareholder class action complaints, theshareholder derivative complaints or other third party assertions will beresolved without costly litigation, in a manner that is not adverse to ourfinancial position, results of operations or cash flows or without requiringroyalty payments in the future which may adversely impact gross margins. Noestimate can be made of the possible loss or possible range of loss associatedwith the resolution of these contingencies. Asa result, no losses have been accrued in our financial statements as of December 31,2005.

**6. Line of Credit**

On August 11, 2005, we entered into a 1-yearloan and security agreement with Cathay Bank, a U.S. bank, for a $35.0 millionrevolving line of credit, all of which was available to us as of December 31,2005. 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 interestrate for the line of credit is 1% below the prime rate reported from time totime by the Wall Street Journal, Western Edition (7.25% at December 31,2005). The line of credit is collateralized by substantially all of the assetsof SST other than intellectual property. The agreement contains certainfinancial covenants, including the levels of qualifying accounts receivable andinventories, which could limit the availability of funds under the agreement. There were no borrowings under this line as of December 31,2005.

On July 16, 2004, weentered into a 2-year loan agreement with Cathay Bank, a U.S. bank, for a$3.0 million revolving line of credit. The interest rate for the line of creditis 3.475% per annum. The line of credit is collateralized by a $3.0 millioncertificate of deposit which is included in non-current other assets. Thecertificate of deposit matures in July 2006 and carries an interest rateof 2.6% per annum. As of December 31, 2004, there were no borrowings underthis line of credit. As of December 31, 2005, we had borrowed $3.0 millionunder our line of credit.

**7. Acquisitions**

*ActransSystems Inc.**  *On April 11,2005, we acquired substantially all of the outstanding capital stock of ActransSystems Inc., or Actrans, a privately held fabless semiconductor companyincorporated and existing under the laws of the Republic of China that designsflash memory and EEPROM. On May 31, 2005, we acquired the remainingoutstanding shares of Actrans. The transaction was accounted for under thepurchase method of accounting and the net assets and results of operations ofActrans were included in the consolidated financial statements from the date ofthe acquisition. We have incorporate Actrans’ split-gate NAND flash technologyinto our portfolio of licensable intellectual property. Actrans engineers havebeen merged into our memory products development team both in Taiwan and theUnited States.

Theaggregate purchase price was $19.9 million, including $4.9 million of cash,common stock valued at $14.7 million and costs related to the acquisition of$218 thousand. The fair value of the 4,358,255 shares of our common stockissued to Actrans was determined based on the average closing price of ourcommon stock over a trading period from two days before to two days after theclose. Below is a summary of the total purchase price (in thousands):

| Cash                     |   | $      | 4,917  |   |
|--------------------------|--------|--------|--------|--------|
| Common Stock             |   | 14,722 |   |
| Direct acqusition  costs |   | 218    |   |
| Total purchase  price    |   | $      | 19,857 |   |

 

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Thetotal purchase price was allocated to the estimated fair value of the assetsacquired and liabilities assumed as follows (in thousands):

| Fair value of  tangible net assets acquired                     |   | $      | 3,557  |   |
|-----------------------------------------------------------------|--------|--------|--------|--------|
| Exisiting  technology                                           |   | 3,370  |   |
| In-process  research and development                            |   | 1,520  |   |
| Non-compete  agreements                                         |   | 810    |   |
| Goodwill                                                        |   | 14,449 |   |
| Customer  relationships and backlog                             |   | 920    |   |
| Trade accounts  payable, accrued expenses and other liabilities |   | (4,769 | )      |
|                                                            |   | $      | 19,857 |   |

 

We value the existing technology and in-processresearch and development, or IPR&D, utilizing a discounted cash flow modelwhich uses forecasts of future revenues and expenses related to the intangibleassets. We utilized a discount rate of 16% for existing technology, 35% forin-process research and development and 17% for the non-compete agreements. Theexisting technology is amortized to cost of revenues over its estimated livesof four to six years. The non-compete agreements are amortized to operatingexpenses over their contract periods of two to four years. As of December 31, 2005, existing technologyand non-compete agreements are all included in intangible assets.

In-process research and development of $1.5 million wasexpensed and included in other operating expenses as of the date of theacquisition in 2005.

The $14.4 million in goodwill was allocated $1.0million to each of the SMPG, ASPG and SPG segments and $11.4 million to theLicense segment, none of which was tax deductible.

*EmosynLLC.**  *On September 10,2004, we consummated the acquisition of an 83.6% ownership of privately heldEmosyn LLC, or Emosyn, for an aggregate cash purchase price of approximately$16.0 million including costs related to the acquisition. Emosyn is a fablesssemiconductor manufacturer specializing in the design and marketing of smartcard ICs for subscriber identification module, or SIM, card applications. Webelieve that the acquisition will help Emosyn leverage our foundry relationshipsand manufacturing operation infrastructure in order to meet the rising demandfor Emosyn’s smart card products. The acquisition also provides us theopportunity to establish SuperFlash technology as the technology-of-choice inthe strategically important smart card products. The acquisition was accountedfor under the purchase method of accounting, and accordingly, the net assetsand results of operations of the acquired business were included in theconsolidated financial statements from the date of acquisition.

Thetotal purchase price was allocated to the estimated fair value of the assetsacquired and liabilities assumed as follows (in thousands):

| Fair value of  tangible net assets acquired                     |   | $      | 9,252  |   |
|-----------------------------------------------------------------|--------|--------|--------|--------|
| Existing  technology                                            |   | 6,029  |   |
| In-process  research and development                            |   | 1,988  |   |
| Trade name                                                      |   | 1,093  |   |
| Customer  relationships                                         |   | 549    |   |
| Backlog                                                         |   | 712    |   |
| Trade accounts  payable, accrued expenses and other liabilities |   | (3,621 | )      |
|                                                            |   | $      | 16,002 |   |

 

We valued the existing technology and IPR&Dutilizing a discounted cash flow model that uses forecasts of future revenuesand expenses related to the intangible asset. We utilized a discount rate of 

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30% for existingtechnology, trade name and customer relationships, 50% for in-process researchand development and 18% for backlog, respectively. The existing technology isamortized to cost of revenues over their estimated lives of five years. Thetrade name, customer relationships and backlog are amortized to operatingexpense over their estimated lives of one to five years. As of December 31,2005, existing technology, trade name, customer relationships and backlog areall included in intangible assets.

In-process research and development of $2.0 millionwas expensed and included in other operating expenses as of the date of the acquisition.

On April 15,2005, we acquired the remaining 16.4% outstanding minority interest held inEmosyn for cash of $3.1 million. The transaction was accounted for as apurchase in the second quarter of 2005. The total purchase price was allocatedto the estimated fair value of the assets acquired and liabilities assumed asfollows (in thousands):

| Minority interest                    |   | $   | 2,122  |   |
|--------------------------------------|--------|-----|--------|--------|
| Existing  technology                 |   | 578 |   |
| In-process  research and development |   | 190 |   |
| Trade name                           |   | 105 |   |
| Customer  relationships              |   | 53  |   |
| Backlog                              |   | 68  |   |
| Total purchase  price                |   | $   | 3,116  |   |

 

In-process research and development acquired of $190thousand was expensed and included in other operating expenses as of the dateof the acquisition of the minority interest in 2005.

*G-Plus, Inc.**  *On November 5, 2004, we purchased substantiallyall the assets of G-Plus Inc., or G-Plus, a privately held company located inSanta Monica, California. The acquisition was accounted for under the purchasemethod of accounting, and accordingly, the net assets and results of G-Plus’operations have been included in the consolidated financial statements sincethat date. G-Plus is a semiconductor manufacturer specializing in the designand marketing of radio frequency ICs and monolithic microwave ICs for a widerange of wireless and multimedia applications. The acquisition provides us theopportunity to make SuperFlash the embedded memory of choice for wirelessapplications. We also believe that the acquisition will help G-Plus leverageour foundry relationships and manufacturing operation infrastructure in orderto meet the rising demand for G-Plus wireless products.

