**SECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C. 20549**

 

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**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 March 31, 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 its charter)

 

| **Delaware**                                                    |   | **94-2794449**                           |
|-----------------------------------------------------------------|--------|------------------------------------------|
| (State or other jurisdiction  of incorporation or organization) |   | (I.R.S. Employer  Identification Number) |

 

**1390 Kifer RoadSunnyvale, California 94086**

(Address of principal executive offices,including zip code)

 

**(408) 523-6500**

(Registrant’s telephone number, includingarea code)

 

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Indicate by check mark whetherthe registrant (1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports)and (2) has been subject to such filing requirements for the past 90 days.Yes ý  No o

 

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

Yes  ý   No  o

 

As of May 6, 2004, there wereoutstanding 42,724,654 shares of the registrant’s Common Stock, par value$0.001 per share.

 

 

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**ZORAN CORPORATION ANDSUBSIDIARIES**

**FORM 10-Q**

**INDEX**

 

**For the Quarter EndedMarch 31, 2004**

 
| **PART I. FINANCIAL INFORMATION** |                                                                                        |
|-----------------------------------|---------------------------------------------------------------------------------------------|
|                              |                                                                                        |   |   |
| **Item 1.**                       | Financial  Statements (Unaudited):                                                          |   |
|                              |                                                                                        |   |   |
|                              |                                                                                        | Condensed Consolidated Balance Sheets as of  March 31, 2004 and December 31, 2003 |   |
|                              |                                                                                        |   |   |
|                              |                                                                                        | Condensed Consolidated Statements of  Operations for the Three Months Ended March 31, 2004 and 2003 |   |
|                              |                                                                                        |   |   |
|                              |                                                                                        | Condensed Consolidated Statements of Cash  Flows for the Three Months Ended March 31, 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 6.**                       | Exhibits and Reports on Form 8-K                                                            |   |
|                              |                                                                                        |   |   |
| Signatures                        |                                                                                        |   |   |

 

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**ZORAN CORPORATIONCONDENSED CONSOLIDATED BALANCESHEETS(in thousands, except share data)(unaudited)**

 
|                                                                                                                                                                                                                                          |   | **March 31,  2004** |    | **December  31,  2003** |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------|---------|-------------------------|--------|
|                                                                                                                                                                                                                                          |   |                |    |                    |   |
| ASSETS                                                                                                                                                                                                                                        |   |                |    |                    |   |
| Current assets:                                                                                                                                                                                                                               |   |                |    |                    |   |
| Cash and cash equivalents                                                                                                                                                                                                                     |   | $                   | 65,559  |                    | $      | 47,994 |   |
| Short-term investments                                                                                                                                                                                                                        |   | 59,711              |    | 78,372                  |   |
| Accounts receivable, net                                                                                                                                                                                                                      |   | 65,811              |    | 65,224                  |   |
| Inventory                                                                                                                                                                                                                                     |   | 17,999              |    | 16,805                  |   |
| Prepaid expenses and other current assets                                                                                                                                                                                                     |   | 10,618              |    | 12,151                  |   |
| Total current assets                                                                                                                                                                                                                          |   | 219,698             |    | 220,546                 |   |
|                                                                                                                                                                                                                                          |   |                |    |                    |   |
| Property and equipment, net                                                                                                                                                                                                                   |   | 19,692              |    | 20,029                  |   |
| Other assets and investments                                                                                                                                                                                                                  |   | 81,580              |    | 69,311                  |   |
| Goodwill                                                                                                                                                                                                                                      |   | 119,272             |    | 119,091                 |   |
| Intangible assets, net                                                                                                                                                                                                                        |   | 178,128             |    | 188,885                 |   |
|                                                                                                                                                                                                                                          |   |                |    |                    |   |
|                                                                                                                                                                                                                                          |   | $                   | 618,370 |                    | $      | 617,862 |   |
|                                                                                                                                                                                                                                          |   |                |    |                    |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                                                                     |   |                |    |                    |   |
| Current liabilities:                                                                                                                                                                                                                          |   |                |    |                    |   |
| Accounts payable                                                                                                                                                                                                                              |   | $                   | 33,658  |                    | $      | 29,038 |   |
| Accrued expenses and other liabilities                                                                                                                                                                                                        |   | 45,113              |    | 45,182                  |   |
| Total current liabilities                                                                                                                                                                                                                     |   | 78,771              |    | 74,220                  |   |
|                                                                                                                                                                                                                                          |   |                |    |                    |   |
| Long-term liabilities                                                                                                                                                                                                                         |   | 8,876               |    | 9,363                   |   |
|                                                                                                                                                                                                                                          |   |                |    |                    |   |
| Stockholders’ equity:                                                                                                                                                                                                                    |   |                |    |                    |   |
| Common stock, $0.001 par value; 105,000,000  shares authorized at March 31, 2004 and December 31, 2003; 42,580,894 shares  issued and outstanding as of March 31, 2004; and 42,347,584 shares issued and  outstanding as of December 31, 2003 |   | 43                  |    | 42                      |   |
| Additional paid-in capital                                                                                                                                                                                                                    |   | 705,949             |    | 703,812                 |   |
| Deferred stock-based compensation                                                                                                                                                                                                             |   | (10,483             | )       | (13,014                 | )      |
| Accumulated other comprehensive income (loss)                                                                                                                                                                                                 |   | 2,373               |    | (91                     | )      |
| Accumulated deficit                                                                                                                                                                                                                           |   | (167,159            | )       | (156,470                | )      |
| Total stockholders’ equity                                                                                                                                                                                                               |   | 530,723             |    | 534,279                 |   |
|                                                                                                                                                                                                                                          |   |                |    |                    |   |
|                                                                                                                                                                                                                                          |   | $                   | 618,370 |                    | $      | 617,862 |   |

