** **

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

----

### ** **

### **FORM 10-Q**

 
| **ý**                                             | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934**                                                         |
|--------------------------------------------------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                   |                                                                                                                                                          |
| **For the Quarterly Period Ended  June 30, 2004** |
|                                                   |                                                                                                                                                          |
| **OR**                                                 |
|                                                   |                                                                                                                                                          |
| **o**                                                  | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934**                                                        |
|                                                   |                                                                                                                                                          |
|                                                   | **For the transition period  from          to          ** |
|                                                   |                                                                                                                                                          |

**Commission File No. 0-27246**

 

**ZORAN CORPORATION**

(Exact name of registrant as specified in itscharter)

 
| **Delaware**                                                    | **94-2794449**                           |
|-----------------------------------------------------------------|------------------------------------------|
| (State or other jurisdiction  of incorporation or organization) | (I.R.S. Employer  Identification Number) |
| ** **                                                      | ** **                               |
| **1390 Kifer Road  Sunnyvale, California 94086**                |
| (Address of principal executive  offices, including zip code)   |
| ** **                                                      | ** **                               |
| **(408) 523-6500**                                              |
| (Registrant’s telephone number, including  area code)      |

 

----

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Actof 1934 during the preceding 12 months (or for such shorter period that the registrantwas required to file such reports) and (2) has been subject to such filingrequirements for the past 90 days. Yes  ýNo  o

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2 of theExchange Act).

Yes ý  No  o

 

As of August 5, 2004, there were outstanding 42,835,826 shares ofthe registrant’s Common Stock, par value $0.001 per share.

 

 

----

 

**ZORAN CORPORATION AND SUBSIDIARIES**

**FORM 10-Q**

**INDEX**

 

**For the Quarter Ended June 30, 2004**

 
| **PART I. FINANCIAL INFORMATION** | ** **                                                                                                              |
|-----------------------------------|-------------------------------------------------------------------------------------------------------------------------|
|                              |                                                                                                                    |   |
| **Item 1.**                       | Financial Statements (Unaudited):                                                                                       |   |
|                              |                                                                                                                    |   |
|                              | Condensed Consolidated Balance Sheets as of  June30, 2004 and December 31, 2003                                    |   |
|                              |                                                                                                                    |   |
|                              | Condensed Consolidated Statements of  Operations for the Three Months and Six Months Ended June 30, 2004 and  2003 |   |
|                              |                                                                                                                    |   |
|                              | Condensed Consolidated Statements of Cash  Flows for the Six Months Ended June 30, 2004 and 2003                   |   |
|                              |                                                                                                                    |   |
|                              | Notes to Condensed Consolidated Financial  Statements                                                                   |   |
|                              |                                                                                                                    |   |
| **Item 2.**                       | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                             |   |
|                              |                                                                                                                    |   |
| **Item 3.**                       | Quantitative and Qualitative Disclosures  About Market Risk                                                             |   |
|                              |                                                                                                                    |   |
| **Item 4.**                       | Controls and Procedures                                                                                                 |   |
|                              |                                                                                                                    |   |
|                              |                                                                                                                    |   |
| **PART II. OTHER INFORMATION**    | ** **                                                                                                              |
|                              |                                                                                                                    |   |
| **Item 1.**                       | Legal Proceedings                                                                                                       |   |
|                              |                                                                                                                    |   |   |
| **Item 4.**                       | Submission of Matters to a Vote of Security  Holders                                                                    |   |
|                              |                                                                                                                    |   |   |
| **Item 6.**                       | Exhibits and Reports on Form 8-K                                                                                        |   |
|                              |                                                                                                                    |   |
| Signatures                        |                                                                                                                    |   |

 

2

----

 

**ZORAN CORPORATION**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

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

**(unaudited)**

 
| ** **                                                                                                                                                                                                                                                      | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
|                                                                                                                                                                                                                                                            |       |                    |       |                        |       |
| ASSETS                                                                                                                                                                                                                                                          |       |                    |       |                        |       |
| Current assets:                                                                                                                                                                                                                                                 |       |                    |       |                        |       |
| Cash and cash equivalents                                                                                                                                                                                                                                       |       | $                       | 62,019     |                        | $          | 47,994 |   |
| Short-term investments                                                                                                                                                                                                                                          |       | 38,055                  |       | 78,372                      |       |
| Accounts receivable, net                                                                                                                                                                                                                                        |       | 71,298                  |       | 65,224                      |       |
| Inventories                                                                                                                                                                                                                                                     |       | 36,644                  |       | 16,805                      |       |
| Prepaid expenses and other current assets                                                                                                                                                                                                                       |       | 11,906                  |       | 12,151                      |       |
| Total current assets                                                                                                                                                                                                                                            |       | 219,922                 |       | 220,546                     |       |
|                                                                                                                                                                                                                                                            |       |                    |       |                        |       |
| Property and equipment, net                                                                                                                                                                                                                                     |       | 19,592                  |       | 20,029                      |       |
| Other assets and investments                                                                                                                                                                                                                                    |       | 108,025                 |       | 69,311                      |       |
| Goodwill                                                                                                                                                                                                                                                        |       | 119,272                 |       | 119,091                     |       |
| Intangible assets, net                                                                                                                                                                                                                                          |       | 168,548                 |       | 188,885                     |       |
|                                                                                                                                                                                                                                                            |       |                    |       |                        |       |
|                                                                                                                                                                                                                                                            |       | $                       | 635,359    |                        | $          | 617,862 |   |
|                                                                                                                                                                                                                                                            |       |                    |       |                        |       |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                                                                                       |       |                    |       |                        |       |
| Current liabilities:                                                                                                                                                                                                                                            |       |                    |       |                        |       |
| Accounts payable                                                                                                                                                                                                                                                |       | $                       | 54,610     |                        | $          | 29,038 |   |
| Accrued expenses and other liabilities                                                                                                                                                                                                                          |       | 45,015                  |       | 45,182                      |       |
| Total current liabilities                                                                                                                                                                                                                                       |       | 99,625                  |       | 74,220                      |       |
|                                                                                                                                                                                                                                                            |       |                    |       |                        |       |
| Long-term liabilities                                                                                                                                                                                                                                           |       | 8,215                   |       | 9,363                       |       |
|                                                                                                                                                                                                                                                            |       |                    |       |                        |       |
| Stockholders’ equity:                                                                                                                                                                                                                                      |       |                    |       |                        |       |
| Common stock, $0.001 par value; 105,000,000  shares authorized at June 30, 2004 and December 31, 2003;  42,788,644 shares issued and outstanding as of June 30, 2004; and  42,347,584 shares issued and outstanding as of December 31, 2003 |       | 43                      |       | 42                          |       |
| Additional paid-in capital                                                                                                                                                                                                                                      |       | 708,452                 |       | 703,812                     |       |
| Deferred stock-based compensation                                                                                                                                                                                                                               |       | (8,366                  | )          | (13,014                     | )          |
| Accumulated other comprehensive income  (loss)                                                                                                                                                                                                                  |       | 694                     |       | (91                         | )          |
| Accumulated deficit                                                                                                                                                                                                                                             |       | (173,304                | )          | (156,470                    | )          |
| Total stockholders’ equity                                                                                                                                                                                                                                 |       | 527,519                 |       | 534,279                     |       |
|                                                                                                                                                                                                                                                            |       |                    |       |                        |       |
|                                                                                                                                                                                                                                                            |       | $                       | 635,359    |                        | $          | 617,862 |   |

 

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

 

3

----

 

**ZORAN CORPORATION**

**CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS**

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

**(unaudited)**

 
| ** **                                                  | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                                  | ** ** | **2004**                              | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                        |       |                                  |       |                                |       |   |   |   |   |
| Revenues:                                                   |       |                                  |       |                                |       |   |   |   |   |
| Hardware product revenues                                   |       | $                                     | 89,681     |                                | $          | 41,510 |   | $ | 157,710 |   | $ | 78,607 |   |
| Software and other revenues                                 |       | 14,035                                |       | 3,221                               |       | 26,643 |   | 3,957 |   |
| Total revenues                                              |       | 103,716                               |       | 44,731                              |       | 184,353 |   | 82,564 |   |
|                                                        |       |                                  |       |                                |       |   |   |   |   |
| Costs and expenses:                                         |       |                                  |       |                                |       |   |   |   |   |
| Cost of hardware product revenues                           |       | 58,838                                |       | 26,227                              |       | 104,166 |   | 52,937 |   |
| Research and development                                    |       | 21,136                                |       | 6,231                               |       | 39,782 |   | 10,710 |   |
| Selling, general and administrative                         |       | 16,485                                |       | 7,796                               |       | 31,302 |   | 14,738 |   |
| Amortization of intangible assets                           |       | 10,343                                |       | 944                                 |       | 20,686 |   | 1,887 |   |
| Deferred stock compensation                                 |       | 2,117                                 |       | 10                                  |       | 4,648 |   | 20 |   |
| Total costs and expenses                                    |       | 108,919                               |       | 41,208                              |       | 200,584 |   | 80,292 |   |
|                                                        |       |                                  |       |                                |       |   |   |   |   |
| Operating income (loss)                                     |       | (5,203                                | )          | 3,523                               |       | (16,231 | ) | 2,272 |   |
|                                                        |       |                                  |       |                                |       |   |   |   |   |
| Interest income                                             |       | 383                                   |       | 1,435                               |       | 783 |   | 3,028 |   |
|                                                        |       |                                  |       |                                |       |   |   |   |   |
| Other income (loss), net                                    |       | (211                                  | )          | (149                                | )          | 114 |   | (171 | ) |
|                                                        |       |                                  |       |                                |       |   |   |   |   |
| Income (loss) before income taxes                           |       | (5,031                                | )          | 4,809                               |       | (15,334 | ) | 5,129 |   |
|                                                        |       |                                  |       |                                |       |   |   |   |   |
| Provision for income taxes                                  |       | 1,114                                 |       | 576                                 |       | 1,500 |   | 703 |   |
|                                                        |       |                                  |       |                                |       |   |   |   |   |
| Net income (loss)                                           |       | $                                     | (6,145     | )                                   | $          | 4,233 |   | $ | (16,834 | ) | $ | 4,426 |   |
|                                                        |       |                                  |       |                                |       |   |   |   |   |
| Basic net income (loss) per share                           |       | $                                     | (0.14      | )                                   | $          | 0.15 |   | $ | (0.40 | ) | $ | 0.16 |   |
|                                                        |       |                                  |       |                                |       |   |   |   |   |
| Diluted net income (loss) per share                         |       | $                                     | (0.14      | )                                   | $          | 0.15 |   | $ | (0.40 | ) | $ | 0.15 |   |
|                                                        |       |                                  |       |                                |       |   |   |   |   |
| Shares used to compute basic net income  (loss) per share   |       | 42,697                                |       | 27,481                              |       | 42,610 |   | 27,452 |   |
|                                                        |       |                                  |       |                                |       |   |   |   |   |
| Shares used to compute diluted net income  (loss) per share |       | 42,697                                |       | 28,991                              |       | 42,610 |   | 28,588 |   |

 

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

 

4

----

 

**ZORAN CORPORATION**

**CONDENSED CONSOLIDATED STATEMENTS OF CASHFLOWS**

**(in thousands)**

**(unaudited)**

 
| ** **                                                                      | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                      | ** ** | **2004**                            | ** ** | **2003** | ** ** |
| Cash flows from operating activities:                                           |       |                                |       |   |   |
| Net income (loss)                                                               |       | $                                   | (16,834    | ) | $ | 4,426 |   |
| Adjustments to reconcile net income (loss)  to net cash provided by operations: |       |                                |       |   |   |
| Depreciation, amortization and other                                            |       | 5,159                               |       | 2,374 |   |
| Amortization of intangible assets                                               |       | 20,686                              |       | 1,907 |   |
| Amortization of deferred stock compensation                                     |       | 4,648                               |       | 20 |   |
| Changes in current assets and liabilities:                                      |       |                                |       |   |   |
| Accounts receivable                                                             |       | (6,074                              | )          | (19,326 | ) |
| Inventory                                                                       |       | (19,839                             | )          | (859 | ) |
| Prepaid expenses and other current assets  and other assets and investments     |       | (3,225                              | )          | (1,437 | ) |
| Accounts payable                                                                |       | 25,572                              |       | 16,324 |   |
| Accrued expenses and other liabilities and  long-term liabilities               |       | (1,315                              | )          | 296 |   |
| Net cash provided by operating activities                                       |       | 8,778                               |       | 3,725 |   |
|                                                                            |       |                                |       |   |   |
| Cash flows from investing activities:                                           |       |                                |       |   |   |
| Capital expenditures for property and  equipment                                |       | (5,243                              | )          | (3,224 | ) |
| Purchases of investments                                                        |       | (146,079                            | )          | (77,670 | ) |
| Proceeds from sales and maturities of  investments                              |       | 151,928                             |       | 63,205 |   |
| Acquisition costs                                                               |       | —                              |       | (650 | ) |
| Net cash provided by (used in) investing  activities                            |       | 606                                 |       | (18,339 | ) |
|                                                                            |       |                                |       |   |   |
| Cash flows from financing activities:                                           |       |                                |       |   |   |
| Proceeds from issuance of common stock                                          |       | 4,641                               |       | 1,612 |   |
| Installment payment on purchased core  technology                               |       | —                              |       | (1,500 | ) |
| Net cash provided by financing activities                                       |       | 4,641                               |       | 112 |   |
|                                                                            |       |                                |       |   |   |
| Net increase (decrease) in cash and cash  equivalents                           |       | 14,025                              |       | (14,502 | ) |
|                                                                            |       |                                |       |   |   |
| Cash and cash equivalents at beginning of  period                               |       | 47,994                              |       | 31,607 |   |
|                                                                            |       |                                |       |   |   |
| Cash and cash equivalents at end of period                                      |       | $                                   | 62,019     |   | $ | 17,105 |   |

 

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

 

5

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**ZORAN CORPORATION**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

**(unaudited)**

 

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

 

The accompanying unaudited condensed consolidated financial statementsof Zoran Corporation and subsidiaries (“Zoran” or the “Company”) have beenprepared in conformity with accounting principles for interim financialinformation generally accepted in the United States of America.  However, certain information or footnotedisclosures normally included in financial statements prepared in accordancewith accounting principles generally accepted in the United States of Americahave been condensed or omitted pursuant to the rules and regulations of theSecurities and Exchange Commission (the “Commission”).  In the opinion of management, the condensedconsolidated financial statements reflect all adjustments considered necessary,consisting only of normally occurring adjustments, for a fair presentation ofthe consolidated financial position, operating results and cash flows for theperiods presented.  The results of operationsfor the interim periods presented are not necessarily indicative of the resultsthat may be expected for the full fiscal year or in any future period.  This quarterly report on Form 10-Q should beread in conjunction with the audited consolidated financial statements andnotes thereto for the year ended December 31, 2003, included in theZoran Corporation 2003 Annual Report on Form 10-K filed with the Commission.