The aggregatepurchase price was $26.9 million, including $4.6 million of cash, common stockvalued at $22.1 million and costs related to the acquisition of $200 thousand. Thefair value of the 3,030,082 shares of our common stock issued to the formerstockholders of G-Plus was determined based on the average closing price of theCompany’s common stock over a two-day trading period prior to the closing date.Below is a summary of the total preliminary purchase price (in thousands):

| Cash                      |   | $      | 4,600  |   |
|---------------------------|--------|--------|--------|--------|
| Common stock              |   | 22,074 |   |
| Acquisition  direct costs |   | 194    |   |
| Total purchase  price     |   | $      | 26,868 |   |

 

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Thetotal purchase price was allocated to the estimated fair value of the assetsacquired and liabilities assumed as follows (in thousands):

| Fair value of  tangible net assets acquired                     |   |   | $      | 5,983  |   |   |
|-----------------------------------------------------------------|--------|--------|--------|--------|--------|--------|
| Existing  technology                                            |   |   | 1,814  |   |   |
| In-process  research and development                            |   |   | 3,908  |   |   |
| Customer  relationships                                         |   |   | 355    |   |   |
| Backlog                                                         |   |   | 11     |   |   |
| Goodwill                                                        |   |   | 15,600 |   |   |
| Trade accounts  payable, accrued expenses and other liabilities |   |   | (803   | )      |   |
| Total purchase  price                                           |   |   | $      | 26,868 |   |   |

 

We valued the existing technology and in-process researchand development, or IP R&D, utilizing a discounted cash flow model whichuses forecasts of future revenues and expenses related to the intangible asset.We utilized a discount rate of 28% for existing technology and customerrelationships, 30-35% for in-process research and development projects,and 26% for backlog, respectively. The existing technology is amortized to costof revenues over its estimated life of four years. The customer relationshipsand backlog are amortized to cost of revenues over their estimated lives of oneto three years. As of December 31, 2005, existing technology, customerrelationships and backlog are all included in intangible assets.

Thefollowing unaudited pro forma financial information presents the combinedresults of operations of Actrans, Emosyn and G-Plus as if the acquisitions hadoccurred as of the beginning of 2005 and 2004. The pro forma financialinformation does not necessarily reflect the results of operations that wouldhave occurred had the combined companies constituted a single entity duringsuch periods, and is not necessarily indicative of results which may beobtained in the future.

| ** **                                | ** ** | **Decemer 31,** | ** ** |
|-------------------------------------------|------------|----------------------|------------|
| ** **                                | ** ** | **2004**             | ** ** | **2005** | ** ** |
| ** **                                | ** ** | **(unaudited)**      | ** ** |
| Revenue                                   |       | $                    | 473,295    |   | $ | 431,498 |   |
| Net income (loss)                         |       | $                    | 13,354     |   | $ | (30,723 | ) |
| Net income (loss)  per share—basic   |       | $                    | 0.13       |   | $ | (0.30 | ) |
| Net income (loss) per  share—diluted |       | $                    | 0.13       |   | $ | (0.30 | ) |

 

**8. Goodwill and Intangible Assets:**

As discussed in note 7, our acquisitions of Emosyn,G-Plus and Actrans included the acquisition of $16.5 million offinite-lived intangible assets. The acquisition of G-Plus and Actrans alsoincluded the acquisition of $29.6 million of goodwill. The goodwill is notbeing amortized but is tested for impairment annually, as well as when an eventor circumstance occurs indicating a possible impairment in value.

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

| ** **              | ** ** | ** ** | ** ** | **Accumulated**  | ** ** | ** ** | ** ** |
|-------------------------|------------|------------|------------|------------------|------------|------------|------------|
| ** **              | ** ** | **Cost**   | ** ** | **Amortization** | ** ** | **Net**    | ** ** |
| Existing  technology    |       | $          | 11,791     |             |       | $          | 2,829      |   |   | $ | 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 |   |

 

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As of December 31,2004, our intangible assets consisted of the following (in thousands):

| ** **              | ** ** | ** ** | ** ** | **Accumulated**  | ** ** | ** ** | ** ** |
|-------------------------|------------|------------|------------|------------------|------------|------------|------------|
| ** **              | ** ** | **Cost**   | ** ** | **Amortization** | ** ** | **Net**    | ** ** |
| Existing  technology    |       | $          | 7,843      |             |       | $          | 437        |   |   | $ | 7,406 |   |   |
| Trade name              |       | 1,093      |       |             | 67         |       |       | 1,026 |   |   |
| Customer  relationships |       | 904        |       |             | 73         |       |       | 831 |   |   |
| Backlog                 |       | 723        |       |             | 219        |       |       | 504 |   |   |
|                    |       | $          | 10,563     |             |       | $          | 796        |   |   | $ | 9,767 |   |   |

 

All intangible assets are being amortized on astraight-line method over their estimated useful lives. Existing technologieshave been assigned useful lives of between four and five years, with aweighted average life of approximately 4.6 years. Non-compete agreements havebeen assigned useful lives between two and four years, with a weighted averageof 3.6 years. Trade names, customer relationships and backlogs have beenassigned useful lives of five years, four years and one year, respectively.Amortization expense was $796 thousand and $3.9 million in 2004 and 2005,respectively.

Estimatedfuture intangible asset amortization expense for the next five years is asfollows (in thousands):

| ** ** | ** ** | **Amortization of**   | ** ** |
|------------|------------|----------------------------|------------|
| ** ** | ** ** | **Intangible Assets** | ** ** |
| 2006       |       |                       | $          | 3,570 |   |   |
| 2007       |       |                       | 3,427      |   |   |
| 2008       |       |                       | 3,096      |   |   |
| 2009       |       |                       | 1,634      |   |   |
| 2010       |       |                       | 89         |   |   |
|       |       |                       | $          | 11,816 |   |   |

 

Thechanges in the carrying amount of goodwill for the year ended December 31,2005 is as follows (in thousands):

| Balance as of  December 31, 2004 |   |   | $      | 15,600 |   |   |
|---------------------------------------|--------|--------|--------|--------|--------|--------|
| Acquisitions                          |   |   | 14,449 |   |   |
| Adjustments                           |   |   | (412   | )      |   |
| Balance as of  December 31, 2005 |   |   | $      | 29,637 |   |   |

 

For the year ended December 31,2005, our adjustments to goodwill included a $412 thousand decrease due tothe realization of previously reserved net operating losses previously reservedfrom the SCC acquisition.

**9. Stock-based Compensation:**

***Employee Stock Purchase Plan:***

Our 1995 Employee StockPurchase Plan, or the Purchase Plan, as amended, has 6.0 million sharesreserved for issuance. Through July 31, 2005, the Purchase Plan providesfor eligible employees to purchase shares of common stock at a price equal to85% of the fair market value of our common stock on the date of the optiongrant, or, if lower, 85% of the fair market value of our common stock sixmonths after the option grant, by withholding up to 10 percent of their annualbase earnings. Since July 31, 2005, the Purchase Plan provides foreligible employees to purchase shares of common stock at a price equal to 90%of the fair value of our common stock six months after the option date bywithholding up to 10% of 

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theirannual base earnings. At December 31, 2005, 1.1 million shares wereavailable for purchase under the Purchase Plan. Shares issued under thePurchase Plan in 2003, 2004 and 2005 were 931 thousand, 507 thousandand 769 thousand, respectively.

***Equity Incentive Plan:***

Our 1995 Equity Incentive Plan, or the EquityIncentive Plan, as amended, has 31.8 million shares of common stockreserved for issuance upon the exercise of stock options to our employees,directors, consultants and affiliates.

Under the Equity IncentivePlan, the Board of Directors has the authority to determine to whom optionswill be granted, the number of shares under option, the option term and theexercise price. The options generally are exercisable beginning one year fromdate of grant and generally thereafter over periods ranging from four to fiveyears from the date of grant. The term of any options issued may not exceed tenyears from the date of grant.

***Directors’ Stock Option Plan:***

Each of our non-employee directors receives stockoption grants under our 1995 Non-Employee Directors’ Stock Option Plan, or theDirectors’ Plan. In April 2005, the Board of Directors amended theDirectors’ Plan. Pursuant to the Directors’ Plan, upon each non-employeedirector’s initial election or appointment to the Board, such new non-employeedirector receives an initial stock option grant for 45,000 shares of commonstock. Each initial stock option grant vests as to 25% of the shares subject tothe grant on the yearly anniversary of the grant date. Previously, each suchinitial stock option 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 December 31, 2005,the Directors’ Plan had 199 thousand shares available for issuance.