 

***Reclassifications***

 

Certain prior period amounts have been reclassified to conform to thecurrent period presentation.

 

**2.****                                      StockBased Compensation**

 

Zoran applies Accounting Principles Board Opinion No. 25, “Accountingfor Stock Issued to Employees,” and related interpretations in accounting forits stock plans.  Stock options aregenerally granted with exercise prices equivalent to fair market value of theunderlying common stock on the date of grant, and no compensation cost isrecognized.  In connection with stockoptions granted through the acquisition of Nogatech, Inc. during 2000 and OakTechnology, Inc. during 2003, the Company recorded deferred stock-basedcompensation which is being amortized over the vesting period of theoptions.  Amortization of deferred stockcompensation expense recognized as a result of the amortization of theseoptions during the quarter ended June 30, 2004 and 2003 was approximately$2,117,000 and $10,000, respectively. Deferred stock compensation expense of these options for the six monthsended June 30, 2004 and 2003 was approximately $4,648,000 and $20,000,respectively.

 

6

----

 

Had compensation cost for the Company’s option and stock purchase plansbeen determined based on the fair value of the options at the grant date, asprescribed in Statement of Financial Accounting Standards No. 123 “Accountingfor Stock Based Compensation” (“SFAS 123”), the Company’s net loss and net lossper share for the three month and six month periods ended June 30, 2004and 2003 would have been as follows (in thousands, except per share data):

 
| ** **                                                                                          | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                          | ** ** | **2004**                              | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                                |       |                                  |       |                                |       |   |   |   |   |
| Net income (loss) attributable to common  stockholders, as reported                                 |       | $                                     | (6,145     | )                                   | $          | 4,233 |   | $ | (16,834 | ) | $ | 4,426 |   |
|                                                                                                |       |                                  |       |                                |       |   |   |   |   |
| Add:                                                                                                |       |                                  |       |                                |       |   |   |   |   |
| Employee stock-based compensation expense  included in net income (loss), net of tax                |       | 2,117                                 |       | 10                                  |       | 4,648 |   | 20 |   |
|                                                                                                |       |                                  |       |                                |       |   |   |   |   |
| Total employee stock-based compensation  expense determined under the fair value method, net of tax |       | (11,477                               | )          | (6,794                              | )          | (23,367 | ) | (13,078 | ) |
|                                                                                                |       |                                  |       |                                |       |   |   |   |   |
| Pro forma net loss attributable to common  stockholders                                             |       | $                                     | (15,505    | )                                   | $          | (2,551 | ) | $ | (35,553 | ) | $ | (8,632 | ) |
|                                                                                                |       |                                  |       |                                |       |   |   |   |   |
| Pro forma net loss per share attributable  to common stockholders:                                  |       |                                  |       |                                |       |   |   |   |   |
| Basic                                                                                               |       | $                                     | (0.36      | )                                   | $          | (0.09 | ) | $ | (0.83 | ) | $ | (0.31 | ) |
| Diluted                                                                                             |       | $                                     | (0.36      | )                                   | $          | (0.09 | ) | $ | (0.83 | ) | $ | (0.31 | ) |
|                                                                                                |       |                                  |       |                                |       |   |   |   |   |
| Net income (loss) per share as reported  attributable to common stockholders:                       |       |                                  |       |                                |       |   |   |   |   |
| Basic                                                                                               |       | $                                     | (0.14      | )                                   | $          | 0.15 |   | $ | (0.40 | ) | $ | 0.16 |   |
| Diluted                                                                                             |       | $                                     | (0.14      | )                                   | $          | 0.15 |   | $ | (0.40 | ) | $ | 0.15 |   |

 

For purposes of the disclosure required under SFAS 123, the fair valueof each option grant is estimated on the date of grant using the Black-Scholesoption pricing model with the following assumptions used for options andpurchase grants during the applicable periods.

 
| ** **               | ** ** | **Stock Option Plans**                      | ** ** |
|--------------------------|------------|---------------------------------------------|------------|
| ** **               | ** ** | **Three Months  Ended  June 30, 2004** | ** ** | **Three Months****Ended  June 30, 2003** | ** ** | **Six Months  Ended  June 30, 2004** | ** ** | **Six Months  Ended****June 30, 2003** | ** ** |
|                     |       |                                        |       |   |   |   |   |   |   |
| Expected life  (years)   |       | 5.2                                         |       | 5.0 |   | 5.2 |   | 5.0 |   |
| Expected  volatility     |       | 82                                          | %          | 92 | % | 84 | % | 92 | % |
| Risk-free  interest rate |       | 3.7                                         | %          | 4.2 | % | 3.4 | % | 4.2 | % |

 

7

----

 
| ** **               | ** ** | **Employee Stock Purchase Plans**             | ** ** |
|--------------------------|------------|-----------------------------------------------|------------|
| ** **               | ** ** | **Three Months  Ended****June 30, 2004** | ** ** | **Three Months  Ended  June 30, 2003** | ** ** | **Six Months****Ended  June 30, 2004** | ** ** | **Six Months****Ended  June 30, 2003** | ** ** |
|                     |       |                                          |       |   |   |   |   |   |   |
| Expected life  (years)   |       | 0.5                                           |       | 0.5 |   | 0.5 |   | 0.5 |   |
| Expected  volatility     |       | 70                                            | %          | 92 | % | 78 | % | 92 | % |
| Risk-free  interest rate |       | 1.4                                           | %          | 2.5 | % | 1.2 | % | 2.5 | % |

 

The Black-Scholes option pricing model was developedfor use in estimating the value of traded options that have no vestingrestrictions and are fully transferable. In addition, option pricing modelsrequire the input of highly subjective assumptions including the expected stockprice volatility. The Company uses projected data for expected volatility andexpected life of its stock options based upon historical and other economicdata trended into future years. Because the Company’s employee stock optionshave characteristics significantly different from those of traded options, andbecause changes in the subjective input assumptions can materially affect theestimate, in management’s opinion, existing valuation models, including theBlack-Scholes model, do not necessarily provide a reliable measure of the fairvalue of the Company’s stock options.

 

**3.****                                      ComprehensiveIncome (Loss)**

 

The following table presents the calculation of comprehensive income(loss) as required by SFAS 130 (“Reporting Comprehensive Income”).  The components of comprehensive income (loss),net of tax, are as follows (in thousands):

 
| ** **                                            | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                            | ** ** | ** **                            | ** ** |
| ** **                                            | ** ** | **2004**                              | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                  |       |                                  |       |                                |       |   |   |   |   |
| Net income (loss)                                     |       | $                                     | (6,145     | )                                   | $          | 4,233 |   | $ | (16,834 | ) | $ | 4,426 |   |
| Change in unrealized gain on investments,  net of tax |       | (1,679                                | )          | (341                                | )          | 785 |   | (216 | ) |
| Total comprehensive income (loss)                     |       | $                                     | (7,824     | )                                   | $          | 3,892 |   | $ | (16,049 | ) | $ | 4,210 |   |

 

The components ofaccumulated other comprehensive income (loss) are unrealized gain (loss) onshort-term and long-term marketable securities.

 

**4.****                                      Inventories**

 

Inventories are stated at the lower of cost (first in, first out) ormarket and consisted of the following (in thousands):

 
| ** **                          | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|-------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
|                                |       |                    |       |                        |       |
| Purchased parts and work in process |       | $                       | 17,410     |                        | $          | 5,701 |   |
| Finished goods                      |       | 19,234                  |       | 11,104                      |       |
|                                |       | $                       | 36,644     |                        | $          | 16,805 |   |

 

**5.****                                      Goodwilland Other Intangible Assets**

 

The Company adopted Statement of Financial Accounting Standards No.142, “Goodwill and Other Intangible Assets”, or SFAS 142, as of January 1,2002. In accordance with SFAS 142, goodwill is not amortized, but is requiredto be reviewed periodically for impairment on at least an annual basis.  For the year ended December 31, 2003,the Company performed the annual analysis as of September 30, 2003 andconcluded that goodwill was not impaired, as the fair value of each reportingunit exceeded its carrying value, including goodwill.

 

8

----

 

***Components ofAcquired Intangible Assets****(in thousands):*

 
| ** **                   | ** ** | ** **        | ** ** | **June 30, 2004**      | ** ** | **December 31, 2003**    | ** ** |
|------------------------------|------------|-------------------|------------|-----------------------------|------------|-------------------------------|------------|
| ** **                   | ** ** | **Life  (Years)** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Balance** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Balance** | ** ** |
| Amortized intangible assets: |       |              |       |                        |       |                          |       |   |   |   |   |   |   |   |   |
| Purchased technology         |       | 2-3               |       | $                           | 176,720    |                          | $          | (48,503 | ) | $ | 128,217 |   | $ | 176,720 |   | $ | (31,792 | ) | $ | 144,928 |   |
| Patents                      |       | 3-5               |       | 27,900                      |       | (5,696                        | )          | 22,204 |   | 27,900 |   | (2,996 | ) | 24,904 |   |
| Customer base                |       | 3-5               |       | 13,010                      |       | (3,594                        | )          | 9,416 |   | 13,010 |   | (2,450 | ) | 10,560 |   |
| Tradename and others         |       | 3-5               |       | 2,100                       |       | (1,031                        | )          | 1,069 |   | 2,100 |   | (900 | ) | 1,200 |   |
| Purchased core technology *  |       | 4-5               |       | 9,734                       |       | (2,092                        | )          | 7,642 |   | 8,799 |   | (1,506 | ) | 7,293 |   |
| Total                        |       |              |       | $                           | 229,464    |                          | $          | (60,916 | ) | $ | 168,548 |   | $ | 228,529 |   | $ | (39,644 | ) | $ | 188,885 |   |

 

----

(*) The Company records the amortization of purchased core technologyas cost of hardware product revenues.

 

Estimated future intangible amortization expense, based on currentbalances, as of June 30, 2004 is as follows (in thousands):

 
| ** **                         | ** ** | **Amount** | ** ** |
|------------------------------------|------------|------------|------------|
|                               |       |       |       |
| Remaining six months of 2004       |       | $          | 21,883     |   |
| Year ending December 31, 2005 |       | 44,031     |       |
| Year ending December 31, 2006 |       | 42,266     |       |
| Year ending December 31, 2007 |       | 38,842     |       |
| Year ending December 31, 2008 |       | 21,526     |       |
| Total                              |       | $          | 168,548    |   |

 

Changes in the carrying amount of goodwill for the six months endedJune 30, 2004 were as follows (in thousands):

 
| ** **                                             | ** ** | **Amount** | ** ** |
|--------------------------------------------------------|------------|------------|------------|
|                                                   |       |       |       |
| Balance at December 31, 2003                      |       | $          | 119,091    |   |
| Adjustment to goodwill related to  acquisition of Oak. |       | 181        |       |
| Balance at June 30, 2004                          |       | $          | 119,272    |   |

 

Goodwill by reporting unit at June 30, 2004 and December 31,2003 was as follows:

 
| ** ** | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|------------|------------|-------------------------|------------|-----------------------------|------------|
|       |       |                    |       |                        |       |
| DVD        |       | $                       | 63,855     |                        | $          | 63,855 |   |
| Imaging    |       | 6,177                   |       | 5,996                       |       |
| DC         |       | 31,252                  |       | 31,252                      |       |
| DTV        |       | 17,988                  |       | 17,988                      |       |
|       |       | $                       | 119,272    |                        | $          | 119,091 |   |

 

**6.****                                      IncomeTaxes**

 

The provision for income taxes reflects the estimated annualizedeffective tax rate applied to earnings excluding charges for amortization ofgoodwill and other intangibles for the interim periods.  The effective tax rate differs from the U.S.statutory rate due to utilization of net operating losses, adjustments for thenondeductible amortization of goodwill and other intangibles and

 

9

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income tax rate differences on foreign earnings.  The Company has provided for tax on income inexcess of net operating loss carryforwards for U.S. federal and stateearnings.  The Company has also providedfor tax on its foreign earnings.

 

**7.****                                      SegmentReporting**

 

SFAS No. 131 establishes standards for the reporting by publicbusiness enterprises of information about operating segments, products andservices, geographic areas, and major customers. The method for determiningwhat information to report is based on the way that management organizes theoperating segments within the Company for making operational decisions and assessmentsof financial performance. The Company’s chief operating decision-maker isconsidered to be the Chief Executive Officer (“CEO”).

 

Subsequent to the acquisitionof Oak Technology, Inc. in 2003, the Company determined it has fourreportable segments: Digital Versatile Disc (DVD), Imaging, Digital Camera (DC)and Digital Television (DTV).  Eachsegment’s primary products are based on highly integrated application-specificintegrated circuits, or ASICs, and system-on-a-chip, or SOC, solutions.  The DVD segment and Imaging segment alsolicenses certain software and other intellectual property.  The DVD group provides products for use inDVD players and DVD recorders. The Imaging group provides products used indigital copiers, laser and inkjet printers as well as multifunctionperipherals. The DC group focuses on solutions for digital camera products aswell as CMOS sensors.  The DTV groupprovides products for standard and high definition digital television productsincluding televisions, set top boxes, personal video recorders, digital videorecorders, and recordable DVD.

 

The Company evaluates operating segment performance based on netrevenues and operating expenses of these segments. The accounting policies ofthe operating segments are the same as those described in the summary ofaccounting policies. No reportable segments have been aggregated.

 

Information about reported segment income or loss is as follows for thethree months and six months ended June 30, 2004 and 2003 (in thousands):

 
| ** **           | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **           | ** ** | **2004**                              | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net revenues:        |       |                                  |       |                                |       |   |   |   |   |
| DVD                  |       | $                                     | 67,154     |                                | $          | 38,394 |   | $ | 114,376 |   | $ | 69,594 |   |
| Imaging              |       | 21,694                                |       | —                              |       | 39,882 |   | — |   |
| DC                   |       | 7,284                                 |       | 6,332                               |       | 15,139 |   | 12,954 |   |
| DTV                  |       | 7,584                                 |       | 5                                   |       | 14,956 |   | 16 |   |
|                 |       | $                                     | 103,716    |                                | $          | 44,731 |   | $ | 184,353 |   | $ | 82,564 |   |
|                 |       |                                  |       |                                |       |   |   |   |   |
| Operating expenses:  |       |                                  |       |                                |       |   |   |   |   |
| DVD                  |       | $                                     | 61,211     |                                | $          | 32,185 |   | $ | 109,272 |   | $ | 62,635 |   |
| Imaging              |       | 13,333                                |       | —                              |       | 23,841 |   | — |   |
| DC                   |       | 8,016                                 |       | 6,705                               |       | 15,917 |   | 13,591 |   |
| DTV                  |       | 13,899                                |       | 1,364                               |       | 26,220 |   | 2,159 |   |
|                 |       | $                                     | 96,459     |                                | $          | 40,254 |   | $ | 175,250 |   | $ | 78,385 |   |
|                 |       |                                  |       |                                |       |   |   |   |   |
| Contribution margin: |       |                                  |       |                                |       |   |   |   |   |
| DVD                  |       | $                                     | 5,943      |                                | $          | 6,209 |   | $ | 5,104 |   | $ | 6,959 |   |
| Imaging              |       | 8,361                                 |       | —                              |       | 16,041 |   | — |   |
| DC                   |       | (732                                  | )          | (373                                | )          | (778 | ) | (637 | ) |
| DTV                  |       | (6,315                                | )          | (1,359                              | )          | (11,264 | ) | (2,143 | ) |
|                 |       | $                                     | 7,257      |                                | $          | 4,477 |   | $ | 9,103 |   | $ | 4,179 |   |

 

10

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A reconciliation of the totals reported for the operating segments tothe applicable line items in the consolidated financial statements for thethree months and six months ended June 30, 2004 and 2003 is as follows (inthousands):

 
| ** **                                  | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                  | ** ** | **2004**                              | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| Contribution margin from operating segments |       | $                                     | 7,257      |                                | $          | 4,477 |   | $ | 9,103 |   | $ | 4,179 |   |
| Amortization of intangibles                 |       | 10,343                                |       | 944                                 |       | 20,686 |   | 1,887 |   |
| Amortization of deferred stock compensation |       | 2,117                                 |       | 10                                  |       | 4,648 |   | 20 |   |
| Total operating loss                        |       | $                                     | (5,203     | )                                   | $          | 3,523 |   | $ | (16,231 | ) | $ | 2,272 |   |

 

Zoran maintains operations in the United States, Israel, Canada, theUnited Kingdom, Germany, China, Taiwan, Korea and Japan. Activities in theUnited States and Israel consist of corporate administration, productdevelopment, logistics and worldwide sales management. Other foreign operationsconsist of sales, product development, and technical support.

 

The distribution of total revenues for the three months and six monthsended June 30, 2004 and 2003 was as follows (in thousands):

 
| ** **                                             | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                             | ** ** | **2004**                              | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenue from unaffiliated customers  originating from: |       |                                  |       |                                |       |   |   |   |   |
| China                                                  |       | $                                     | 37,433     |                                | $          | 15,110 |   | $ | 66,240 |   | $ | 30,377 |   |
| Japan                                                  |       | 28,527                                |       | 12,457                              |       | 52,364 |   | 17,835 |   |
| Taiwan                                                 |       | 17,427                                |       | 6,438                               |       | 22,213 |   | 10,490 |   |
| Korea                                                  |       | 11,471                                |       | 8,142                               |       | 21,909 |   | 18,576 |   |
| North America                                          |       | 5,738                                 |       | 2,148                               |       | 14,562 |   | 3,060 |   |
| Other                                                  |       | 3,120                                 |       | 436                                 |       | 7,065 |   | 2,226 |   |
|                                                   |       | $                                     | 103,716    |                                | $          | 44,731 |   | $ | 184,353 |   | $ | 82,564 |   |

 

For the threemonths ended June 30, 2004, one customer accounted for 12% of totalrevenues.  For the same period of 2003, threecustomers accounted for 26%, 18% and 11% of total revenues, respectively.  For the six months ended June 30, 2004,no customer accounted for more than 10% of total revenues.  For the same period of 2003, three customersaccounted for 22%, 18% and 11% of total revenues, respectively.

 

As of June 30, 2004, three customers accounted for 12%, 11% and11% of total net accounts receivable, respectively, and as of December 31,2003, two customers accounted for 14% and 10% of total net accounts receivable,respectively.

 

**8.****                                      Acquisition**

 

On August 11, 2003, pursuant to an Agreement and Plan ofReorganization dated as of May 4, 2003 (the “Merger Agreement”) amongZoran, a wholly-owned subsidiary of Zoran (“Merger Sub”), and OakTechnology, Inc., Oak was merged with and into Merger Sub.

 

The transaction was accounted for under SFAS No. 141, “BusinessCombinations,” using the purchase method of accounting and accordingly theresults of operations of Oak have been included in the Company’s financialstatements since the date of acquisition.

 

Zoran’s primary objective in acquiring Oak was based on the Company’sbelief that the combined company would benefit from the following:

 

•                  Oak’scomplementary technologies and products, especially in the digital TV markets,and the ability of the combined company to expand its existing customer baseand market share in the digital consumer electronics market by integrating theproduct lines of each company;

 

•                  Oak’sintellectual property portfolio and related expertise, especially intellectualproperty relating to front-end optical recording;

 

11

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•                  access to Oak’scustomer relationships, providing cross-selling opportunities to existingcustomers as well as opportunities to build new relationships;

 

•                  the opportunityto achieve synergies and realize significant cost savings, includingoperational efficiencies, such as acceleration of various product developmentactivities by leveraging Oak’s intellectual property, reduced overhead and, ingeographic areas where the two companies overlap, increased efficiency in thecombined company’s sales channels; and

 

•                  Oak’s existingmarket position as a leading supplier of HDTV integrated circuits, providingthe combined company with access to this high-growth market segment.

 

The purchase price exceeded the net assets acquired resulting in therecognition of goodwill and other intangible assets.

 

The financial statements reflect a purchase price of approximately$392.7 million, determined as follows (in thousands):

 
| Cash payments                       |   | $       | 100,992 |   |
|-------------------------------------|--------|---------|---------|--------|
| Fair value of common stock issued   |   | 227,462 |    |
| Fair value of stock options granted |   | 57,446  |    |
| Acquisition costs                   |   | 6,847   |    |
| Total consideration                 |   | $       | 392,747 |   |

 

The cash payment and fair value of common stock issued represents theconversion of each outstanding share of Oak common stock into $1.78 in cash and0.2323 of a share of Zoran common stock. As a result of the acquisition,56,737,298 shares of Oak common stock were converted into $101.0 millionin cash and 13,180,074 shares of Zoran common with a fair value of$227.5 million based on the fair market value of Zoran common stock forthe period two days before and after the date on which the terms of agreementwere finalized and announced, May 5, 2003.

 

Non-qualified options to purchase approximately 4.5 million sharesof Zoran common stock with a term of ten years were granted to Oak employees aspart of the acquisition. The corresponding fair value of these options of$57.4 million was estimated based on the fair value of the Zoran commonstock as of the acquisition date using the Black-Scholes option pricing modelapplying the following assumptions: expected life of 50 months, risk-freeinterest rate of 3.65%, expected volatility of 93% and no expected dividendyield. The intrinsic value of the unvested options, totaling approximately$19.2 million, has been recorded as deferred stock compensation and willbe amortized over the vesting period using the multiple option approach.

 

Acquisition costs include $3.3 million of investment banker fees,$1.7 million of insurance costs, $1.1 million of legal and accountingfees and $0.7 million in other acquisition related expenses.

 

The purchase price allocation was as follows (in thousands):

 
| Net assets acquired                 |   | $       | 65,644  |   |
|-------------------------------------|--------|---------|---------|--------|
| Deferred stock compensation         |   | 19,212  |    |
| In-process research and development |   | 50,100  |    |
| Intangible assets                   |   | 197,650 |    |
| Goodwill                            |   | 60,141  |    |
|                                |   | $       | 392,747 |   |

 

12

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The following table summarizes the estimated fair value of the tangibleassets acquired and liabilities assumed at the date of acquisition (inthousands):

 
| Cash and short-term investments |   | $       | 71,325 |   |
|---------------------------------|--------|---------|--------|--------|
| Accounts receivable             |   | 8,086   |   |
| Other current assets            |   | 17,090  |   |
| Inventory                       |   | 3,676   |   |
| Property, plant and equipment   |   | 13,075  |   |
| Other assets                    |   | 816     |   |
| Current liabilities             |   | (38,196 | )      |
| Non-current liabilities         |   | (10,228 | )      |
| Net assets acquired             |   | $       | 65,644 |   |

 

Tangible assets were valued at estimates of their current fair values.The valuation of the acquired intangible assets, which was based onmanagement’s estimates and considered various factors including appraisals,resulted in a value of purchased technology of approximately$157.9 million, patents of $27.0 million, customer base of$11.5 million and trademarks and tradenames of approximately$1.3 million. Purchased technology is being amortized over a weightedaverage estimated life of 4.8 years and patents, customer base, trademarksand tradenames are being amortized over their estimated useful lives offive years with no residual values.

 

During the period August 11, 2003 through June 30, 2004, werevised estimates related to certain assets and liabilities, and as a result,we decreased the purchase price and goodwill by $3.4 million.

 

Approximately $60.0 million of the purchase price was allocated togoodwill. Goodwill represents the excess of the purchase price over the fairvalue of the net tangible and identifiable intangible assets acquired. Inaccordance with SFAS 142, “Goodwill and Other Intangible Assets”, goodwillwill not be amortized and will be tested for impairment at least annually. Wedo not expect goodwill to be deductible for tax purposes.

 

Approximately $50.1 million of the purchase price was allocated toin-process research and development which had not yet reached technologicalfeasibility and had no alternative future use. Accordingly, this amount wasimmediately expensed upon the acquisition date. This amount was determinedusing management’s estimates including consultation with an independentappraiser. The value of the in-process research and development was determinedusing a discounted cash flow method and factors including projected financialresults, relative risk of successful development, time-value of money and levelof completion.

 

The Company expects that the in-process technologies will besuccessfully completed by the second quarter of calendar 2005 withapproximately $9.4 million in remaining costs as of June 30,2004.  At the time of acquisition, Oakhad five material development projects in process as follows:

 

•                  OTI-4100—ahighly integrated, fully programmable system-on-a-chip (SOC) solution for theemerging class of appliance type printers. The OTI-4100 incorporates the RISCCPU core and Quatro SIMD DSP core to provide an easy to program controllerplatform.

 

•                  Fire 3—aprogrammable SOC solution that will complement the OTI-4110 and ZR-4100 in theinkjet market. Fire 3 will provide a fully scalable solution platform to covermuch of the performance and feature range of an OEM’s laser offerings.

 

•                  Integrated PrintSystem—The Integrated Print System (“IPS”) is a dynamic embedded scalablearchitecture providing peripheral manufacturers with highly integrated modularcontroller and connectivity software for powering single and multifunctionaldevices.

 

•                  Generation 9—anintegrated SOC that integrates a previous generation of HDTV digital videotechnology with a new Audio-DSP Core as well as a MIPS 64 bit processor andcertain other video processing features.

 

•                  A new lower costhighly integrated HDTV decoder—the first in a family of highly integrated HDTVdecoders specifically designed for the FCC mandated digital television chassismarket. This device includes all the required interfacing to support digitalcable applications and is applicable to existing CRT and flat panel displaydevices.

 

The value of in-process research and development was determined usingthe multi-period excess earnings method by estimating the expected net cashflows from the projects once commercially viable and discounting the net cashflows back to their present value using a discount rate of 22%. This rate wasbased on the industry segment for the technology, nature of the products to bedeveloped, length

 

13

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of time to complete the project and overall maturity and history of thedevelopment team. The net cash flows from the identified projects were based onestimates of revenue, cost of revenue, research and development expenses,selling general and administrative expenses, and applicable income taxes. Theseestimates did not take into account any potential synergies that could berealized as a result of the acquisition. Revenues for the incremental coretechnologies developed are expected to commence in the fourth quarter of 2005and extend through 2011. Revenue projections were based on estimates of marketsize and growth, expected trends in technology and the expected timing of newproduct introductions.  As of June 30,2004, there have been no material variations from the underlying assumptionsthat were used in the original computation of the value of the acquiredin-process research and development.

 

The following unaudited pro forma financial information presents thecombined results of operations of Zoran and Oak as if the acquisition hadoccurred as of the beginning of fiscal 2003 and 2002, after giving effect tocertain adjustments, including amortization of intangibles. The in-processresearch and development charge of $50.1 million is not reflected in theunaudited pro forma combined condensed statement of operations. The unauditedpro forma financial information does not necessarily reflect the results ofoperations that would have occurred had the combined companies constituted asingle entity during such periods, and is not necessarily indicative of resultswhich may be obtained in the future.

 
| ** **                                   | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------|------------|----------------------------------|------------|
| ** **                                   | ** ** | **2003**                         | ** ** | **2002** | ** ** |
|                                         |       |                             |       |   |   |
| **In thousands except  for per share data:** |       |                             |       |   |   |
| Pro forma revenues                           |       | $                                | 275,658    |   | $ | 284,770 |   |
|                                         |       |                             |       |   |   |
| Pro forma net loss                           |       | $                                | (73,247    | ) | $ | (83,628 | ) |
|                                         |       |                             |       |   |   |
| Pro forma net loss per share:                |       |                             |       |   |   |
| Basic                                        |       | $                                | (1.77      | ) | $ | (2.08 | ) |
|                                         |       |                             |       |   |   |
| Diluted                                      |       | $                                | (1.77      | ) | $ | (2.08 | ) |

 

**9.****                                      NetIncome (Loss) Per Share**

 

Basic and diluted net income (loss) per share have been computed usingthe weighted average number of shares of common stock and dilutive commonequivalent shares from stock options and warrants outstanding during the periodin accordance with Statement of Financial Accounting Standards (SFAS) No. 128,“Earnings per Share.”  The followingtable provides a reconciliation of the components of the basic and diluted netincome (loss) per share computations (in thousands, except per share data):

 
| ** **                                    | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                    | ** ** | **2004**                              | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                          |       |                                  |       |                                |       |   |   |   |   |
| Net income (loss) from continuing  operations |       | $                                     | (6,145     | )                                   | $          | 4,233 |   | $ | (16,834 | ) | $ | 4,426 |   |
|                                          |       |                                  |       |                                |       |   |   |   |   |
| Basic common shares                           |       | 42,697                                |       | 27,481                              |       | 42,610 |   | 27,452 |   |
| Effect of dilutive securities:                |       |                                  |       |                                |       |   |   |   |   |
| Common stock options                          |       | —                                |       | 1,510                               |       | — |   | 1,136 |   |
| Dilutive weighted average shares              |       | 42,697                                |       | 28,991                              |       | 42,610 |   | 28,588 |   |
|                                          |       |                                  |       |                                |       |   |   |   |   |
| Net income (loss) per share:                  |       |                                  |       |                                |       |   |   |   |   |
| Basic                                         |       | $                                     | (0.14      | )                                   | $          | 0.15 |   | $ | (0.40 | ) | $ | 0.16 |   |
| Diluted                                       |       | $                                     | (0.14      | )                                   | $          | 0.15 |   | $ | (0.40 | ) | $ | 0.15 |   |

** **

**Options to purchase 5,051,000shares and 3,246,000 shares of common stock were excluded from the computationof diluted net loss per share for the three months ended June 30, 2004 and2003, respectively, as these shares would have had an anti-dilutive effect.**

** **

**14**

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** **

**Options to purchase 5,044,000shares and 3,597,000 shares of common stock were excluded from the computationof diluted net loss per share for the six months ended June 30, 2004 and2003, respectively, as these shares would have had an anti-dilutive effect.**

** **

**10.****                               SubsequentEvent**

 

On July 8, 2004, Zoran acquired Emblaze Semiconductor Ltd., asubsidiary of Emblaze Ltd. and a provider of semiconductor-based solutions forhigh volume multimedia mobile phones. Under the terms of the agreement, Zoran’s wholly-owned Israelisubsidiary, Zoran Microelectronics Ltd., acquired all of the outstanding commonshares of Emblaze Semiconductor for approximately $54.2 million in cash.  The transaction will be accounted for underSFAS No. 141, “Business Combinations,” using the purchase method ofaccounting.  The Company is currently inthe process of finalizing the valuation analysis and purchase price allocationwith the assistance of a third party appraiser.