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Activityunder the Equity Incentive Plan and Directors’ Plan are as follows (in thousands,except per share data):

| ** **                        | ** ** | **Available** | ** ** | ** **                   | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
|-----------------------------------|------------|---------------|------------|------------------------------|------------|-------------------------------|------------|------------|------------|------------|------------|------------|------------|--------------|------------|
| ** **                        | ** ** | **for**       | ** ** | **Options Outstanding** | ** ** | **Average**                   | ** ** |
| ** **                        | ** ** | **Grant**     | ** ** | **Shares**                   | ** ** | **Price Per Share** | ** ** | **Amount** | ** ** | **Price**  | ** ** |
| Balances,  December 31, 2002 |       |          | 5,054      |                         |       | 10,654                        |       | $          | 0.05       |       | -          |       | $          | 29.44        |       | $ | 79,510 |   |   | $ | 7.46 |   |   |
| Granted                           |       |          | (1,337     | )                            |       | 1,337                         |       | 2.30       |       | -          |       | 13.57      |       | 11,460       |       |   | 8.57 |   |   |
| Exercised                         |       |          | —     |                         |       | (1,102                        | )          | 0.05       |       | -          |       | 10.29      |       | (2,305       | )          |   | 2.09 |   |   |
| Terminated                        |       |          | 742        |                         |       | (742                          | )          | 0.95       |       | -          |       | 26.02      |       | (9,595       | )          |   | 12.98 |   |   |
| Authorized                        |       |          | 1,650      |                         |       | —                        |       | —     |       |       |       | —     |       | —       |       |   | — |   |   |
| Balances,  December 31, 2003 |       |          | 6,109      |                         |       | 10,147                        |       | 0.07       |       | -          |       | 29.44      |       | 79,070       |       |   | 7.79 |   |   |
| Granted                           |       |          | (2,395     | )                            |       | 2,395                         |       | 5.77       |       | -          |       | 16.34      |       | 19,531       |       |   | 8.15 |   |   |
| Exercised                         |       |          | —     |                         |       | (1,067                        | )          | 0.07       |       | -          |       | 11.81      |       | (2,786       | )          |   | 2.61 |   |   |
| Terminated                        |       |          | 444        |                         |       | (444                          | )          | 2.83       |       | -          |       | 26.02      |       | (4,998       | )          |   | 11.25 |   |   |
| Authorized                        |       |          | —     |                         |       | —                        |       | —     |       |       |       | —     |       | —       |       |   | — |   |   |
| Balances,  December 31, 2004 |       |          | 4,158      |                         |       | 11,031                        |       | 0.08       |       | -          |       | 29.44      |       | 90,817       |       |   | 8.23 |   |   |
| Granted                           |       |          | (2,469     | )                            |       | 2,469                         |       | 2.62       |       | -          |       | 5.51       |       | 10,460       |       |   | 4.24 |   |   |
| Exercised                         |       |          | —     |                         |       | (342                          | )          | 0.08       |       | -          |       | 4.71       |       | (719         | )          |   | 2.10 |   |   |
| Terminated                        |       |          | 1,471      |                         |       | (1,471                        | )          | 1.35       |       | -          |       | 26.02      |       | (14,849      | )          |   | 10.10 |   |   |
| Balances,  December 31, 2005 |       |          | 3,160      |                         |       | 11,687                        |       | $          | 0.44       |       | -          |       | $          | 29.44        |       | $ | 85,709 |   |   | $ | 7.33 |   |   |

 

At December 31, 2003, 2004 and 2005, 6.9 million,6.9 million and 7.1 million options were exercisable at aweighted-average exercise price per share of $7.96, $8.59 and $8.01,respectively.

Theoptions outstanding and currently exercisable by exercise price under theEquity Incentive Plan and the Directors’ Plan at December 31, 2005 are asfollows (in thousands, except per exercise price data):

| ** ** | ** ** | ** **                              | ** ** | **Options Outstanding** | ** ** | **Options Exercisable**                         | ** ** |
|------------|------------|-----------------------------------------|------------|------------------------------|------------|------------------------------------------------------|------------|
| ** ** | ** ** | **Range of  Exercise Prices** | ** ** | **Number  Outstanding**      | ** ** | **Weighted-  Average  Remaining  Contractual  Life** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Number  Outstanding** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** |
|       |       | $                                       | 0.44       |                         | -          |                                                 | $          | 2.00 |   |   | 1,416 |   |   |   | 2.23 |   |   |   | $ | 1.15 |   |   |   | 1,416 |   |   |   | $ | 1.15 |   |   |
|       |       | $                                       | 2.08       |                         | -          |                                                 | $          | 3.65 |   |   | 1,636 |   |   |   | 6.50 |   |   |   | $ | 2.97 |   |   |   | 1,062 |   |   |   | $ | 3.00 |   |   |
|       |       | $                                       | 3.72       |                         | -          |                                                 | $          | 4.63 |   |   | 1,322 |   |   |   | 6.66 |   |   |   | $ | 4.41 |   |   |   | 901 |   |   |   | $ | 4.44 |   |   |
|       |       | $                                       | 4.69       |                         | -          |                                                 | $          | 5.02 |   |   | 1,177 |   |   |   | 8.34 |   |   |   | $ | 4.91 |   |   |   | 262 |   |   |   | $ | 4.92 |   |   |
|       |       | $                                       | 5.05       |                         | -          |                                                 | $          | 6.48 |   |   | 1,342 |   |   |   | 8.69 |   |   |   | $ | 5.95 |   |   |   | 217 |   |   |   | $ | 5.79 |   |   |
|       |       | $                                       | 6.66       |                         | -          |                                                 | $          | 8.61 |   |   | 1,258 |   |   |   | 8.00 |   |   |   | $ | 7.65 |   |   |   | 548 |   |   |   | $ | 7.92 |   |   |
|       |       | $                                       | 8.63       |                         | -          |                                                 | $          | 9.85 |   |   | 1,190 |   |   |   | 6.24 |   |   |   | $ | 9.30 |   |   |   | 660 |   |   |   | $ | 9.31 |   |   |
|       |       | $                                       | 9.92       |                         | -          |                                                 | $          | 17.79 |   |   | 1,232 |   |   |   | 6.18 |   |   |   | $ | 12.44 |   |   |   | 922 |   |   |   | $ | 12.41 |   |   |
|       |       | $                                       | 18.56      |                         | -          |                                                 | $          | 28.35 |   |   | 1,097 |   |   |   | 4.34 |   |   |   | $ | 21.06 |   |   |   | 1,097 |   |   |   | $ | 21.06 |   |   |
|       |       | $                                       | 29.44      |                         | -          |                                                 | $          | 29.44 |   |   | 17 |   |   |   | 4.50 |   |   |   | $ | 29.44 |   |   |   | 17 |   |   |   | $ | 29.44 |   |   |
|       |       | $                                       | 0.44       |                         | -          |                                                 | $          | 29.44 |   |   | 11,687 |   |   |   | 6.33 |   |   |   | $ | 7.33 |   |   |   | 7,102 |   |   |   | $ | 8.01 |   |   |

 

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Thefair value of each option grant for both of the SST stock option plans areestimated on the date of grant using the Black-Scholes multiple options pricingmodel with the following weighted average assumptions by year:

| ** **               | ** ** | **Year ended December 31,** | ** ** |
|--------------------------|------------|--------------------------------------------|------------|
| ** **               | ** ** | **2003**                                   | ** ** | **2004** | ** ** | **2005** | ** ** |
| Risk-free  interest rate |       | 2.4 - 3.1                                  | %          | 2.7 - 3.9 | % | 3.7 - 4.2 | % |
| Expected term of  option |       | 5 years                                    |       | 5 years |   | 5 years |   |
| Expected  volatility     |       | 99                                         | %          | 94 | % | 84 | % |
| Expected dividend yield  |       | 0                                          | %          | 0 | % | 0 | % |

 

Thefair value of each stock right grant for the employee stock purchase plan isestimated using the Black-Scholes model with the following weighted averageassumptions by year:

| ** **               | ** ** | **Year ended December 31,** | ** ** |
|--------------------------|------------|--------------------------------------------|------------|
| ** **               | ** ** | **2003**                                   | ** ** | **2004** | ** ** | **2005** | ** ** |
| Risk-free interest  rate |       | 1.0 - 1.4                                  | %          | 1.2 - 2.1 | % | 2.7 - 3.7 | % |
| Expected term of  right  |       | 1/2 year                                   |       | 1/2 year |   | 1/2 year |   |
| Expected  volatility     |       | 86                                         | %          | 74 | % | 57 | % |
| Expected dividend yield  |       | 0                                          | %          | 0 | % | 0 | % |

 

Option grants and PurchasePlan rights are priced at the date of grant. The risk-free interest rate rangerepresents the low and high end of the range used at different points duringthe year.

**10. Shareholders’ Equity:**

***Authorized Capital Shares:***

Our authorized capitalshares consist of 250.0 million shares of common stock and 7.0 million sharesof preferred stock. Of the preferred stock, 450 thousand shares have beendesignated as series A junior participating preferred stock. All of our capitalshares have no par value.

***Share Purchase Rights Plan:***

We have a Share Purchase RightsPlan, adopted in May 1999 and subsequently amended, in which preferredstock rights were distributed as a rights dividend at a rate of one right foreach share of common stock held as of the close of business on May 27,1999. Preferred stock rights will also be issued with any new issuance ofcommon shares. Each right entitles the registered holder under certaincircumstances to purchase from us one three-hundredth (one-third of oneone-hundredth) of a share of series A junior participating preferred stock. Untilthe occurrence of certain events the preferred stock rights will betransferable with and only with the Common Shares. The effect will be todiscourage acquisitions of more than 15 percent of our common stock withoutnegotiations with our Board of Directors. The rights expire May 3, 2009.