 

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**Item2.   Management’s Discussion and Analysisof Financial Condition and Results of Operations**

 

*This report includesa number of forward-looking statements which reflect the Company’s currentviews with respect to future events and financial performance. Theseforward-looking statements are subject to certain risks and uncertainties,including those discussed below under the heading “Future Performance and RiskFactors” and in “Item 7—Management’s Discussion and Analysis of FinancialCondition and Results of Operations—Future Performance and Risk Factors”included in the**Company’s Annual Report onForm 10-K for the year ended December 31, 2003. In this report,the words “anticipates,” “believes,” “expects,” “intends,” “future” and similarexpressions identify forward-looking statements. Readers are cautioned not toplace undue reliance on these forward-looking statements, which speak only asof the date hereof.*

 

**Overview**

 

Prior to the acquisition of Oak Technology, Inc. on August 11,2003, our products consisted of integrated circuits and related products usedin digital versatile disc players, or DVDs, movie and home theater systems,digital cameras and video editing systems. As a result of the acquisition of Oak, we now also provide integratedcircuits, software and platforms for digital television applications thatenable the delivery and display of digital video content through a set-top boxor television as well as digital imaging products consisting of semiconductorhardware and software that enable users to print, scan, process and transmitdocuments to computer peripherals that perform printing functions.

 

We derive most of our revenues from the sale of our integrated circuitproducts. Historically, average selling prices in the semiconductor industry ingeneral, and for our products in particular, have decreased over the life of aparticular product. Average selling prices for our hardware products havefluctuated substantially from period to period, primarily as a result of changesin our customer mix of original equipment manufacturer, or OEM, sales versussales to resellers and the transition from low-volume to high-volumeproduction. In the past, we have periodically reduced the prices of some of ourproducts in order to better penetrate the consumer market. We believe that, asour product lines continue to mature and competitive markets evolve, we arelikely to experience further declines in the average selling prices of ourproducts, although we cannot predict the timing and amount of such futurechanges with any certainty.

 

Our cost of hardware product revenues consists primarily of fabricationcosts, assembly and test costs, and the cost of materials and overhead fromoperations. If we are unable to reduce our cost of hardware product revenues tooffset anticipated decreases in average selling prices, our product grossmargins will decrease. Our hardware product gross margin is also dependent onproduct mix and on the proportion of products sold directly to our OEM customersversus indirectly through our marketing partners.  These marketing partners purchase ourproducts at lower prices but absorb most of the associated marketing and salessupport expenses, maintain inventories and provide customer support andtraining. As a result, lower gross margins on sales to these resellers arepartially offset by reduced selling and marketing expenses related to suchsales.  Our DVD hardware product sales inJapan are primarily made through Fujifilm, our strategic partner and resellerin Japan.  We expect both product andcustomer mix to continue to fluctuate in future periods, causing furtherfluctuations in margins.

 

We also derive revenue from licensing our software and otherintellectual property. Licensing revenue includes one-time license fees androyalties based on the number of units distributed by the licensee. Quarterlylicensing revenue can be significantly affected by the timing of a small numberof licensing transactions, each accounting for substantial revenues. Accordingly,licensing revenues have fluctuated, and will continue to fluctuate, on aquarterly basis. In addition, we have historically generated a portion of ourtotal revenues from development contracts, primarily with key customers,although development revenue has declined substantially as a percentage oftotal revenues over the past several years. These development contracts haveprovided us with partial funding for the development of some of our products.These development contracts provide for license and milestone payments whichare recorded as development revenue. We classify all development costs,including costs related to these development contracts, as research anddevelopment expenses. We retain ownership of the intellectual propertydeveloped by us under these development contracts. While we intend to continueto enter into development contracts with certain strategic partners, we expectdevelopment revenue to continue to decline as a percentage of total revenues.

 

Our research and development expenses consist of salaries and relatedcosts of employees engaged in ongoing research, design and developmentactivities and costs of engineering materials and supplies. We are also a partyto research and development agreements with the Chief Scientist in Israel’sMinistry of Industry and Trade and the Israel-United States BinationalIndustrial Research and Development Foundation, which fund up to 50% ofincurred project costs for approved products up to specified contract maximums.These agreements require us to use our best efforts to achieve specifiedresults and require us to pay royalties at rates of 3% to 5% of resultingproduct sales, and up to 30% of resulting license revenues, up to a maximum of100% to 150% of total funding received. Reported research and developmentexpenses are net of these grants, which fluctuate from period to period. Webelieve that significant investments in research and development are requiredfor us to remain competitive, and we expect to

 

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continue to devote significant resources to product development,although such expenses as a percentage of total revenues may fluctuate.

 

Our selling, general and administrative expenses consist primarily ofemployee-related expenses, royalties, sales commissions, product promotion andother professional services. We expect that selling, general and administrativeexpenses will continue to increase to support our anticipated growth.

 

We conduct a material amount of our research and development andcertain sales and marketing and administrative operations in Israel through ourwholly-owned Israeli subsidiary.  As aresult, some of our expenses are incurred in New Israeli Shekels. To date,substantially all of our hardware product revenues and our software and otherrevenues have been denominated in U.S. dollars and most costs of hardwareproduct revenues have been incurred in U.S. dollars. We expect that most of ourrevenues and costs of revenue will continue to be denominated and incurred inU.S. dollars for the foreseeable future. We have not experienced materiallosses or gains as a result of currency exchange rate fluctuations and have notengaged in hedging transactions to reduce our exposure to such fluctuations. Wemay in the future elect to take action to reduce our foreign exchange risk.

 

Our effective income tax rate has benefited from the availability ofnet operating losses which we have utilized to reduce taxable income for U.S.federal income tax purposes and by our Israeli subsidiary’s status as an“Approved Enterprise” under Israeli law, which provides a ten-year tax holidayfor income attributable to a portion of our operations in Israel. Our U.S.federal net operating losses expire at various times between 2004 and 2020, andthe benefits from our subsidiary’s Approved Enterprise status expire at varioustimes beginning in 2004.

 

**Statement Regarding Use of Non-GAAP Financial Measures**

 

To supplement the consolidated financial results prepared undergenerally accepted accounting principles (“GAAP”) we include non-GAAP financialmeasures in our Management’s Discussion and Analysis, our quarterly pressreleases regarding operating results and our presentations to investors.  These non-GAAP financial measures consist ofGAAP financial measures adjusted to include or exclude certain revenues, costs,expenses and gains associated with acquisitions.  The purpose of such adjustment is to give anindication of our baseline performance before gains, losses or other chargesthat are considered by management to be outside of our core operatingresults.  In some instances, we usefinancial measures that exclude the effects of the Oak acquisition to provide ameaningful comparison of results in periods occurring before and after thatacquisition.  Management uses thesenon-GAAP measures as a basis for planning and forecasting future periods.  These non-GAAP measures may differ materiallyfrom the non-GAAP measures used by other companies and should not be regardedas a replacement for corresponding GAAP measures.

 

**Oak Acquisition**

 

On August 11, 2003, we completed our acquisition of Oak throughthe merger of Oak with a wholly-owned subsidiary of Zoran.  The acquisition was accounted for under thepurchase method of accounting.

 

Following the completion of the acquisition, the results of operationsof Oak have been included in our consolidated financial statements.  Accordingly, our results of operations forthe three month and six month periods ended June 30, 2004 each includeOak’s operations for the full period, while our results of operations for thethree month and six month periods ended June 30, 2003 reflect only Zoran’shistorical operations.

 

Subsequent to the acquisitionof Oak Technology, Inc. in 2003, the Company determined it has fourreportable segments: Digital Versatile Disc (DVD), Imaging, Digital Camera (DC)and Digital Television (DTV).  Eachsegment’s primary products are based on highly integrated application-specificintegrated circuits, or ASICs, and system-on-a-chip, or SOC, solutions.  The DVD segment and Imaging segment alsolicenses certain software and other intellectual property.  The DVD group provides products for use inDVD players and DVD recorders. The Imaging group provides products used indigital copiers, laser and inkjet printers as well as multifunctionperipherals. The DC group focuses on solutions for digital camera products aswell as CMOS sensors.  The DTV groupprovides products for standard and high definition digital television productsincluding televisions, set top boxes, personal video recorders, digital videorecorders, and recordable DVD.

 

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**Resultsof Operations**

** **

*Revenues*

 

Total revenues were $103.7 million and $184.4 million for the three andsix month periods ended June 30, 2004, compared to $44.7 million and $82.6million for the same periods of 2003, representing increases of 131.9% and123.3% respectively. The increase for the quarter was due to the inclusion of$29.2 million of revenues from the former Oak operations and increased sales of$28.8 million and $952,000 for the DVD segment and the DC segment,respectively. The increase in year-to-date revenue was due to the inclusion of$53.9 million of revenues from the former Oak operations and increased sales of$44.8 million and $2.2 million for the DVD segment and the DC segment,respectively. The increase in revenues for both DVD and DC segments for thethree and six month periods were due to increased unit shipments. Totalrevenues by segment for the three months ended June 30, 2004 were 64.8%DVD, 20.9% Imaging, 7.3% DTV and 7.0% DC, compared to 85.8% DVD and 14.2% DCfor the same period in 2003. Total revenues by segment for the six months endedJune 30, 2004 were 62.0% DVD, 21.6% Imaging, 8.2% DC and 8.1% DTV,compared to 84.3% DVD and 15.7% DC. We anticipate that DVD revenue willcontinue to comprise the majority of revenue for the remainder of the year.

 

Hardware product revenues were $89.7 million and $157.7 million for thethree and six month periods ended June 30, 2004, compared to $41.5 millionand $78.6 million for the same periods of 2003, representing increases of116.0% and 100.6% respectively. The increase for the quarter was due to a $31.3million increase in hardware product sales for the DVD segment, $15.7 millionin hardware product revenue from the former Oak operations, and a $1.1 millionincrease in hardware sales for the DC segment. The increase in year-to-daterevenue was due to a $46.2 million increase in hardware product sales for theDVD segment, $29.6 million in hardware product revenue from the former Oakoperations, and a $2.3 million increase in hardware product sales for the DCsegment. The increase in revenues for both the DVD and DC segments for thethree and six month periods were due to increased unit shipments. Hardwareproduct revenues by segment for the three months ended June 30, 2004, were74.3% DVD, 9.2% Imaging, 8.4% DTV and 8.1% DC, compared to 85.1% DVD and 14.9%DC for the same period in 2003. Hardware product revenues by segment for thesix months ended June 30, 2004, were 71.0% DVD, 10.2% Imaging, 9.6% DC and9.2% DTV, compared to 83.7% DVD and 16.3% DC. We anticipate that DVD revenuewill continue to comprise the majority of hardware product revenue for the remainderof the year.

 

Software and other revenues were $14.0 million and $26.6 million forthe three and six month periods ended June 30, 2004, compared to $3.2million and $4.0 million for the same periods of 2003, representing increasesof 335.8% and 573.4% respectively.  Theincrease for the quarter includes additional revenues of $13.4 millionattributable to the Imaging segment acquired in the Oak acquisition, partiallyoffset by a $2.5 million decrease in software and other revenues in the DVDsegment. For the six months ended June 30, 2004, the increase in revenueswas again primarily due to additional revenues of $24.3 million primarily fromthe Imaging segment, partially offset by a $1.4 million decrease in licensingof DVD related intellectual property and other revenues. The decrease in DVDrelated intellectual property and other revenues was a result of fewer IPlicensing contracts.

 

*Cost of Hardware Product Revenues*

 

Cost of hardware product revenues was $58.8 million and $104.2 millionfor the three and six month periods ended June 30, 2004, compared to $26.2million and $52.9 million for the same periods of 2003. The increased costswere due to increased shipments for both periods. As a percent of hardwareproduct revenues, hardware product costs were 65.6% and 66.0% for the three andsix month periods ended June 30, 2004, compared to 63.2% and 67.3% for thesame periods of 2003. The increase in hardware product costs as a percent tohardware product revenues for the quarter was due to erosion of average sellingprices for our older DVD products. The reduction in hardware product costs as apercent of hardware product revenues for the six month period was due to theaddition of the higher margin Imaging hardware products acquired from Oak inAugust 2003. We currently anticipate that hardware product costs as apercentage of revenue will diminish over the remainder of the year as wetransition our DVD customer base to our newer generation products thatincorporate greater integration and functionality.