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**11. Net Income (Loss) Per Share:**

Areconciliation of the numerator and the denominator of basic and diluted netloss per share are as follows (in thousands except for per share data):

| ** **                                       | ** ** | **Year ended December 31,** | ** ** |
|--------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                       | ** ** | **2003**                                   | ** ** | **2004** | ** ** | **2005** | ** ** |
| Numerator—Basic  and diluted                |       |                                       |       |   |   |   |   |
| Net income (loss)                                |       | $                                          | (65,167    | ) | $ | 23,929 |   | $ | (29,838 | ) |
| Denominator—Basic                           |       |                                       |       |   |   |   |   |
| Weighted average common stock outstanding        |       | 94,723                                     |       | 95,756 |   | 101,369 |   |
| Basic net income  (loss) per share               |       | $                                          | (0.69      | ) | $ | 0.25 |   | $ | (0.29 | ) |
| Numerator—Diluted:                          |       |                                       |       |   |   |   |   |
| Net income (loss)                                |       | $                                          | (65,167    | ) | $ | 23,929 |   | $ | (29,838 | ) |
| Denominator—Diluted:                        |       |                                       |       |   |   |   |   |
| Weighted average common stock outstanding        |       | 94,723                                     |       | 95,756 |   | 101,369 |   |
| Dilutive  potential of common stock equivalents: |       |                                       |       |   |   |   |   |
| Options                                          |       | —                                     |       | 3,387 |   | — |   |
|                                             |       | 94,723                                     |       | 99,143 |   | 101,369 |   |
| Diluted net income  (loss) per share             |       | $                                          | (0.69      | ) | $ | 0.24 |   | $ | (0.29 | ) |

 

Anti-dilutive stockoptions to purchase approximately 5.4 million shares of common stock with aweighted average price of $13.03 were excluded from the computation of dilutednet income per share for 2004 because the exercise price of the optionsexceeded the average fair market value of the stock for 2004. Stock options topurchase 10.1 million and 13.1 million shares of common stock with weightedaverage price of $7.79 and $6.60 were outstanding at December 31, 2003 and2005, respectively, but were not included in the computation of diluted netloss per share because we had a net loss in 2003 and 2005.

**12. Other Operating Expenses:**

Otheroperating expenses comprised (in thousands):

| ** **                           | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------|------------|--------------------------------------------|------------|
| ** **                           | ** ** | **2003**                                   | ** ** | **2004** | ** ** | **2005** | ** ** |
| Operating lease  impairment          |       | $                                          | —     |   | $ | 1,479 |   | $ | — |   |
| In-process  research and development |       | —                                     |       | 5,896 |   | 1,695 |   |
| Atmel Settlement                     |       | 37,849                                     |       | — |   | 1,250 |   |
|                                 |       | $                                          | 37,849     |   | $ | 7,375 |   | $ | 2,945 |   |

*** ***

***Operating leaseimpairment.*****  **Duringthe second quarter of 2004, we recorded a period charge to other operatingexpense of $1.5 million relating to an operating lease for an abandonedbuilding. This charge represents the estimated difference between the totaldiscounted future sublease income and our discounted lease commitments relatingto this building. At December 31, 2003, 2004 and 2005, payments made havereduced the recorded liability to $270 thousand, $976 thousand and $4 thousand,respectively.

***In-process researchand development.***   A portion of the purchaseprice of each acquisition was allocated to in-process research and developmentand immediately expensed. For 2005, the amount of in-process research anddevelopment expensed for the Actrans Systems Inc and minority interest of Emosynacquisitions was $1.5 million and $190 thousand, respectively. These costs areincluded in other operating expenses.

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***Atmel Settlement.******  ***As discussed in Note 5, in September 2003,the Federal Circuit Court issued a decision upholding the trial court verdictthat we infringed on the ‘811 and ‘829 patents in our lawsuit with Atmel. As aresult of that decision, we accrued the judgment of $36.5 million. In October 2003,the court denied our petition to reconsider its decision. In December 2003,we recorded an additional $1.3 million in settlement fees related to theinterest on the judgment from the time the judgment was entered in May 2002to the payment date of the judgment in December 2003. The total judgmentand interest of $37.8 million was paid to Atmel in December 2003. In 2005,we paid Atmel $1.25 million to in settlement fees for the ‘903 patent lawsuit.

**13.Impairment of Equity Investments:**

During 2003, Insyde, a company in which we have aninvestment, completed an initial public offering on the Taiwan Stock Exchange.Since the initial public offering there had been a significant decline in themarket value of the investment. During 2004, we recognized a $509 thousand lossfrom the impairment of our equity investment because Insyde’s stock price had declinedbelow the acquisition cost for more than six months. We could not conclude thatthe value of our investment would be recovered in the foreseeable future. Theimpairment was, therefore, considered to be “other-than-temporary” in nature,thus the investment value was permanently written down to reflect the fairvalue.

During the fourth quarterof 2005, we wrote down our investment in Advanced Chip Engineering Technology,or ACET, a company in which we have an investment,  as they intend on issuing an additional roundof equity financing at a lower per share price than our existing carryingvalue. We could not conclude that the price of ACET stock will rise in theforeseeable future, and therefore, the value of our investment would berecovered. Consequently, we recorded an impairment charge of $2.2 million onour existing investment.

**14. Comprehensive Income (Loss)**

Thecomponents of comprehensive income (loss), net of tax, are as follows (inthousands):

| ** **                                             | ** ** | **For the Year Ended  December 31** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                             | ** ** | **2004**                                                | ** ** | **2005** | ** ** |
| Net income (loss)                                      |       | $                                                       | 23,929     |   | $ | (29,838 | ) |
| Other  comprehensive income:                           |       |                                                    |       |   |   |
| Change in unrealized gains on investments, net of  tax |       | 7,337                                                   |       | 15,259 |   |
| Change in cumulative translation adjustment            |       | 27                                                      |       | (21 | ) |
| Total comprehensive  income                            |       | $                                                       | 31,293     |   | $ | (14,600 | ) |

 

Thecomponents of accumulated other comprehensive income are as follows (inthousands):

| ** **                                       | ** ** | **As of December 31,** | ** ** |
|--------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                       | ** ** | **2004**                              | ** ** | **2005** | ** ** |
| Net unrealized  gains on investments, net of tax |       | $                                     | 16,515     |   | $ | 31,774 |   |
| Cumulative  translation adjustment               |       | 27                                    |       | 6 |   |
|                                             |       | $                                     | 16,542     |   | $ | 31,780 |   |

 

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**15. Income Taxes:**

Theprovision for income taxes reflected in the Statements of Operations for theyears ended December 31, 2003, 2004 and 2005 are as follows (inthousands):

| ** ** | ** ** | **Year ended December 31,** | ** ** |
|------------|------------|--------------------------------------------|------------|
| ** ** | ** ** | **2003**                                   | ** ** | **2004** | ** ** | **2005** | ** ** |
| Current:   |       |                                       |       |   |   |   |   |
| Federal    |       | $                                          | 2,516      |   | $ | 736 |   | $ | 6 |   |
| State      |       | 2                                          |       | 2 |   | 7 |   |
| Foreign    |       | 1,580                                      |       | 3,168 |   | 2,024 |   |
|       |       | 4,098                                      |       | 3,906 |   | 2,037 |   |
| Deferred:  |       |                                       |       |   |   |   |   |
| Federal    |       | 16,818                                     |       | — |   | 412 |   |
| State      |       | 5,500                                      |       | — |   | — |   |
|       |       | 22,318                                     |       | — |   | 412 |   |
|       |       | $                                          | 26,416     |   | $ | 3,906 |   | $ | 2,449 |   |

 

Oureffective tax rate (benefit)/provision differs from the statutory federalincome tax rate as shown in the following schedule:

| ** **                           | ** ** | **Year ended December 31,** | ** ** |
|--------------------------------------|------------|--------------------------------------------|------------|
| ** **                           | ** ** | **2003**                                   | ** ** | **2004** | ** ** | **2005** | ** ** |
| United States  statutory rate        |       | (35.0                                      | )%         | 35.0 | % | (35.0 | )% |
| State taxes, net  of federal benefit |       | —                                     |       | — |   | 0.2 |   |
| Foreign taxes, net                   |       | 4.0                                        |       | 12.9 |   | 43.9 |   |
| Research and  development credit     |       | (4.8                                       | )          | (4.0 | ) | (8.9 | ) |
| Tax exempt  interest                 |       | (2.0                                       | )          | (2.6 | ) | (0.7 | ) |
| Change in  estimated tax contingency |       | —                                     |       | (1.5 | ) | 2.8 |   |
| Change in  valuation allowance       |       | 106.1                                      |       | (30.5 | ) | 5.2 |   |
| Write offs                           |       | —                                     |       | 4.9 |   | — |   |
| Other                                |       | (0.1                                       | )          | (0.2 | ) | 1.4 |   |
|                                 |       | 68.2                                       | %          | 14.0 | % | 8.9 | % |

 