 

*Research and Development*

 

Research and development (“R&D”) expenses were $21.1 million and$39.8 million for the three and six month periods ended June 30, 2004,compared to $6.2 million and $10.7 million for the same periods of 2003. Theincreases were primarily a result of the inclusion of the former Oak operationsas well as continued investments in research and development across all of oursegments.  In addition, in the three andsix month periods ended June 30, 2003, we recorded approximately $500,000and $2.0 million, respectively, in grants from the Chief Scientist in Israel’sMinistry of Industry and Trade as an offset to R&D expense.  As a

 

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percentage of revenues, R&D expenses increased to 20.4% and 21.6%for the three and six month periods ended June 30, 2004, compared to 13.9%and 13.0% for the same periods of 2003. We expect R&D expenses to increasein the second half of the year as we continue to invest in our next generationproducts.

 

*Selling, General and Administrative*

 

Selling, general and administrative (“SG&A”) expenses were $16.5million and $31.3 million for the three and six month periods endedJune 30, 2004, compared to $7.8 million and $14.7 million for the sameperiods of 2003.  This increase wasprimarily a result of the inclusion of the former Oak operations as well as thecontinued increase in marketing and field application support expenses tosupport planned revenue growth in our Asia Pacific markets.  As a percentage of revenues, SG&Aexpenses were 15.9% and 17.0% for the three and six month periods endedJune 30, 2004, compared to 17.4% and 17.9% for the same periods of 2003primarily as a result of increased revenues.

 

*Amortization of Intangible Assets*

 

During the three months ended June 30, 2004, we incurred chargesof $10.3 million related to the amortization of intangible assets compared to$944,000 for the three months ended June 30, 2003.  For the six months ended June 30, 2004,we recorded amortization of intangible assets of $20.7 million compared to $1.9million during the same period of the prior year.  This increase was due to the addition ofapproximately $198 million of amortizable intangible assets acquired in the Oakacquisition.

 

*Amortization of Deferred Stock Compensation*

 

For the three months ended June 30, 2004, we recorded charges of$2.1 million related to the amortization of deferred stock compensationcompared to $10,000 during the same period of the prior year.  For the six months ended June 30, 2004,these charges were $4.6 million compared to $20,000 during the same period ofthe prior year.  The increase was due tothe stock options granted in connection with the Oak acquisition during 2003which resulted in a deferred stock compensation balance of $19.2 million at thetime of acquisition which is being amortized over the remaining vestingperiod.  As of June 30, 2004, theCompany had a remaining deferred stock compensation balance of $8.4 millionwhich will be amortized over the remaining vesting period using the multipleoption approach through the quarter ending September 30, 2007.

 

*Operating Loss*

 

The operating losses of $5.2 million and $16.2 million for thethree and six month periods ended June 30, 2004, were driven primarily bycharges of $10.3 and $20.7 million, respectively, for the amortization ofintangible assets and $2.1 million and $4.6 million, respectively, for theamortization of deferred stock compensation, each related primarily to the Oakacquisition.  Excluding these charges,our operating income would have been $7.3 million, or 7.0% of total revenues,and $9.1 million, or 4.9% of total revenues, for the three and six months endedJune 30, 2004.  On a comparablebasis, excluding the amortization of intangible assets of $944,000 and $1.9 millionand deferred stock compensation of $10,000 and $20,000 for the three and sixmonth periods ended June 30, 2003, respectively, we would have recorded anoperating income of $4.5 million, or 10% of total revenues, and $4.2 million or5.1% of total revenues. These improvements in adjusted operating income wereprimarily due to the net contribution of product segments acquired in the Oakacquisition.  Zoran’s legacy productsegments contributed approximately the same level of operating income as in thecomparable periods of the previous year. Continued investment in DVD recordingtechnology, HDTV technology and advanced sensor technology adversely affectedour profitability.

 

*Interest and Other Income*

 

Interest and other income was $172,000 and $897,000 for the three andsix months ended June 30, 2004, compared to $1.3 million and $2.9 millionfor the same periods of 2003. The decrease was primarily due to a decline ininterest rates and a decrease in our cash balances due primarily to the use ofcash in the Oak acquisition.

 

*Provision for Income Taxes*

 

Excluding charges related to the amortization of goodwill and otherintangibles, our estimated effective tax rate was 15% for the second quarter of2004.  We have recorded a tax ratecommensurate with the jurisdictional distribution of profits between the U.S.and Israel and the underlying tax positions as a result of the approvedenterprise status in Israel.

 

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At June 30, 2004, we continue to carry a full valuation allowanceagainst our net deferred tax assets as management has determined that it ismore likely than not that our deferred tax assets may not be realized.

 

**Liquidity and Capital Resources**

 

At June 30, 2004, we had $62.0 million of cash and cashequivalents, $38.1 million of short-term investments and $120.3 million ofworking capital. In addition, we had $99.1 million of investments in long-termmarketable securities which are included in other assets on our consolidatedbalance sheet.

 

Net cash provided by operating activities during the six months endedJune 30, 2004 was $8.8 million. While we recorded a net loss of $16.8 million, this loss includednon-cash charges of approximately $30.5 million comprised of depreciation ofproperty and equipment of $5.2 million, amortization of intangible asset of$20.7 million and amortization of deferred stock compensation of $4.6 million,resulting in net income adjusted for non-cash charges of approximately $13.7million for the six months ended June 30, 2004.  Additional cash from operating activities wasprovided by a $25.6 million increase in accounts payable, partially offset by a$19.8 million increase in inventory.

 

Cashprovided by investing activities was $606,000 during the six months endedJune 30, 2004, reflecting the net sale of investments of $5.8 millionoffset by the purchase of $5.2 million of property and equipment.

 

Cash provided by financing activities was $4.6 million during the sixmonths ended June 30, 2004, attributable to the issuance of common stockduring the period.

 

At June 30, 2003, we had $17.1 million of cash and cashequivalents, $125.6 million of short-term investments and $172.1 million ofworking capital. In addition, we had $71.3 million of investments in long-termmarketable securities which are included in other investments in ourconsolidated balance sheet.

 

Our operating activities provided cash of $3.7 million during the sixmonths ended June 30, 2003, primarily due to our net income of $4.4million adjusted for the cash impact associated with an increase of $16.3million in accounts payable and the adjustment related to depreciation andamortization of $2.4 million. Partially offsetting the increase in accountspayable was the cash impact of a $19.3 million increase in accounts receivable.The increase in accounts payable was due to normal timing differences in ourpayment patterns while the increase in accounts receivable was due to theincrease in revenue.

 

Cash used in investing activities was $18.3 million during the sixmonths ended June 30, 2003, principally reflecting the purchases ofshort-term and long-term marketable investments net of proceeds from sales andmaturities of $14.5 million and capital expenditures for property and equipmentof $3.2 million.

 

Cash provided by financing activities was $112,000 for the six monthsended June 30, 2003, reflecting $1.6 million in proceeds from the issuanceof common stock offset by installment payments of $1.5 million on coretechnology.

 

AtJune 30, 2004, we did not have any relationships with unconsolidatedentities or financial partnerships, such as entities often referred to asstructured finance or special purpose entities, established for the purpose offacilitating off-balance sheet arrangements or other contractually narrow orlimited purposes. Accordingly, we are not exposed to the type of financing,liquidity, market or credit risk that could arise if we had engaged in suchrelationships.

 

We believe that our current balances of cash, cash equivalents andshort-term investments, and anticipated cash flow from operations, will satisfyour anticipated working capital and capital expenditure requirements at leastthrough the next 12 months. Nonetheless, our future capital requirements mayvary materially from those now planned and will depend on many factorsincluding, but not limited to:

 

•                  the levels atwhich we maintain inventory and accounts receivable;

 

•                  the marketacceptance of our products;

 

•                  unanticipatedexpenses associated with the recently completed acquisitions of Oak and EmblazeSemiconductor;

 

•                  the levels ofpromotion and advertising required to launch our new products or to entermarkets and attain a competitive position in the marketplace;

 

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•                  our business,product, capital expenditure and research and development plans and technologyroadmap;

 

•                  volume pricingconcessions;

 

•                  capitalimprovements to new and existing facilities;

 

•                  technologicaladvances;

 

•                  the response ofcompetitors to our products; and

 

•                  ourrelationships with our suppliers and customers.

 

In addition, we may require an increase in the level of working capitalto accommodate planned growth, hiring and infrastructure needs. Additionalcapital may also be required for additional acquisitions of businesses,products or technologies.

 

To the extent that our existing resources and cashgenerated from operations are insufficient to fund our future activities, wemay need to raise additional funds through public or private financings or borrowings.If additional funds are raised through the issuance of debt securities, thesesecurities could have rights, preferences and privileges senior to holders ofcommon stock, and the terms of this debt could impose restrictions on ouroperations. The sale of additional equity or convertible debt securities couldresult in additional dilution to our stockholders. We cannot be certain thatadditional financing will be available in amounts or on terms acceptable to us,if at all. If we are unable to obtain this additional financing, we may berequired to reduce the scope of our planned product development and sales andmarketing efforts, which could harm our business, financial condition andoperating results.

 

**Future Performance and Risk Factors**

 

Our future business, operating results and financial condition aresubject to various risks and uncertainties, including those described below.

 

**We are subject to a number of special risksas a result of our recent acquisition of Oak Technology, Inc.**

 

On August 11, 2003, we completed the acquisition Oak.  Although we have made substantive progresswith the integration of the Oak operations, we remain subject to a number ofrisks and uncertainties, including the following:

 

•                  We have facedand continue to face a number of significant challenges in integrating thetechnologies, operations and personnel of Zoran and Oak in a timely andefficient manner, and our failure to do so effectively could have a materialadverse effect on the business and operating results of the combined company.

 

•                  We may notachieve the strategic objectives, cost savings and other anticipated potentialbenefits of the merger, and our failure to achieve these strategic objectivescould have a material adverse effect on our revenues, expenses and operatingresults.

 

**Our quarterly revenues and operating resultsfluctuate due to a variety of factors, which may result in volatility or adecline in the prices of our stock.**

 

Our historical operating results, and those of Oak, have variedsignificantly from quarter to quarter due to a number of factors, including:

 

•                  fluctuation indemand for their products;

 

•                  the timing ofnew product introductions or enhancements by Zoran, Oak and their competitors;

 

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•                  the level ofmarket acceptance of new and enhanced versions of their products and theircustomers’ products;

 

•                  the timing orcancellation of large customer orders;

 

•                  the length andvariability of the sales cycle for their products;

 

•                  pricing policychanges by Zoran, Oak and their competitors and suppliers;

 

•                  the cyclicalnature of the semiconductor industry;

 

•                  the availabilityof development funding and the timing of development revenue;

 

•                  changes in themix of products sold;

 

•                  seasonality in demandfor their products;

 

•                  increasedcompetition in product lines, and competitive pricing pressures; and

 

•                  the evolving andunpredictable nature of the markets for products incorporating Zoran’s andOak’s integrated circuits and embedded software.

 

We expect that the operating results of the combined company willcontinue to fluctuate in the future as a result of these factors and a varietyof other factors, including:

 

•                  the cost andavailability of adequate foundry capacity;

 

•                  fluctuations inmanufacturing yields;

 

•                  changes in orthe emergence of new industry standards;

 

•                  failure toanticipate changing customer product requirements;

 

•                  the loss or gainof important customers;

 

•                  productobsolescence; and

 

•                  the amount ofresearch and development expenses associated with new product introductions.

 

The operating results of the combined company could also be harmed by:

 

•                  economicconditions generally or in various geographic areas where we or our customersdo business;

 

•                  terrorism andinternational conflicts or other crisis, such as the recent recurrence ofSevere Acute Respiratory Syndrome, or SARS;

 

•                  other conditionsaffecting the timing of customer orders;

 

•                  changes ingovernmental regulations that could affect our products; or

 

•                  a downturn in themarkets for our customers’ products, particularly the consumer electronicsmarket.

 

These factors are difficult or impossible to forecast. We place orderswith independent foundries several months in advance of the scheduled deliverydate, often in advance of receiving non-cancelable orders from our customers.This limits our ability to react to fluctuations in demand for their products.If anticipated shipments in any quarter are canceled or do not occur as quicklyas expected, or if we fail to foresee a technology change that could render aproduct obsolete, expense and inventory levels could be disproportionatelyhigh. If anticipated license revenues in any quarter are canceled or do notoccur, gross margins may be reduced. A significant portion of our expenses arerelatively fixed, and the timing of increases in expenses is based in largepart on our forecast of future revenues. As a result, if revenues do not meetour expectations, we may be unable to quickly adjust expenses to levelsappropriate to actual revenues, which could harm our operating results.

 

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Product supply and demand fluctuations common to the semiconductorindustry are historically characterized by periods of manufacturing capacity shortagesimmediately followed by periods of overcapacity, which are caused by theaddition of manufacturing capacity in large increments. We cannot predictwhether we will achieve timely, cost-effective access to that capacity whenneeded, or if there will be a capacity shortage again in the future.

 

As a result of these factors, our operating results may varysignificantly from quarter to quarter. These fluctuations may be morepronounced in the future as a result of the challenges we face in integrating theoperations of Zoran and Oak. Any shortfall in revenues or net income fromlevels expected by the investment community could cause a decline in thetrading price of our stock.

 

**Our customers experience fluctuating productcycles and seasonality, which causes their sales to fluctuate.**

 

Because the markets that our customers serve are characterized bynumerous new product introductions and rapid product enhancements, ouroperating results may vary significantly from quarter to quarter. During thefinal production of a mature product, our customers typically exhaust theirexisting inventory of our products. Consequently, orders for our products maydecline in those circumstances, even if the products are incorporated into bothmature products and replacement products. A delay in a customer’s transition tocommercial production of a replacement product would delay our ability torecover the lost sales from the discontinuation of the related mature product.Our customers also experience significant seasonality in the sales of theirconsumer products, which affects their orders of our products. Typically, thesecond half of the calendar year represents a disproportionate percentage ofsales for our customers due to the holiday shopping period for consumer electronicsproducts, and therefore, a disproportionate percentage of our sales. We expectthese seasonal sales fluctuations to continue for the foreseeable future.

 

**Product supply and demand in thesemiconductor industry is subject to cyclical variations.**

 

The semiconductor industry is subject to cyclical variations in productsupply and demand. Downturns in the industry often occur in connection with, oranticipation of, maturing product cycles for both semiconductor companies andtheir customers and declines in general economic conditions. These downturnshave been characterized by abrupt fluctuations in product demand, productionover-capacity and accelerated decline of average selling prices. In some cases,these downturns have lasted more than one year. A downturn in the semiconductorindustry could harm our sales and revenues if demand drops, or our grossmargins if average selling prices decline.