As of December 31,2004 and 2005 our deferred tax assets and liabilities consisted of (inthousands):

| ** **                                   | ** ** | **December 31,** | ** ** |
|----------------------------------------------|------------|-----------------------|------------|
| ** **                                   | ** ** | **2004**              | ** ** | **2005** | ** ** |
| Allowance for  excess and obsolete inventory |       | $                     | 237        |   | $ | 132 |   |
| Allowance for  sales returns                 |       | 27                    |       | 29 |   |
| Allowance for  doubtful accounts             |       | 48                    |       | 35 |   |
| Other                                        |       | 2,500                 |       | 2,078 |   |
| Capitalized  research and development        |       | 1,591                 |       | 1,108 |   |
| Net operating  loss carry-forwards           |       | 1,456                 |       | 9,492 |   |
| Depreciation                                 |       | 1,902                 |       | 853 |   |
| Tax credits                                  |       | 20,213                |       | 26,525 |   |
| Total deferred  tax asset                    |       | $                     | 27,974     |   | $ | 40,252 |   |
| Valuation  allowance                         |       | (27,191               | )          | (39,682 | ) |
| Acquired  intangibles                        |       | (783                  | )          | (570 | ) |
|                                         |       | $                     | —     |   | $ | — |   |

 

86

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During 2005, we maintained a full valuation allowanceon our net deferred tax assets. The valuation allowance was determined inaccordance with the provisions of Statement of Financial Accounting Standards No. 109,or SFAS No. 109, “Accounting for Income Taxes,” which requires anassessment of both positive and negative evidence when determining whether itis more likely than not that deferred tax assets are recoverable; suchassessment is required on a jurisdiction by jurisdiction basis. Cumulativelosses incurred in the U.S. in recent years represented sufficient negativeevidence under SFAS No. 109 and accordingly, a full valuation allowancewas recorded against U.S. deferred tax assets. We intend to maintain a fullvaluation allowance on the U.S. deferred tax assets until sufficient positiveevidence exists to support reversal of the valuation allowance.

The valuation allowance as of December 31, 2005 included deferred taxassets acquired in the Acquisition of G-Plus and Actrans. Future reversals ofthis valuation allowance will be recorded first as reductions to the basis ofgoodwill, follow by reductions of any remaining acquired intangible assets.Thereafter, any remaining valuation allowance reduction will be recorded asincome tax benefit during the period in which the valuation allowance isreversed.

At December 31, 2005, we had $15.9 million offederal net operating loss carry forward and had state net operating loss carryforward of $25.8 million. The federal net operating loss expires between 2020to 2026. The state net operating loss expires between 2006 to 2016. The netoperating loss is subject to limitations due to ownership changes, however,they should not expire because of these limitations. At December 31, 2005,we had available research and development credit carry forwards for federal andstate income tax purposes of $14.4 million and $13.1 million, respectively. Thefederal carry forwards expire between 2006 and 2026. The state carry forwardshas no expiration dates.

Undistributed earnings of foreign subsidiaries ofapproximately $81.6 million at December 31, 2005, are considered to beindefinitely reinvested and, accordingly, no provision for federal and stateincome taxes has been provided thereon. Upon distribution of those earnings inthe form of dividends or otherwise, we would be subject to both U.S. incometaxes (subject to an adjustment for foreign tax credits) and withholding taxespayable to various foreign countries.

On October 22,2004, the President signed the American Jobs Creation Act of 2004, or the Act.Among other provisions, the Act includes a temporary incentive for U.S.corporations to repatriate accumulated income earned abroad. We did notrepatriate foreign earnings under the Act. It is not anticipated that the otherprovisions of the Act will have a material impact on our effective tax rate.

**16. Segment Reporting:**

Our operations involve the design, development,manufacturing, marketing and technical support of our nonvolatile memorytechnology and products. We offer low to medium density devices that target abroad range of existing and emerging applications in the digital consumer,networking, wireless communications and Internet computing markets. Ourproducts are differentiated based upon attributes such as density, voltage,access speed, package and predicted endurance. We also license our technologyfor use in non-competing applications.

We manage our business in five reportable segments:the Standard Memory Product Group, or SMPG, the Application Specific ProductGroup, or ASPG, the Special Product Group, or SPG, the SST CommunicationsCorporation Products, or SCC, and Technology Licensing. We do not allocateamortization expense, operating expenses, interest and other income, interestexpense, impairment of equity investments and provision for or benefit fromincome taxes to any of these segments for internal reporting purposes, as we donot believe that allocating these expenses are material in evaluating abusiness unit’s performance.

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SMPG includes our standard flash memory productfamilies: the Multi-Purpose Flash, or MPF, family and the Multi-Purpose FlashPlus, or MPF+, family. These product families allow us to produce productsoptimized for cost and functionality to support a broad range of mainstreamapplications that use nonvolatile memory products. Effective July 1, 2003, wetransferred the Small Sector Flash, or SSF, family from SMPG to SPG. EffectiveJanuary 1, 2004, we transferred the last MTP series of products from SMPG toSPG. Accordingly, our segment revenues.

ASPG includes Concurrent SuperFlash, Serial Flash,Firmware Hub, or FWH, and Low Pin Count, or LPC, flash products. These productsare designed to address specific applications such as cellular phones, harddisk drives and PCs. ASPG also includes flash embedded controllers such the ATAflash disk controller to consumer, industrial and mass data storageapplications. We acquired a majority ownership of Emosyn on September 10,2004. On April 15, 2005, we acquired the remaining minority interest ofEmosyn. As a result of the acquisition of the remaining minority interest, themanagement of Emosyn’s products was integrated into ASPG. Effective for thesecond quarter of 2005, Emosyn is no longer considered its own reportablesegment by us and Emosyn’s flash memory based smart-card IC’s are now includedin ASPG. These products are used primarily in cell phone applications andinclude such benefits of use as lower power consumption, long term dataretention and high endurance of data access. Our segment revenues and grossmargin information have been reclassified for presentation purposes as if thetransfer occurred as of September 10, 2004.

SPG includes ComboMemory, ROM/RAM Combos, the SmallSector Flash, or SSF, family, Multi-Time Programmable, or MTP, family,FlashFlex51 microcontrollers and other special flash products. These productsare used in applications requiring low power and a small form factor such ascellular phones, wireless modems, MP3 players, pagers and personal digitalorganizers. Effective July 1, 2003, we transferred the SSF family fromSMPG to SPG. Effective January 1, 2004, we transferred the last MTP seriesof products from SMPG to SPG. Accordingly, our segment revenues and grossprofit information have been reclassified for presentation purposes as if thetransfer occurred as of January 1, 2003.

SCC includes RF transmitter, receiver, synthesizer,power amplifier and switch products. These products provide end-to-end RFsolutions to enable wireless multimedia and broadband networking applications. Weformed SST Communications Corporation and acquired the operations of G-Plus on November 5,2004. The segment data is reflected from this date forward.

Technology Licensing includes both license fees androyalties.

Thefollowing table shows our product revenues and gross profit (loss) for eachsegment (in thousands):

| ** **            | ** ** | **Year Ended  December 31, 2005** | ** ** |
|-----------------------|------------|--------------------------------------------------|------------|
| ** **            | ** ** | **Revenues**                                     | ** ** | **Gross  Profit (Loss)** | ** ** |
| SMPG                  |       | $                                                | 205,234    |   |   | $ | 6,510 |   |   |
| ASPG                  |       | 154,709                                          |       |   | 33,780 |   |   |
| SPG                   |       | 30,954                                           |       |   | 2,792 |   |   |
| SCC                   |       | 3,199                                            |       |   | (28 | ) |   |
| Technology  Licensing |       | 36,803                                           |       |   | 36,803 |   |   |
|                  |       | $                                                | 430,899    |   |   | $ | 79,857 |   |   |

 

88

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| ** **            | ** ** | **Year Ended  December 31, 2004** | ** ** |
|-----------------------|------------|--------------------------------------------------|------------|
| ** **            | ** ** | **Revenues**                                     | ** ** | **Gross  Profit (Loss)** | ** ** |
| SMPG                  |       | $                                                | 269,376    |   |   | $ | 48,352 |   |   |
| ASPG                  |       | 90,126                                           |       |   | 22,499 |   |   |
| SPG                   |       | 44,636                                           |       |   | 12,706 |   |   |
| SCC                   |       | 593                                              |       |   | (123 | ) |   |
| Technology  Licensing |       | 44,467                                           |       |   | 44,467 |   |   |
|                  |       | $                                                | 449,198    |   |   | $ | 127,901 |   |   |

 

| ** **            | ** ** | **Year Ended  December 31, 2003** | ** ** |
|-----------------------|------------|--------------------------------------------------|------------|
| ** **            | ** ** | **Revenues**                                     | ** ** | **Gross  Profit** | ** ** |
| SMPG                  |       | $                                                | 166,776    |   | $ | 21,428 |   |
| ASPG                  |       | 60,481                                           |       | 11,544 |   |
| SPG                   |       | 29,272                                           |       | 4,782 |   |
| Technology  Licensing |       | 38,512                                           |       | 38,512 |   |
|                  |       | $                                                | 295,041    |   | $ | 76,266 |   |