 

**Our success for the foreseeable future willbe dependent on growth in demand for integrated circuits for a limited numberof applications.**

 

In recent years, we have derived a substantial majority of our productrevenues from the sale of integrated circuits for DVD and digital cameraapplications. We expect that sales of our products for these applications willcontinue to account for a significant portion of our revenues for theforeseeable future. As a result of Oak’s sale of its optical storage business,the future financial performance of the former Oak operations will depend onour ability to successfully develop and market new products in the digitaltelevision, HDTV and digital imaging markets. If the markets for these productsand applications decline or fail to develop as expected, or we are notsuccessful in our efforts to market and sell our products to manufacturers whoincorporate integrated circuits into these products, our financial results willbe harmed.

 

**Our financial performance is highly dependenton the timely and successful introduction of new and enhanced products.**

 

Our financial performance depends in large part on our ability tosuccessfully develop and market next-generation and new products in a rapidlychanging technological environment. If we fail to successfully identify newproduct opportunities and timely develop and introduce new products thatachieve market acceptance, we may lose our market share and our future revenuesand earnings may suffer. In recent years, our success has been dependent on oursuccessful development and timely introduction of integrated circuits for DVDplayers, DVD recorders and digital cameras. These markets are characterized bythe incorporation of a steadily increasing level of integration and numbers offeatures on a chip at the same or lower system cost, enabling originalequipment manufacturers, or OEMs, to continually improve the features or reducethe prices of the systems they sell. If we are unable to continually developand introduce integrated circuits with increasing levels of integration and newfeatures at competitive prices, our operating results will suffer.

 

In the consumer electronics market, Oak’s performance has been highlydependent upon the successful development and timely introduction of newproducts and solutions for broadband digital television and HDTV. In thedigital office market, Oak’s performance has been dependant on its ability tosuccessfully develop embedded image processing system on a chip, or SOC,solutions for the digital office market, in particular, embedded digital colorcopier technology and image processing chips for a variety of imagingperipherals, including printers and multi-function peripherals, or MFPs. Amongother technological changes, embedded PDF and color capability are rapidlyemerging as market requirements for printers and other imaging devices. Some ofOak’s competitors have the capacity to supply these solutions, and some oftheir solutions have been well received in the marketplace. We face thechallenge of continuing Oak’s development of digital television and HDTVsolutions as well as developing new imaging products with the capability tohandle greater color and image complexity, including web-based documents, andwork with higher-performing devices in networked environments. If we are unableto meet these challenges with

 

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the development of products that can effectively compete in the OEMsoftware and solutions market, our future operating results could suffer.

 

**We must keep pace with rapid technologicalchanges and evolving industry standards to remain competitive.**

 

Our future success will depend on our ability to anticipate and adaptto changes in technology and industry standards and our customers’ changingdemands. The consumer electronics market, in particular, is characterized byrapidly changing technology, evolving industry standards, frequent new productintroductions, short product life cycles and increasing demand for higherlevels of integration. Our ability to adapt to these changes and to anticipatefuture standards, and the rate of adoption and acceptance of those standards,will be a significant factor in maintaining or improving our competitiveposition and prospects for growth. If new industry standards emerge, ourproducts or the products of our customers could become unmarketable or obsolete,and we could lose market share or be required to incur substantialunanticipated costs to comply with these new standards.

Our success will also depend on the successful development of newmarkets and the application and acceptance of new technologies and products inthose new markets. For example, our success will depend on the ability of ourcustomers to develop new products and enhance existing products in therecordable DVD player market and products for the broadband digital televisionand HDTV markets and to introduce and promote those products successfully.These markets may not continue to develop to the extent or in the time periodsthat we currently anticipate due to factors outside our control, such as delaysin implementation of FCC 02-320 requiring all new televisions to include adigital receiver. If new markets do not develop as we anticipate, or if ourproducts do not gain widespread acceptance in these markets, our business,financial condition and results of operations could be materially and adverselyaffected. The emergence of new markets for our products is also dependent inpart upon third parties developing and marketing content in a format compatiblewith commercial and consumer products that incorporate our products. If thiscontent is not available, manufacturers may not be able to sell productsincorporating our products, and our sales would suffer.

 

**We rely on independent foundries andcontractors for the manufacture, assembly and testing of our integratedcircuits and other hardware products, and the failure of any of these thirdparties to deliver products or otherwise perform as requested could damage ourrelationships with our customers and harm our sales and financial results.**

 

We do not operate any manufacturing facilities, and we rely onindependent foundries to manufacture substantially all of our products. Theseindependent foundries fabricate products for other companies and may alsoproduce products of their own design. From time to time, there aremanufacturing capacity shortages in the semiconductor industry. We do not havelong-term supply contracts with any of our suppliers, including our principalsupplier, Taiwan Semiconductor Manufacturing Company, or TSMC. Therefore, TSMCand our other suppliers are not obligated to manufacture products for us forany specific period, in any specific quantity or at any specified price, exceptas may be provided in a particular purchase order.

 

Our reliance on independent foundries involves a number of risks,including:

 

•                  the inability toobtain adequate manufacturing capacity;

 

•                  theunavailability of or interruption in access to certain process technologiesnecessary for manufacture of our products;

 

•                  lack of controlover delivery schedules;

 

•                  lack of controlover quality assurance;

 

•                  lack of controlover manufacturing yields and cost; and

 

•                  potentialmisappropriation of our intellectual property.

 

In addition, TSMC and some of our other foundries are located in areasof the world that are subject to natural disasters such as earthquakes. Whilethe 1999 earthquake in Taiwan did not have a material impact on our independentfoundries, a similar event centered near TSMC’s facility could severely reduceTSMC’s ability to manufacture our integrated circuits. The loss of any of our manufacturersas a supplier, our inability to expand the supply of their products in responseto increased demand, or our inability to obtain timely and adequate deliveriesfrom our current or future suppliers due to a natural disaster or any otherreason could delay or reduce shipments of our products. Any of thesecircumstances could damage our relationships with current and prospectivecustomers and harm our sales and financial results.

 

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We also rely on a limited number of independent contractors for theassembly and testing of our products. Our reliance on independent assembly andtesting houses limits our control over delivery schedules, quality assuranceand product cost. Disruptions in the services provided by our assembly ortesting houses or other circumstances that would require them to seekalternative sources of assembly or testing could lead to supply constraints ordelays in the delivery of our products. These constraints or delays could damageour relationships with current and prospective customers and harm our financialresults.

 

**Because foundry capacity is limited from timeto time, we may be required to enter into costly long-term supply arrangementsto secure foundry capacity.**

 

If we are not able to obtain additional foundry capacity as required,our relationships with our customers would be harmed and our sales would likelybe reduced. In order to secure additional foundry capacity, we have considered,and may in the future need to consider, various arrangements with suppliers,which could include, among others:

 

**•**                  optionpayments or other prepayments to a foundry;

 

•                  nonrefundabledeposits with or loans to foundries in exchange for capacity commitments;

 

•                  contracts thatcommit us to purchase specified quantities of silicon wafers over extendedperiods;

 

•                  issuance of ourequity securities to a foundry;

 

•                  investment in afoundry;

 

•                  joint ventures;or

 

•                  otherpartnership relationships with foundries.

 

We may not be able to make any such arrangement in a timely fashion orat all, and such arrangements, if any, may not be on terms favorable to us.Moreover, if we are able to secure foundry capacity, we may be obligated toutilize all of that capacity or incur penalties. Such penalties may be expensiveand could harm our financial results.

 

**If our independent foundries do not achievesatisfactory yields, our relationships with our customers may be harmed.**

 

The fabrication of silicon wafers is a complex process. Minute levelsof contaminants in the manufacturing environment, defects in photo masks usedto print circuits on a wafer, difficulties in the fabrication process or otherfactors can cause a substantial portion of the integrated circuits on a waferto be non-functional. Many of these problems are difficult to detect at anearly stage of the manufacturing process and may be time consuming andexpensive to correct. As a result, foundries often experience problemsachieving acceptable yields, which are represented by the number of good integratedcircuits as a proportion of the number of total integrated circuits on anyparticular wafer. Poor yields from our independent foundries would reduce ourability to deliver our products to customers, harm our relationships with ourcustomers and harm our business.

 

**We face competition or potential competitionfrom companies with greater resources than ours, and if we are unable tocompete effectively with these companies, our market share may decline and ourbusiness could be harmed.**

 

We face intense competition in the markets in which we compete. Weexpect that the level of competition will increase in the future from existingcompetitors and from other companies that may enter our existing or futuremarkets with solutions that may be less costly or provide higher performance oradditional features.

 

Competition in Zoran’s core compression technology market hashistorically been dominated by large companies, such asST Microelectronics, and companies that develop and use their ownintegrated circuits, such as Sony and Matsushita. As this market continues todevelop, we face competition from other large semiconductor vendors.

 

The DVD market continues to expand, and additional competitors areexpected to enter the market for DVD players and software. Some of thesepotential competitors may develop captive implementations for use only withtheir own PC and consumer electronics products. It is also possible thatapplication software vendors, such as Microsoft, may attempt to enter the DVDapplication market in the future. This increased competition may result inprice reductions, reduced profit margins and loss of market share.

 

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We face competition from several large semiconductor companies in thebroadband digital television and set-top box markets. We expect competition tocontinue to increase in these markets as industry standards become well knownand as other competitors enter these markets.

 

We also face significant competition in the digital office market. Thefuture growth of the digital office market is highly dependent onOEMs continuing to outsource an increasing portion of their productdevelopment work. While the trend toward outsourcing on the part of our OEMcustomers in this market has accelerated in recent years, any reversal of thistrend, or a change in the way they outsource, could seriously harm ourbusiness.

 

Many of our existing competitors, as well as OEM customers that areexpected to compete with us in the future, have substantially greaterfinancial, manufacturing, technical, marketing, distribution and otherresources, broader product lines and longer standing relationships withcustomers than we have. In addition, much of our future success is dependent onthe success of our OEM customers. If we or our OEM customers are unable tocompete successfully against current and future competitors, we couldexperience price reductions, order cancellations and reduced gross margins, anyone of which could harm our business.

 

**Our products are characterized by averageselling prices that decline over relatively short time periods; if we areunable to reduce our costs or introduce new products with higher averageselling prices, our financial results will suffer.**

 

Average selling prices for our products decline over relatively shorttime periods, while many of our manufacturing costs are fixed. When our averageselling prices decline, our revenues decline unless we are able to sell moreunits, and our gross margins decline unless we are able to reduce ourmanufacturing costs by a commensurate amount. Our operating results suffer whengross margins decline. We have experienced these problems, and we expect tocontinue to experience them in the future, although we cannot predict when theymay occur or how severe they will be.

 

**We derive most of our revenue from sales to asmall number of large customers, and if we are not able to retain thesecustomers, or they reschedule, reduce or cancel orders, our revenues would bereduced and our financial results would suffer.**

 

Zoran’s and Oak’s largest customers have accounted for a substantialpercentage of their revenues. In 2003, sales to Fujifilm accounted forapproximately 14% of Zoran’s total revenues, and Zoran’s four largest customersaccounted for approximately 46% of its total revenues. Similarly, during Oak’sfiscal 2002, Oak’s top 10 customers accounted for approximately 69% of itstotal revenues. Sales to these large customers have varied significantly fromyear to year and will continue to fluctuate in the future. These sales also mayfluctuate significantly from quarter to quarter. We may not be able to retainour key customers, or these customers may cancel purchase orders orreschedule or decrease their level of purchases from us. Any substantialdecrease or delay in sales to one or more of our key customers could harm oursales and financial results. In addition, any difficulty in collecting amountsdue from one or more key customers could harm our financial results.

 

Fujifilm has been our largest customer over the last six years.Fujifilm purchases our products primarily as a reseller. Fujifilm acts as theprimary reseller in Japan of DVD related products developed by us underdevelopment contracts with Fujifilm. We may sell these products directly inJapan only to specified customers with Fujifilm’s consent. Fujifilm providesmore sales and marketing support than our other resellers. Fujifilm has alsoprovided funding to support Zoran’s development efforts. If our relationshipwith Fujifilm were terminated, our business could be harmed.

 

**Our products generally have long sales cyclesand implementation periods, which increases our costs in obtaining orders andreduces the predictability of our operating results.**

 

Our products are technologically complex. Prospective customersgenerally must make a significant commitment of resources to test and evaluateour products and to integrate them into larger systems. As a result, our salesprocesses are often subject to delays associated with lengthy approval processesthat typically accompany the design and testing of new products. The salescycles of our products often last for many months or even years. Longer salescycles require us to invest significant resources in attempting to make salesand delay the generation of revenue.

 

Long sales cycles also subject us to other risks, including customers’budgetary constraints, internal acceptance reviews and cancellations. Inaddition, orders expected in one quarter could shift to another because of thetiming of customers’ purchase decisions. The time required for our customers toincorporate our products into their own can vary significantly with the needsof our customers and generally exceeds several months, which furthercomplicates our planning processes and reduces the predictability of ouroperating results.

 

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**We are not protected by long-term contractswith our customers.**

 

We generally do not enter into long-term purchase contracts with ourcustomers, and we cannot be certain as to future order levels from ourcustomers. Customers generally purchase our products subject to cancelableshort-term purchase orders. We cannot predict whether our current customerswill continue to place orders, whether existing orders will be canceled, orwhether customers who have ordered products will pay invoices for deliveredproducts. When we do enter into a long-term contract, the contract is generallyterminable at the convenience of the customer. In the event of an early terminationby one of our major customers, it is unlikely that we will be able to rapidlyreplace that revenue source, which would harm our financial results.

 

**Regulation of our customers’ products mayslow the process of introducing new products and could impair our ability tocompete.**

 

The Federal Communications Commission, or FCC, has broad jurisdictionover our target markets in the digital television business we acquired fromOak. Various international entities or organizations may also regulate aspects ofour business or the business of our customers. Although our products are notdirectly subject to regulation by any agency, the transmission pipes, as wellas much of the equipment into which our products are incorporated, are subjectto direct government regulation. For example, before they can be sold in theUnited States, advanced televisions and emerging interactive displays must betested and certified by Underwriters Laboratories and meet FCC regulations.Accordingly, the effects of regulation on our customers or the industries inwhich our customers operate may in turn harm our business. FCC regulatorypolicies affecting the ability of cable operators or telephone companies tooffer certain services and other terms on which these companies conduct theirbusiness may impede sales of our products. In addition, our digital televisionbusiness may also be adversely affected by the imposition of tariffs, dutiesand other import restrictions on our suppliers or by the imposition of exportrestrictions on products that we sell internationally. Changes in current lawsor regulations or the imposition of new laws or regulations in the UnitedStates or elsewhere could harm our business. For example, any delays by the FCCin imposing its pending requirement that all new televisions have a digitalreceiver could have an adverse effect on our HDTV business.