 

| ** **                            | ** ** | **Year ended December 31,** | ** ** |
|---------------------------------------|------------|--------------------------------------------|------------|
| ** **                            | ** ** | **2003**                                   | ** ** | **2004** | ** ** | **2005** | ** ** |
| Gross profit from  operating segments |       | $                                          | 76,266     |   | $ | 127,901 |   | $ | 79,857 |   |
| Amortization of  intangibles          |       | —                                     |       | (796 | ) | (2,086 | ) |
| Total gross profit                    |       | $                                          | 76,266     |   | $ | 127,105 |   | $ | 77,771 |   |

 

Ournet revenues are all denominated in U.S. dollars and are summarized as follows(in thousands):

| ** **                   | ** ** | **Year ended December 31,** | ** ** |
|------------------------------|------------|--------------------------------------------|------------|
| ** **                   | ** ** | **2003**                                   | ** ** | **2004** | ** ** | **2005** | ** ** |
| United States.               |       | $                                          | 19,600     |   | $ | 32,833 |   | $ | 21,261 |   |
| Europe                       |       | 9,957                                      |       | 28,863 |   | 32,008 |   |
| Japan.                       |       | 27,575                                     |       | 35,233 |   | 26,455 |   |
| Korea.                       |       | 25,214                                     |       | 36,715 |   | 32,702 |   |
| Taiwan                       |       | 109,254                                    |       | 125,491 |   | 74,753 |   |
| China (including  Hong Kong) |       | 76,107                                     |       | 148,100 |   | 208,658 |   |
| Other Asian  Countries       |       | 27,334                                     |       | 41,963 |   | 35,062 |   |
|                         |       | $                                          | 295,041    |   | $ | 449,198 |   | $ | 430,899 |   |

 

Foreign revenue is based on the country to which theproduct is shipped by us or our logistics center.

Thelocations and net book value of our long-lived assets as follows:

| ** **    | ** ** | **December 31,** | ** ** |
|---------------|------------|-----------------------|------------|
| ** **    | ** ** | **2004**              | ** ** | **2005** | ** ** |
| United States |       | $                     | 13,443     |   | $ | 14,692 |   |
| China         |       | 1,035                 |       | 3,111 |   |
| Taiwan        |       | 898                   |       | 1,273 |   |
| Other         |       | 1,244                 |       | 339 |   |
|          |       | $                     | 16,620     |   | $ | 19,415 |   |

 

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**17. EquityInvestments and Related Party Reporting:**

Equityinvestments comprise (in thousands):

| ** **                                       | ** ** | **December 31, 2005**       | ** ** |
|--------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                       | ** ** | **Equity  Investments  at Cost** | ** ** | **Available for Sale  Investments at  Fair Market Value** | ** ** | **Total  Equity  Investment** | ** ** |
| Advanced Chip  Engineering Technology Inc.  |       |                                  | $          | 1,772 |   |   |   | $ | — |   |   |   | $ | 1,772 |   |   |
| Apacer  Technology, Inc.                    |       |                                  | 4,357      |   |   |   | — |   |   |   | 4,357 |   |   |
| Grace  Semiconductor Mfg. Corporation            |       |                                  | 83,150     |   |   |   | — |   |   |   | 83,150 |   |   |
| Insyde Software  Corporation(1)                  |       |                                  | 448        |   |   |   | 543 |   |   |   | 991 |   |   |
| King Yuan  Electronics Company, Limited          |       |                                  | —     |   |   |   | 4,296 |   |   |   | 4,296 |   |   |
| Nanotech                                         |       |                                  | 3,316      |   |   |   | — |   |   |   | 3,316 |   |   |
| Powertech  Technology, Incorporated              |       |                                  | 445        |   |   |   | 26,537 |   |   |   | 26,982 |   |   |
| Professional  Computer Technology Limited(2)     |       |                                  | 807        |   |   |   | 7,681 |   |   |   | 8,488 |   |   |
| Silicon  Technology Co., Ltd.                    |       |                                  | 939        |   |   |   | — |   |   |   | 939 |   |   |
| Other                                            |       |                                  | 878        |   |   |   | — |   |   |   | 878 |   |   |
|                                             |       |                                  | $          | 96,112 |   |   |   | $ | 39,057 |   |   |   | $ | 135,169 |   |   |

 

| ** **                                       | ** ** | **December 31, 2004**       | ** ** |
|--------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                       | ** ** | **Equity  Investments  at Cost** | ** ** | **Available for Sale  Investments at  Fair Market Value** | ** ** | **Total  Equity  Investment** | ** ** |
| Advanced Chip  Engineering Technology Inc.  |       |                                  | $          | 4,012 |   |   |   | $ | — |   |   |   | $ | 4,012 |   |   |
| Apacer  Technology, Inc.                    |       |                                  | 4,357      |   |   |   | — |   |   |   | 4,357 |   |   |
| Grace  Semiconductor Mfg. Corporation            |       |                                  | 83,150     |   |   |   | — |   |   |   | 83,150 |   |   |
| Insyde Software  Corporation(1)                  |       |                                  | 322        |   |   |   | 266 |   |   |   | 588 |   |   |
| King Yuan  Electronics Company, Limited          |       |                                  | —     |   |   |   | 2,318 |   |   |   | 2,318 |   |   |
| Nanotech                                         |       |                                  | 3,767      |   |   |   | — |   |   |   | 3,767 |   |   |
| Powertech Technology,  Incorporated              |       |                                  | 767        |   |   |   | 14,076 |   |   |   | 14,843 |   |   |
| Professional  Computer Technology Limited(2)     |       |                                  | 675        |   |   |   | 6,434 |   |   |   | 7,109 |   |   |
| Silicon  Technology Co., Ltd.                    |       |                                  | 939        |   |   |   | — |   |   |   | 939 |   |   |
| Other                                            |       |                                  | 574        |   |   |   | — |   |   |   | 574 |   |   |
|                                             |       |                                  | $          | 98,563 |   |   |   | $ | 23,094 |   |   |   | $ | 121,657 |   |   |

----

(1)          Includes $133 thousandin convertible bonds for 2004 and 2005.

(2)          Includes $1.3 millionand $1.7 million in convertible bonds for 2004 and 2005, respectively.

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Thefollowing table is a summary of our related party revenues and purchases (inthousands):

| ** **                                                | ** ** | **Year Ended  December 31, 2005** | ** ** |
|-----------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                | ** ** | **Revenues**                                     | ** ** | **  Purchases  ** | ** ** |
| Silicon  Technology Co., Ltd                              |       | $                                                | 3,711      |   |   | $ | — |   |   |
| Apacer  Technology, Inc. & related entities |       | 2,180                                            |       |   | — |   |   |
| Professional  Computer Technology Limited                 |       | —                                           |       |   | — |   |   |
| Silicon  Professional Technology Ltd                      |       | 230,706                                          |       |   | — |   |   |
| Grace  Semiconductor Manufacturing Corp                   |       | 1,577                                            |       |   | 45,373 |   |   |
| King Yuan  Electronics Company, Limited                   |       | —                                           |       |   | 34,882 |   |   |
| Powertech  Technology, Incorporated                       |       | —                                           |       |   | 15,111 |   |   |
|                                                      |       | $                                                | 238,174    |   |   | $ | 95,366 |   |   |

 

| ** **                                                | ** ** | **Year Ended  December 31, 2004** | ** ** |
|-----------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                | ** ** | **Revenues**                                     | ** ** | **  Purchases  ** | ** ** |
| Silicon  Technology Co., Ltd                              |       | $                                                | 7,943      |   |   | $ | — |   |   |
| Apacer  Technology, Inc. & related entities |       | 2,359                                            |       |   | 707 |   |   |
| Silicon  Professional Technology Ltd                      |       | 214,195                                          |       |   | — |   |   |
| Grace  Semiconductor Manufacturing Corp                   |       | 156                                              |       |   | 59,278 |   |   |
| King Yuan  Electronics Company, Limited                   |       | —                                           |       |   | 38,248 |   |   |
| Powertech  Technology, Incorporated                       |       | —                                           |       |   | 14,718 |   |   |
|                                                      |       | $                                                | 224,653    |   |   | $ | 112,931 |   |   |

 

| ** **                                                | ** ** | **Year Ended  December 31, 2003** | ** ** |
|-----------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                | ** ** | **Revenues**                                     | ** ** | **Purchases** | ** ** |
| Silicon  Technology Co., Ltd                              |       | $                                                | 3,615      |   |   | $ | — |   |   |
| Apacer  Technology, Inc. & related entities |       | 1,555                                            |       |   | 2,361 |   |   |
| Silicon  Professional Technology Ltd                      |       | 164,810                                          |       |   | — |   |   |
| Grace  Semiconductor Manufacturing Corp                   |       | —                                           |       |   | 12 |   |   |
| King Yuan  Electronics Company, Limited                   |       | —                                           |       |   | 19,659 |   |   |
| Powertech  Technology, Incorporated                       |       | —                                           |       |   | 9,280 |   |   |
|                                                      |       | $                                                | 169,980    |   |   | $ | 31,312 |   |   |