 

**We are dependent upon our international salesand operations; economic, political or military events in a country where wemake significant sales or have significant operations could interfere with oursuccess or operations there and harm our business.**

 

During 2003, 97% of our total revenues and 89% of Oak’s total revenueswere derived from international sales. We anticipate that international saleswill continue to account for the majority of our total revenues for theforeseeable future. In addition, substantially all of our semiconductorproducts are manufactured, assembled and tested outside of the United States byindependent foundries and subcontractors.

 

We are subject to the risks inherent in doing business internationally,including:

 

•                  unexpectedchanges in regulatory requirements;

 

•                  fluctuations inexchange rates;

 

•                  political andeconomic instability;

 

•                  imposition oftariffs and other barriers and restrictions;

 

•                  the burdens ofcomplying with a variety of foreign laws; and

 

•                  health risks ina particular region.

 

A material amount of our research and development personnel andfacilities and a portion of our sales and marketing personnel are located inIsrael. Political, economic and military conditions in Israel directly affectour operations. Some of our employees in Israel are obligated to perform up to39 days of military reserve duty annually. The absence of these employeesfor significant periods during the work week may cause us to operateinefficiently during these periods.

 

Our operations in China are subject to the economic and politicaluncertainties affecting that country. For example, the Chinese economy hasexperienced significant growth in the past decade, but such growth has beenuneven across geographic and economic sectors. This growth may decrease and anyslowdown may have a negative effect on our business. We also maintain officesin Taipei, Taiwan, Hong Kong and Seoul, Korea, and our operations are subjectto the economic and political uncertainties affecting these countries as well.

 

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The significant concentration of our manufacturing activities withthird party foundries in Taiwan exposes us to the risk of political instabilityin Taiwan, including the potential for conflict between Taiwan and China. Wehave several significant OEM customers in Japan, Korea and other parts of Asia.Adverse economic circumstances in Japan and elsewhere in Asia could affectthese customers’ willingness or ability to do business with us in the future ortheir success in developing and launching devices containing our products.

 

**Our business and future operating resultscould be harmed by terrorist activity or armed conflict.**

 

Our business and operating results are subject to uncertainties arisingout of possible terrorist attacks on the United States and other regions of theworld including locations where we maintain operations and by armed conflict inthe Middle East and related economic instability. Our operations could beharmed due to:

 

•                  disruption incommercial activities associated with heightened security concerns affectinginternational travel and commerce;

 

•                  reduced demandfor consumer electronic products due to a potential extension of the globaleconomic slowdown;

 

•                  tightenedimmigration controls that may adversely affect the residence status of keynon-U.S. managers and technical employees in our U.S. facilities or our abilityto hire new non-U.S. employees in such facilities; or

 

•                  potentialexpansion of armed conflict in the Middle East which could adversely affect ouroperations in Israel.

 

**The prices of our products may become lesscompetitive due to foreign exchange fluctuations.**

 

Foreign currency fluctuations may affect the prices of our products.Prices for our products are currently denominated in U.S. dollars for sales toour customers throughout the world. If there is a significant devaluation ofthe currency in a specific country, the prices of our products will increaserelative to that country’s currency, and our products may be less competitivein that country. Also, we cannot be sure that our international customers willcontinue to be willing to place orders denominated in U.S. dollars. If they donot, our revenue and operating results will be subject to foreign exchangefluctuations.

 

**Our ability to compete could be jeopardizedif we are unable to protect our intellectual property rights.**

 

Our success and ability to compete depend in large part upon protectionof our proprietary technology. We rely on a combination of patent, tradesecret, copyright and trademark laws, non-disclosure and other contractualagreements and technical measures to protect our proprietary rights. Theseagreements and measures may not be sufficient to protect our technology fromthird-party infringement, or to protect us from the claims of others.Monitoring unauthorized use of our products is difficult, and we cannot becertain that the steps we have taken will prevent unauthorized use of ourtechnology, particularly in foreign countries where the laws may not protectour proprietary rights as fully as in the United States. The laws of certainforeign countries in which our products are or may be developed, manufacturedor sold, including various countries in Asia, may not protect our products orintellectual property rights to the same extent as do the laws of the UnitedStates and thus make the possibility of piracy of our technology and productsmore likely in these countries. If competitors are able to use our technology,our ability to compete effectively could be harmed.

 

The protection offered by patents is subject to numerous uncertainties.For example, our competitors may be able to effectively design around ourpatents, or the patents may be challenged, invalidated or circumvented. Thosecompetitors may also independently develop technologies that are substantiallyequivalent or superior to our technology. Moreover, while we hold, or haveapplied for, patents relating to the design of our products, some of ourproducts are based in part on standards, for which we do not hold patents orother intellectual property rights.

 

Oak has generally limited access to and distribution of the source andobject code of its software and other proprietary information. With respect toits page description language software and drivers for the digital officemarket and in limited circumstances with respect to firmware and platforms forits HDTV products, Oak has granted licenses that give its customers access toand restricted use of the source code of Oak’s software. This access increasesthe likelihood of misappropriation or misuse of our technology.

 

**We are involved in several lawsuits.**

 

Zoran and Oak are parties to various legal proceedings, including anumber of patent-related lawsuits. In connection with these lawsuits,management time has been, and will continue to be, expended. In addition, bothOak and Zoran have incurred, and we expect to continue to incur, substantiallegal and other expenses in connection with these pending lawsuits. Noprovision for any liability that may result upon adjudication of these lawsuitshas been made in our financial statements.

 

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**We could become subject to claims andlitigation regarding intellectual property rights, which could seriously harmits business and require it to incur significant costs.**

 

In recent years, there has been significant litigation in the UnitedStates involving patents and other intellectual property rights. In the past,Zoran and Oak have been subject to claims and litigation regarding allegedinfringement of other parties’ intellectual property rights, and both Oak andZoran are currently parties to a number of patent-related lawsuits. We couldbecome subject to additional litigation in the future, either to protect ourintellectual property or as a result of allegations that we infringe others’intellectual property rights. Claims that our products infringe proprietaryrights would force us to defend ourselves and possibly our customers ormanufacturers against the alleged infringement. These claims and any resultinglawsuit, if successful, could subject us to significant liability for damagesor invalidation of our proprietary rights. These lawsuits, regardless of theirsuccess, would likely be time-consuming and expensive to resolve and woulddivert management time and attention. Any potential intellectual propertylitigation could force us to do one or more of the following:

 

•                  stop sellingproducts that incorporate the challenged intellectual property;

 

•                  obtain from theowner of the infringed intellectual property right a license to sell or use therelevant technology, which license may not be available on reasonable terms orat all;

 

•                  pay damages; or

 

•                  redesign thoseproducts that use such technology.

 

Although patent disputes in the semiconductor industry have often beensettled through cross-licensing arrangements, we may not be able in any or everyinstance to settle an alleged patent infringement claim through across-licensing arrangement. We have a more limited patent portfolio than manyof our competitors. If a successful claim is made against us or any of ourcustomers and a license is not made available to us on commercially reasonableterms or we are required to pay substantial damages or awards, our business,financial condition and results of operations would be materially adverselyaffected.

 

**If necessary licenses of third-partytechnology are not available to us or are very expensive, our products couldbecome obsolete.**

 

From time to time, we may be required to license technology from thirdparties to develop new products or product enhancements. Third party licensesmay not be available on commercially reasonable terms, if at all. If we areunable to obtain any third-party license required to develop new products andproduct enhancements, we may have to obtain substitute technology of lowerquality or performance standards or at greater cost, either of which couldseriously harm the competitiveness of our products.

 

Certain technology used in our products is licensed from third parties,and in connection with these licenses, we are required to fulfillconfidentiality obligations and, in some cases, pay royalties. Some of ourproducts require various types of copy protection software that we must licensefrom third parties. If we are unable to obtain or maintain our right to use thenecessary copy protection software, we would be unable to sell and market theseproducts.

 

**The new requirements of Section 404 ofthe Sarbanes-Oxley Act will increase our operating expenses, and our recentacquisitions will increase the cost of compliance and increase the risks ofachieving timely compliance.**

 

Rules adopted by the Securities and Exchange Commission pursuant toSection 404 of the Sarbanes-Oxley Act of 2002 require annual review andevaluation of our internal control systems, and attestation of these systems byour independent auditors.  We are currentlyundergoing a review of our internal control systems and procedures andconsidering improvements that will be necessary in order for us to comply withthe requirements of Section 404 by the end of our fiscal year endingDecember 31, 2004.  This evaluationprocess will require us to hire additional personnel and engage outsideadvisory services and will result in additional accounting and legal expenses,all of which will cause our operating expenses to increase.  In addition, the evaluation and attestationprocesses required by Section 404 are new and untested, and we mayencounter problems or delays in completing the implementation of improvementsand receiving a favorable review and attestation of our internal controls byour independent auditors.  Our recentacquisitions of Oak and Emblaze Semiconductor will increase the complexity andcost of our compliance under Section 404 and will also increase the risksof achieving timely compliance.  Ourinability to obtain a timely and favorable attestation by our independentauditors could adversely affect the market price of our common stock.

 

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**If we are not able to apply our net operatinglosses against taxable income in future periods, our financial results will beharmed.**

 

Our future net income and cash flow will be affected by our ability toapply our net operating losses, or NOLs, against taxable income in futureperiods. Our NOLs totaled approximately $261 million for federal and$83 million for state tax reporting purposes as of December 31, 2003.As a result of the change of control resulting from our initial public offeringin 1995, the amount of NOLs that we can use to reduce future taxable income forfederal tax purposes is limited to approximately $3.0 million per year.The Internal Revenue Code contains a number of provisions that could limit theuse of NOLs against income of the combined company as a result of the merger oras a result of the combination of these transactions. Our utilization of Oak’sNOLs may be further limited due to prior Oak transactions. No opinion or IRSruling has been sought regarding the potential application of any of theseprovisions. Changes in tax laws in the United States may further limit ourability to utilize these NOLs. Any further limitation on our ability to utilizethese respective NOLs could harm our financial condition.

 

**Any additional acquisitions we make coulddisrupt our business and severely harm our financial condition.**

 

We have made investments in, and acquisitions of other complementarycompanies, products and technologies. We have recently completed theacquisitions of Oak and Emblaze Semiconductor, and we may acquire additionalbusinesses, products or technologies in the future. In the event of any futureacquisitions, we could:

 

•                  issue stock thatwould dilute its current stockholders’ percentage ownership;

 

•                  incur debt;

 

•                  assumeliabilities;

 

•                  incur expensesrelated to the future impairment of goodwill and the amortization of otherintangible assets; or

 

•                  incur otherlarge write-offs immediately or in the future.

 

Our operation of any other acquired business will also involve numerousrisks, including:

 

•                  problemscombining the purchased operations, technologies or products;

 

•                  unanticipatedcosts;

 

•                  diversion ofmanagement’s attention from our core business;

 

•                  adverse effectson existing business relationships with customers;

 

•                  risks associatedwith entering markets in which we have no or limited prior experience; and

 

•                  potential lossof key employees, particularly those of the purchased organizations.

 

We may not be able to successfully complete the integration of thebusiness, products or technologies or personnel that we might acquire in thefuture, and any failure to do so could disrupt our business and seriously harmour financial condition.

 

In addition, we have made minority equity investments in early-stagecompanies, and we expect to continue to review opportunities to make additionalinvestments in such companies where we believe such investments will provide uswith opportunities to gain access to important technologies or otherwiseenhance important commercial relationships. We have little or no influence overthe early-stage companies in which we have made or may make strategic, minorityequity investments. Each of these investments involves a high degree of risk.We may not be successful in achieving the technological or commercial advantageupon which any given investment is premised, and failure by the early-stagecompany to achieve its own business objectives could result in a loss of all orpart of our invested capital and require us to write off all or a portion ofsuch investment.

 

**Our products could contain defects, whichcould reduce sales of those products or result in claims against us.**

 

We develop complex and evolving products. Despite testing by us and ourcustomers, errors may be found in existing or new products. This could resultin, among other things, a delay in recognition or loss of revenues, loss ofmarket share or failure to achieve market acceptance. These defects may causeus to incur significant warranty, support and repair costs, divert theattention of our engineering personnel from our product development efforts andharm our relationships with customers. The occurrence of

 

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these problems could result in the delay or loss of market acceptanceof our products and would likely harm our business. Defects, integration issuesor other performance problems in our products could result in financial orother damages to customers or could damage market acceptance of such products.Our customers could also seek damages from us for their losses. A productliability claim brought against us, even if unsuccessful, would likely be timeconsuming and costly to defend.

 

**If we do not maintain current developmentcontracts or are unable to enter into new development contracts, our businesscould be harmed.**

 

We historically have generated a portion of our total revenues fromdevelopment contracts, primarily with key customers. These developmentcontracts have provided us with partial funding for the development of some ofour products. Under these contracts, we receive payments upon reaching certaindevelopment milestones. If we fail to achieve the milestones specified in ourexisting development contracts, if our existing contracts are terminated or ifwe are unable to secure future development contracts, our ability tocost-effectively develop new products would be reduced and our business wouldbe harmed.

 

**We may need additional funds to execute ourbusiness plan, and if we are unable to obtain such funds, we will not be ableto expand our business as planned.**

 

We may require substantial additional capital to finance our futuregrowth, secure additional foundry capacity and fund our ongoing research anddevelopment activities beyond 2004. Our capital requirements will depend onmany factors, including:

 

•                  acceptance ofand demand for our products;

 

•                  the types ofarrangements that we may enter into with our independent foundries;

 

•                  the extent towhich we invest in new technology and research and development projects; and

 

•                  any additionalacquisitions that we may make.

 

To the extent that our existing sources of liquidity and cash flow fromoperations are insufficient to fund our activities, we may need to raiseadditional funds. If we raise additional funds through the issuance of equitysecurities, the percentage ownership of our existing stockholders would bereduced. Further, such equity securities may have rights, preferences orprivileges senior to those of our common stock. Additional financing may not beavailable to us when needed or, if available, it may not be available on termsfavorable to us.

 

**If we fail to manage our future growth, ifany, our business would be harmed.**

 

We anticipate that our future growth, if any, will require us torecruit and hire a substantial number of new engineering, managerial, sales andmarketing personnel. Our ability to manage growth successfully will alsorequire us to expand and improve administrative, operational, management andfinancial systems and controls. Many of our key operations, including amaterial portion of our research and development operations and a significantportion of our sales and administrative operations are located in Israel. Amajority of our sales and marketing and certain of our research and developmentand administrative personnel, including our President and Chief ExecutiveOfficer and other officers, are based in the United States. The geographicseparation of these operations places additional strain on our resources andour ability to manage growth effectively. If we are unable to manage growtheffectively, our business will be harmed.