 

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Thefollowing table is a summary of our related party accounts receivable andaccounts payable and accruals (in thousands):

| ** **                                         | ** ** | **December 31, 2004** | ** ** | **December 31, 2005**          | ** ** |
|----------------------------------------------------|------------|---------------------------------|------------|------------------------------------------|------------|
| ** **                                         | ** ** | **Trade  Accounts  Receivable** | ** ** | **Accounts  Payable and  Accruals** | ** ** | **Trade  Accounts  Receivable** | ** ** | **Accounts  Payable and  Accruals** | ** ** |
| Silicon  Technology Co., Ltd.                      |       |                            | $          | 322                                      |       |   |   | $ | — |   |   |   | $ | 370 |   |   |   | $ | — |   |   |
| Apacer  Technology, Inc. and related entities |       |                            | 458        |                                     |       |   | 320 |   |   |   | 237 |   |   |   | — |   |   |
| Professional  Computer Technology Limited          |       |                            | —     |                                     |       |   | 72 |   |   |   | — |   |   |   | 123 |   |   |
| Silicon  Professional Technology Ltd.              |       |                            | 32,037     |                                     |       |   | 694 |   |   |   | 53,785 |   |   |   | 846 |   |   |
| Grace  Semiconductor Mfg. Corp.                    |       |                            | 156        |                                     |       |   | 17,227 |   |   |   | 1,466 |   |   |   | 4,949 |   |   |
| King Yuan  Electronics Company, Limited            |       |                            | —     |                                     |       |   | 13,702 |   |   |   | — |   |   |   | 10,004 |   |   |
| Powertech  Technology, Incorporated                |       |                            | —     |                                     |       |   | 3,867 |   |   |   | — |   |   |   | 5,945 |   |   |
|                                               |       |                            | $          | 32,973                                   |       |   |   | $ | 35,882 |   |   |   | $ | 55,858 |   |   |   | $ | 21,867 |   |   |

 

In 1996, we acquired a 14% interest in SiliconTechnology Co., Ltd., or Silicon Technology, a privately held Japanese company,for $939 thousand in cash. Bing Yeh, our President, CEO and Chairman of ourBoard of Directors, is also a member of Silicon Technology’s board of directors.We acquired the interest in Silicon Technology in order to provide a presencefor our products in Japan. We now have our own office in Japan, althoughSilicon Technology continues to sell our products. At December 31, 2005,our investment, which is carried at cost, represented 8.7% of the outstandingequity of Silicon Technology. Our sales to Silicon Technology were made atprevailing market prices and the payment terms are consistent with the paymentterms extended to our other customers. We are not obligated to provide SiliconTechnology with any additional financing.

In 2000, we acquired a 10% interest in Apacer TechnologyInc, or Apacer, for $9.9 million in cash. Apacer, a privately held Taiwanesecompany and a related entity of Acer, is a memory module manufacturer. BingYeh, our President, CEO and Chairman of our Board of Directors, is also amember of Apacer’s board of directors. In 2001, we invested an additional $2.1million in Apacer. In August 2002, wemade an additional investment of $181 thousand. The investment waswritten down to $4.4 million during 2002. At December 31, 2005, ourinvestment represented 9.5% of the outstanding equity of Apacer. Our sales tothe related Acer entities were made at prevailing market prices and the paymentterms are consistent with the payment terms extended to our other customers. Ourpurchases from Apacer are made pursuant to purchase orders at prevailing marketprices. We do not have a long-term contract with Apacer to supply us withproducts. If Apacer were to terminate its relationship with us, we believe thatwe would be able to procure the necessary products from other productionsubcontractors. We are not obligated to provide Apacer with any additionalfinancing.

In 2000, we acquired a 15% interest in ProfessionalComputer Technology Limited, or PCT, a Taiwanese company, for $1.5 million incash. Bing Yeh, our President, CEO and Chairman of our Board of Directors, isalso a member of PCT’s board of directors. PCT is one of our stockingrepresentatives. In May 2002, we made an additional investment of $179thousand in PCT. During 2003, PCT completed an initial public offering on theTaiwan Stock Exchange and we sold a portion of our holdings. Under Taiwansecurity regulations, a certain number of shares must be held in a centralcustody and are restricted from sale for a period of time. The shares availablefor sale within one year are carried at the quoted market price and included inlong-term available-for-sale investments in the balance sheet as of December 31,

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2005. Shares required tobe held in custody for greater than a one year period are carried at cost andincluded in equity investments. In February 2004, we purchased $1.7million of PCT’s European convertible bonds. As of December 31, 2005, thevalue of the stock and convertible bond investment recorded as long-termavailable-for-sale is valued at $7.7 million and the restricted portion of theinvestment carried at cost is recorded at $807 thousand. At December 31,2005 our investment represented 11.5% of the outstanding equity and 13.2% ofthe European convertible bonds of PCT.

PCT and it subsidiary, Silicon Professional AllianceCorporation, or SPAC, earn commissions for point-of-sales transactions to itscustomers. Commissions to PCT and SPAC are paid at the same rate as all of ourother stocking representatives in Asia. In 2003, 2004 and 2005 we paid salescommissions of $1.2 million, $579 thousand and $315 thousand,respectively, to PCT and SPAC. Shipments, by us or our logistics center, to PCTand SPAC for reshipment accounted for 27.3%, 31.3% and 38.9% of our productshipments in 2003, 2004 and 2005. In addition, PCT and SPAC solicited sales,for which they earned a commission, for 12.0%, 3.3% and 2.0% of our shipmentsto end users in 2003, 2004 and 2005, respectively.

PCT has established a separate company andwholly-owned subsidiary, Silicon Professional Technology, Ltd., or SPT, toprovide forecasting, planning, warehousing, delivery, billing, collection andother logistic functions for us in Taiwan. SPT now services substantially allof our end customers based in Taiwan, China and other Southeast Asia countries.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. We pay SPTa fee based on a percentage of revenue for each product sold through SPT to ourend customers. The fee paid to SPT covers the cost of warehousing and insuringinventory and accounts receivable, personnel costs required to maintainlogistics and information technology functions and the costs to perform billingand collection of accounts receivable. SPT receives extended payment terms andis obligated to pay us whether or not they have collected the accountsreceivable.

We do not have any long-term contracts with SPT, PCTor SPAC, and SPT, PCT or SPAC may cease providing services to us at any time. IfSPT, PCT or SPAC were to terminate their relationship with us we wouldexperience a delay in reestablishing warehousing, logistics and distributionfunctions which would harm our business. We are not obligated to provide SPT,PCT or SPAC with any additional financing.

In 2000, we acquired a 1% interest in King YuanElectronics Company, Limited, or KYE, a Taiwanese company, which is aproduction subcontractor, for $4.6 million in cash. A member of our managementteam holds a supervisor position at KYE. The role and responsibilities of asupervisor are defined and governed by Corporate Law in Taiwan. The investmentwas made in KYE in order to strengthen the relationship between us and KYE. During2001, KYE completed an initial public offering on the Taiwan Stock Exchange. Accordingly,the investment has been included in long-term available-for-sale investments inthe balance sheet as of December 31, 2004 and 2005. The investment was writtendown to $1.3 million during 2001 and is valued at $4.3 million as of December 31,2005 based on the quoted market price.  At December 31, 2005, our investmentrepresented 0.4% of the outstanding equity of KYE. Our purchases from KYE aremade pursuant to purchase orders at prevailing market prices. We do not have along-term contract with KYE to supply us with services. If KYE were toterminate its relationship with us, we believe that we would be able to procurethe necessary services from other production subcontractors. We are notobligated to provide KYE with any additional financing.

In 2000, we acquired a 3% interest in PowertechTechnology, Incorporated, or PTI, a Taiwanese company, which is a productionsubcontractor, for $2.5 million in cash. Bing Yeh, our President, CEO andChairman of our Board of Directors, is also a member of PTI’s board ofdirectors. The investment was made in PTI in order to strengthen ourrelationship with PTI. During 2003, PTI completed an initial public offering onthe Taiwan Stock Exchange and we sold a portion of our holdings. Under Taiwansecurity regulations, a certain number of shares must be held in a centralcustody and are restricted from sale for a 

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period of time. The sharesavailable for sale within one year are carried at the quoted market price andincluded in long-term available-for-sale investments in the balance sheet as ofDecember 31, 2004 and 2005. Shares required to be held in custody forgreater than a one year period are carried at cost and included in equityinvestments. In August 2004, we invested $723 thousand cash in PTI sharesavailable for sale. As of December 31, 2005, the value of the investmentrecorded as long-term available-for-sale is valued at $26.5 million and therestricted portion of the investment carried at cost is recorded at $445thousand. At December 31, 2005, our investment represented 2.4% of theoutstanding equity of PTI. During early 2006, we sold four million shares ofPTI for approximately a net gain of $12.2 million. We hold 5.5 millionshares of PTI as of March 3, 2006. Refer to Note 19 of theConsolidated Financial Statements. Our purchases from PTI are made pursuant topurchase orders at prevailing market prices. We do not have a long-termcontract with PTI to supply us with services. If PTI were to terminate itsrelationship with us, we believe that we would be able to procure the necessaryservices from other production subcontractors. We are not obligated to providePTI with any additional financing.