 

**We rely on the services of our executiveofficers and other key personnel, whose knowledge of our business and industrywould be extremely difficult to replace.**

 

Our success depends to a significant degree upon the continuingcontributions of our senior management. Management and other employees mayvoluntarily terminate their employment with us at any time upon short notice.The loss of key personnel could delay product development cycles or otherwiseharm our business. We believe that our future success will also depend in largepart on our ability to attract, integrate and retain highly-skilledengineering, managerial, sales and marketing personnel, located in the UnitedStates, Israel and China. Competition for such personnel is intense, and we maynot be successful in attracting, integrating and retaining such personnel.Failure to attract, integrate and retain key personnel could harm our abilityto carry out our business strategy and compete with other companies.

 

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**The Israeli rate of inflation may negativelyimpact our costs if it exceeds the rate of devaluation of the new Israelishekel against the United States dollar.**

 

A portion of the cost of our operations, relating mainly to ourpersonnel and facilities in Israel, is incurred in new Israeli shekels. As aresult, we bear the risk that the rate of inflation in Israel will exceed therate of devaluation of the new Israeli shekel in relation to the United Statesdollar, which will increase our costs as expressed in United States dollars. Todate, we have not engaged in hedging transactions. In the future, we may enterinto currency hedging transactions to decrease the risk of financial exposurefrom fluctuations in the exchange rate of the United States dollar against thenew Israeli shekel. These measures may not adequately protect us from theimpact of inflation in Israel.

 

**The government programs in which weparticipate and tax benefits we receive require us to meet several conditionsand may be terminated or reduced in the future, which would increase our costs.**

 

Historically, we have financed a portion of our research anddevelopment activities with grants for research and development from the ChiefScientist in Israel’s Ministry of Industry and Trade. Although we did not receiveproceeds from such grants in 2001 or 2002, we did earn such proceeds in 2003and we plan to seek additional grants from the Chief Scientist in the future.To be eligible for these grants, our development projects must be approved bythe Chief Scientist on a case-by-case basis. If our development projects arenot approved by the Chief Scientist, we will not receive grants to fund theseprojects, which would increase our research and development costs. We alsoreceive tax benefits, in particular exemptions and reductions as a result ofthe “Approved Enterprise” status of our existing operations in Israel. To beeligible for these tax benefits, we must maintain our Approved Enterprisestatus by meeting conditions, including making specified investments in fixedassets located in Israel and investing additional equity in our Israelisubsidiary. If we fail to meet these conditions in the future, the tax benefitswould be canceled and we could be required to refund the tax benefits alreadyreceived. These tax benefits may not be continued in the future at theircurrent levels or at any level. Israeli governmental authorities have indicatedthat the government may reduce or eliminate these benefits in the future, whichwould harm our business.

 

**Provisions in our charter documents andDelaware law could prevent or delay a change in control of Zoran.**

 

Our certificate of incorporation and bylaws and Delaware law containprovisions that could make it more difficult for a third party to acquire us,even if doing so would be beneficial to our stockholders. These includeprohibitions:

 

•                  prohibiting amerger with a party that has acquired control of 15% or more of our outstandingcommon stock, such as a party that has completed a successful tender offer,until three years after that party acquired control of 15% of our outstandingcommon stock;

 

•                  authorizing theissuance of up to 3,000,000 shares of “blank check” preferred stock;

 

•                  eliminatingstockholders’ rights to call a special meeting of stockholders; and

 

•                  requiringadvance notice of any stockholder nominations of candidates for election to ourboard of directors.

 

**Our stock price has fluctuated and maycontinue to fluctuate widely.**

 

The market price of our common stock has fluctuated significantly sinceour initial public offering in 1995. Between January 1, 2003 andJune 30, 2004, the closing sale price of our common stock, as reported onThe Nasdaq National Market, ranged from a low of $10.85 to a high of $27.28.The market price of our common stock is subject to significant fluctuations inthe future in response to a variety of factors, including:

 

•                  announcementsconcerning our business or that of our competitors or customers;

 

•                  quarterlyvariations in operating results;

 

•                  changes inanalysts’ earnings estimates;

 

•                  announcements oftechnological innovations;

 

•                  the introductionof new products or changes in product pricing policies by Zoran or itscompetitors;

 

•                  loss of keypersonnel;

 

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•                  proprietaryrights or other litigation;

 

•                  generalconditions in the semiconductor industry; and

 

•                  developments inthe financial markets.

 

In addition, the stock market has, from time to time, experiencedextreme price and volume fluctuations that have particularly affected themarket prices for semiconductor companies or technology companies generally andwhich have been unrelated to the operating performance of the affectedcompanies. Broad market fluctuations of this type may reduce the future marketprice of our common stock.

 

**Item 3.****           Quantitativeand Qualitative Disclosures About Market Risk**

 

We are exposed to financial market risks including changes in interestrates and foreign currency exchange rates.

 

The fair value of our investment portfolio or related income would notbe significantly impacted by either a 10% increase or decrease in interestrates due mainly to the short-term nature of the major portion of ourinvestment portfolio.

 

A majority of our revenue and capital spending is transacted in U.S.dollars, although a portion of the cost of our operations, relating mainly toour personnel and facilities in Israel, is incurred in New Israeli Shekels. Wehave not engaged in hedging transactions to reduce our exposure to fluctuationsthat may arise from changes in foreign exchange rates. Based on our overallcurrency rate exposure at June 30, 2004, a near-term 10% appreciation ordepreciation of the New Israeli Shekel would have an immaterial affect on ourfinancial condition.

 

**Item 4.****           Controlsand Procedures**

 

***Disclosure Controls and Procedures****.** ***Underthe supervision and with the participation of our management, including ourChief Executive Officer and our Chief Financial Officer, we evaluated theeffectiveness of our disclosure controls and procedures, as such term isdefined under Rule 13a-15(e) promulgated under the Securities Exchange Actof 1934, as amended. Based upon that evaluation, our Chief Executive Officerand Chief Financial Officerconcludedthat our disclosure controls and procedures were effective as of the end of theperiod covered by this quarterly report.

 

***Internal Controls Over Financial Reporting****.* There has been no change in our internal control over financialreporting during the quarter ended June 30, 2004 that has materiallyaffected, or is reasonably likely to materially affect, our internal controlover financial reporting.

 

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**PART II. OTHER INFORMATION**

 

**Item 1.****           Legal Proceedings**

 

We and our Oak subsidiary have initiated two legal actions againstMediaTek, Inc. and customers of MediaTek alleging that products incorporatingcertain MediaTek components infringe three patents co-owned by Zoran and Oakrelating to optical drive controller design and integrated CD/DVD controllerdesign.

 

On March 11, 2004, Zoran and Oak filed a complaint withthe United States International TradeCommission (the “ITC”) alleging that certain MediaTek DVD player and opticaldisk controller chips and chipsets, and products in which they are used,infringe Zoran’s and Oak’s patents.  Inaddition to MediaTek, the complaint named 10 other proposed defendants thatsell products, including DVD players and PC optical storage devices, that useMediaTek’s chips and chipsets.  The otherproposed defendants were ASUSTek Computer. Inc., Creative Labs, Inc., CreativeTechnology, Ltd., Jiangsu Shinco Electronic Group Co., Ltd., LITE-ONInformation Technology Corporation, Mintek Digital, Shinco International AVCo., Ltd., TEAC Corporation, TEAC America, Inc., Terapin Technology Corporationand Terapin Technology.  The complaintrequested that the ITC institute an immediate investigation of the accusedproducts and issue exclusion and cease and desist orders prohibiting theimportation into the United States of the infringing MediaTek devices andproducts that contain them.  OnApril 8, 2004, the ITC instituted an investigation based on Zoran’scomplaint.  On April 28, 2004, Zoranand Oak reached a settlement with respondents Creative Technology, Ltd. andCreative Labs, Inc., and these respondents were subsequently dismissed from theinvestigation pursuant to the terms of the settlement agreement.  On July 13, 2004, the ITC grantedZoran’s request that nine additional proposed defendants be added to theinvestigation.  These companies areArtronix Technology, ASUS Computer International, Audiovox Corporation, EPOScience and Technology, Inc., Initial Technology, Inc., Micro-StarInternational Co., Ltd., MSI Computer Corp., Shinco Digital Technology Ltd. andUltima Electronics Corporation. Discovery is currently underway. The hearing is scheduled to begin on January 10, 2005, and thetarget date for completion of the investigation is July 14, 2005.

 

On March 15, 2004, Zoran and Oak filed acomplaint against MediaTek and Mintek Digital in the United States DistrictCourt, Central District of California alleging similar facts regardinginfringement by MediaTek’s chips and chipsets and products in which they areused. The lawsuit seeks both monetary damages and an injunction to stop the importationand sale of infringing products. Zoran subsequently amended the complaint toname ASUSTek Computer, Inc., Jiangsu Shinco Electronic Group Co., Ltd., LITE-ONInformation Technology Corporation, Mintek Digital, Shinco International AVCo., Ltd., TEAC Corporation, TEAC America, Inc., Terapin Technology Corporationand Terapin Technology as defendants. On June 17, 2004, pursuant tostipulation of the parties, the case was transferred to the United StatesDistrict Court, Northern District of California. On July 2, 2004,Defendants filed a First Amended Answer which included counterclaims fordeclaration of noninfringement, declaration of invalidity, declaration ofunenforceability, breach of covenant not to sue, breach of covenant of goodfaith and fair dealing and unfair competition.

 

On July 23, 2004, MediaTek filed a complaint with the ITC allegingthat certain Zoran and Oak DVD player and optical disk controller chips andchipsets infringe two MediaTek patents. The complaint requested that the ITC institute an investigation into theaccused products and issue exclusion and cease and desist orders prohibitingimportation into the United States of allegedly infringing chips and productsthat contain them.  The ITC has not yetinstituted an investigation.  Also onJuly 23, 2004, MediaTek filed a complaint against Zoran and Oak in theUnited States District Court, District of Delaware alleging infringement of thesame two patents asserted in MediaTek’s ITC complaint and seeking monetarydamages and injunctive relief.  Basedupon our preliminary review, we believe we have meritorious defenses to the twoMediaTek complaints, which we believe were filed in response to the proceedingsthat we have been prosecuting against MediaTek and its customers.  We intend to defend the MediaTek actionsvigorously.  However, the litigation isin the preliminary stage, and we cannot predict its outcome withcertainty.  Patent litigation isparticularly complex and can extend for a protracted time, which cansubstantially increase litigation expenses.

 

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**Item 4.  Submission of Mattersto a Vote of Security Holders**

 

Our 2004 Annual Meeting of Stockholders was held onJune 18, 2004.  At the meeting, the following seven persons nominatedby management were elected to serve as members of our Board of Directors:

 
| ** **          | ** ** | **Shares**    | ** ** |
|---------------------|------------|---------------|------------|
| **Nominee**         | ** ** | **Voted For** | ** ** | **Withheld** | ** ** |
| ** **          | ** ** | ** **    | ** ** | ** ** | ** ** |
| Levy Gerzberg       |       | 36,790,606    |       | 1,530,800 |   |
|                |       |          |       |   |   |
| Uzia Galil          |       | 35,948,937    |       | 2,372,469 |   |
|                |       |          |       |   |   |
| James D. Meindl     |       | 36,755,606    |       | 1,565,800 |   |
|                |       |          |       |   |   |
| James B. Owens, Jr. |       | 36,090,409    |       | 2,230,997 |   |
|                |       |          |       |   |   |
| David Rynne         |       | 36,890,888    |       | 1,430,518 |   |
|                |       |          |       |   |   |
| Arthur B. Stabenow  |       | 35,955,127    |       | 2,366,279 |   |
|                |       |          |       |   |   |
| Philip M. Young     |       | 36,773,796    |       | 1,547,610 |   |

 

The following additional items were voted upon at themeeting:

 

1.                     A proposal to approve the adoption of our 2004 EquityIncentive Plan was not approved.  Thevote on this proposal was of 9,619,614 shares for; 14,931,139 shares against;117,565 shares abstaining; and 13,653,088 broker non-votes.

 

2.                     A proposal to approve an amendment to our 1995 OutsideDirectors Stock Option Plan to increase the maximum aggregate number of sharesthat may be issued thereunder by 100,000 shares was not approved.  The vote on this proposal was 10,759,317shares for; 13,789,884 shares against; 119,118 shares abstaining; and13,653,087 broker non-votes.

 

3.                     A proposal to approve an amendment to our 1995Employee Stock Purchase Plan to increase the maximum aggregate number of sharesthat may be issued thereunder by 250,000 shares was approved.  The vote on this proposal was 21,541,117shares for; 3,025,649 shares against; 101,533 shares abstaining; and 13,653,087broker non-votes.

 

4.                     A proposal to ratify the appointment ofPricewaterhouseCoopers LLP as our independent accountants for the fiscal yearending December 31, 2004 was approved by a vote of 37,628,402 shares for;645,438 shares against; 47,565 shares abstaining; and 1 broker non-vote.

 

**Item 6.  Exhibits and Reports on Form 8-K**

** **

(a)                                  Exhibits:

 

31.1                            Certificationof Chief Executive Officer pursuant to Rule 13a-14(a).

31.2                            Certificationof Chief Financial Officer pursuant to Rule 13a-14(a).

32.1                            Certificationof Chief Executive Officer, pursuant to 18 U.S.C. Section 1350.

32.2                            Certificationof Chief Financial Officer, pursuant to 18 U.S.C. Section 1350.

 

(b)                                 OnApril 27, 2004, we filed a Report on Form 8-K, pursuant to Item 12thereof, relating to financial information for the quarter ended March 31,2004 and the outlook for the second quarter of 2004, as presented in a pressrelease dated April 27, 2004.

 

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**SIGNATURES**

 

 

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

 

 

**ZORAN CORPORATION**

 

 
| Date:  August 9, 2004 |   |   | /s/  Karl Schneider                                    |   |
|---------------------------------|--------|--------|-------------------------------------------------------------|--------|
|                            |   |   | Karl Schneider                                              |   |
|                            |   |   | Senior Vice President, Finance  and Chief Financial Officer |   |
|                            |   |   |                                                        |
|                            |   |   | (Principal Financial and Accounting Officer)                |   |

 

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