We have invested $83.2 million in GSMC, a CaymanIslands company, which owns a wafer foundry subsidiary, Grace, in Shanghai,China. Bing Yeh, our President, CEO and Chairman of our Board of Directors, isalso a member of GSMC’s board of directors. In addition, a member of ourmanagement team holds one supervisor position at GSMC. The role andresponsibilities of a supervisor are defined and governed by Corporate Law inthe Cayman Islands. This investment is carried at cost. GSMC has a wholly ownedsubsidiary, Shanghai Grace Semiconductor Manufacturing Corporation, or Grace,which is a wafer foundry company with operations in China. Grace began tomanufacture our products since late 2003. We do not have a long-term contractwith Grace to supply us with products. At December 31, 2005, ourinvestment represented 9.8% of the outstanding equity of GSMC.

In 2002, we acquired a 6% interest in Insyde SoftwareCorporation, or Insyde, a Taiwanese company, for $964 thousand in cash. BingYeh, our President, CEO and Chairman of our Board of Directors, is also amember of Insyde’s board of directors. During 2003, Insyde completed an initialpublic offering on the Taiwan Stock Exchange. Under Taiwan securityregulations, a certain number of shares must be held in a central custody andare restricted from sale for a period of time. The shares available for salewithin one year are carried at the quoted market price and included inlong-term available-for-sale investments in the balance sheet as of December 31,2004 and 2005. Shares required to be held in custody for greater than a oneyear period are carried at cost and included in equity investments. In January 2004,we invested an additional $133 thousand cash in Insyde’s convertible bonds. Thestock investment was written down $509 thousand during 2004. Refer to Note 13of these Notes to the Consolidated Financial Statements. At December 31,2005, our investment represented 6.2% of the outstanding equity and 6.3% of theconvertible bonds of Insyde.

In June 2004, we acquired a 9% interest inAdvanced Chip Engineering Technology, or ACET, a privately held Taiwanesecompany for $4.0 million cash. ACET, a related entity of KYE, is a productionsubcontractor. Chen Tsai, our Senior Vice President of Worldwide BackendOperations, is also a member of ACET’s board of directors. During 2005, werecorded a $2.2 million impairment charge related to our investment in ACET.ACET is in the process of raising an additional round of equity financing at alower per share cost than our current basis. Consequently, our investment wasovervalued. At December 31, 2005 our investment, which is carried at cost,represented 9.4% of the outstanding equity of ACET.

In November 2004,we acquired a 30% interest in Nanotech Corporation, or Nanotech, a privatelyheld Cayman Island company, for $3.8 million cash. Nanotech, a developmentstage company, has a wholly owned subsidiary which is in the process ofestablishing foundry operations in China. Bing Yeh, our President, CEO and Chairmanof our Board of Directors, is also a member of Nanotech’s board of directors. TsuyoshiTaira, a member of our Board of Directors, also invested in this round offinancing. We are not obligated to provide Nanotech with any additionalfinancing. At December 31, 2005 our 

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investment, which is accounted for under the equitymethod, represented 29% of the outstanding equity of Nanotech.

**18. Employee Benefit Plans:**

***Profit Sharing Plan:***

Wehave a Profit Sharing Plan under which employees may collectively earn up to10% of our operating profit, provided that both net earnings before interestincome (expense), net provision for (benefit from) income taxes and operatingprofit are greater than 10% of sales. For purposes of the Profit Sharing Plan, “operatingprofit” is net revenues less cost of revenues and less operating expenses. Thesum paid to any particular employee as profit sharing is a function of theemployee’s length of service, performance and salary. We plan to pay profitsharing sums, when available, to employees twice a year. During 2004, profitsharing expenses of $3.7 million were recorded. No profit sharing was paid for2003 or 2005.

***401(k) Plan:***

Wehave adopted the SST 401(k) Tax Sheltered Savings Plan and Trust, or the401(k) Plan, as amended, which is intended to qualify under Section 401of the Internal Revenue Code of 1986. The 401(k) Plan covers essentiallyall U.S. employees. Each eligible employee may elect to contribute to the 401(k) Plan,through payroll deductions, up to 15% of their compensation, subject to certainlimitations. At our discretion, we may make additional contributions on behalfof employees. All employee contributions are 100% vested. During 2003, 2004 and2005, we matched the first $1,000 of each employees’ contribution, for a totalof $384 thousand, $379 thousand and $493 thousand, respectively.

**19. Subsequent Events:**

In January and February of 2006, we soldfour million common shares of our investment in Powertech Technology,Incorporated, or PTI, for a pre-tax gain of approximately $12.2 million. Wecontinue to own approximately 5.5 million shares of PTI at March 3, 2006.

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**SCHEDULE II**

**SILICONSTORAGE TECHNOLOGY, INC. VALUATION AND QUALIFYING ACCOUNTS (in thousands)**

| **Description**                                                                 | ** ** | ** ** | ** ** | **Balance at  Beginning  of Period** | ** ** | **Charged to  Costs and  Expenses** | ** ** | **Write-off  of Accounts  /Other** | ** ** | **Balance at  End of  Period** | ** ** |
|---------------------------------------------------------------------------------|------------|------------|------------|------------------------------------------------|------------|-----------------------------------------------|------------|-----------------------------------------|------------|------------------------------------------|------------|
| Year ended  December 31, 2003                                              |       |       |       | ** **                                     |       |                                          |       |                                    |       |                                     |       |   |   |   |   | ** ** |   |
| Allowance for doubtful accounts                                                 |       |       | $          | 4,420                                          | ** ** |                                          |       | $                                       | 228        |                                     |       |   | $ | (3,530 | ) |   |   | $ | 1,118 | ** ** |   |
| Allowance for sales returns                                                     |       |       | $          | 1,787                                          | ** ** |                                          |       | $                                       | 316        |                                     |       |   | $ | (802 | ) |   |   | $ | 1,301 | ** ** |   |
| Allowance for excess and obsolete inventories and  adverse purchase commitments |       |       | $          | 28,722                                         | ** ** |                                          |       | $                                       | 6,670      |                                     |       |   | $ | (23,638 | ) |   |   | $ | 11,754 | ** ** |   |
| Valuation allowance on deferred tax assets                                      |       |       | $          | —                                         | ** ** |                                          |       | $                                       | 41,114     |                                     |       |   | $ | — |   |   |   | $ | 41,114 | ** ** |   |
| Year ended  December 31, 2004                                              |       |       |       | ** **                                     |       |                                          |       |                                    |       |                                     |       |   |   |   |   | ** ** |   |
| Allowance for doubtful accounts                                                 |       |       | $          | 1,118                                          | ** ** |                                          |       | $                                       | 825        |                                     |       |   | $ | (754 | ) |   |   | $ | 1,189 | ** ** |   |
| Allowance for sales returns                                                     |       |       | $          | 1,301                                          | ** ** |                                          |       | $                                       | 1,347      |                                     |       |   | $ | (639 | ) |   |   | $ | 2,009 | ** ** |   |
| Allowance for excess and obsolete inventories and  adverse purchase commitments |       |       | $          | 11,754                                         | ** ** |                                          |       | $                                       | 35,883     |                                     |       |   | $ | (7,155 | ) |   |   | $ | 40,482 | ** ** |   |
| Valuation allowance on deferred tax assets                                      |       |       | $          | 41,114                                         | ** ** |                                          |       | $                                       | —     |                                     |       |   | $ | (13,923 | ) |   |   | $ | 27,191 | ** ** |   |
| Year ended  December 31, 2005                                              |       |       |       | ** **                                     |       |                                          |       |                                    |       |                                     |       |   |   |   |   | ** ** |   |
| Allowance for doubtful accounts                                                 |       |       | $          | 1,189                                          | ** ** |                                          |       | $                                       | (424       | )                                        |       |   | $ | (7 | ) |   |   | $ | 758 | ** ** |   |
| Allowance for sales returns                                                     |       |       | $          | 2,009                                          | ** ** |                                          |       | $                                       | 2,051      |                                     |       |   | $ | (2,483 | ) |   |   | $ | 1,577 | ** ** |   |
| Allowance for excess and obsolete inventories and  adverse purchase commitments |       |       | $          | 40,482                                         | ** ** |                                          |       | $                                       | 37,314     |                                     |       |   | $ | (26,039 | ) |   |   | $ | 51,752 | ** ** |   |
| Valuation  allowance on deferred tax assets                                     |       |       | $          | 27,191                                         | ** ** |                                          |       | $                                       | 12,327     |                                     |       |   | $ | — |   |   |   | $ | 39,518 | ** ** |   |

 

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