 

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

 

3

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**ZORAN CORPORATIONCONDENSED CONSOLIDATED STATEMENTSOF OPERATIONS(in thousands, except per share data)(unaudited)**

 
|                                                        |   | **Three  Months Ended  March 31,** |    |
|-------------------------------------------------------------|--------|------------------------------------|---------|
|                                                        |   | **2004**                           |    | **2003** |   |
|                                                        |   |                               |    |   |   |
| Revenues:                                                   |   |                               |    |   |   |
| Hardware product revenues                                   |   | $                                  | 68,029  |   | $ | 37,097 |   |
| Software and other revenues                                 |   | 12,608                             |    | 736 |   |
| Total revenues                                              |   | 80,637                             |    | 37,833 |   |
|                                                        |   |                               |    |   |   |
| Costs and expenses:                                         |   |                               |    |   |   |
| Cost of hardware product revenues                           |   | 45,328                             |    | 26,710 |   |
| Research and development                                    |   | 18,646                             |    | 4,479 |   |
| Selling, general and administrative                         |   | 14,817                             |    | 6,942 |   |
| Amortization of intangible assets                           |   | 10,343                             |    | 943 |   |
| Amortization of deferred stock compensation                 |   | 2,531                              |    | 10 |   |
| Total costs and expenses                                    |   | 91,665                             |    | 39,084 |   |
|                                                        |   |                               |    |   |   |
| Operating loss                                              |   | (11,028                            | )       | (1,251 | ) |
|                                                        |   |                               |    |   |   |
| Interest income                                             |   | 400                                |    | 1,593 |   |
|                                                        |   |                               |    |   |   |
| Other income (loss), net                                    |   | 325                                |    | (22 | ) |
|                                                        |   |                               |    |   |   |
| Income (loss) before income taxes                           |   | (10,303                            | )       | 320 |   |
|                                                        |   |                               |    |   |   |
| Provision for income taxes                                  |   | 386                                |    | 127 |   |
|                                                        |   |                               |    |   |   |
| Net income (loss)                                           |   | $                                  | (10,689 | ) | $ | 193 |   |
|                                                        |   |                               |    |   |   |
| Basic net income (loss) per share                           |   | $                                  | (0.25   | ) | $ | 0.01 |   |
|                                                        |   |                               |    |   |   |
| Diluted net income (loss) per share                         |   | $                                  | (0.25   | ) | $ | 0.01 |   |
|                                                        |   |                               |    |   |   |
| Shares used to compute basic net income  (loss) per share   |   | 42,522                             |    | 27,396 |   |
|                                                        |   |                               |    |   |   |
| Shares used to compute diluted net income  (loss) per share |   | 42,522                             |    | 28,096 |   |

 

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

 

4

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**ZORANCORPORATIONCONDENSED CONSOLIDATED STATEMENTSOF CASH FLOWS(in thousands)(unaudited)**

 
|                                                                            |   | **Three  Months Ended  March 31,** |    |
|---------------------------------------------------------------------------------|--------|------------------------------------|---------|
|                                                                            |   | **2004**                           |    | **2003** |   |
| Cash flows from operating activities:                                           |   |                               |    |   |   |
| Net income (loss)                                                               |   | $                                  | (10,689 | ) | $ | 193 |   |
| Adjustments to reconcile net income (loss)  to net cash provided by operations: |   |                               |    |   |   |
| Depreciation, amortization and other                                            |   | 2,492                              |    | 876 |   |
| Amortization of intangible assets                                               |   | 10,343                             |    | 1,194 |   |
| Amortization of deferred stock compensation                                     |   | 2,531                              |    | 10 |   |
| Changes in current assets and liabilities:                                      |   |                               |    |   |   |
| Accounts receivable                                                             |   | (587                               | )       | (11,613 | ) |
| Inventory                                                                       |   | (1,194                             | )       | 4,983 |   |
| Prepaid expenses and other current assets  and other assets and investments     |   | 494                                |    | (1,280 | ) |
| Accounts payable                                                                |   | 4,620                              |    | 4,333 |   |
| Accrued expenses and other liabilities and  long-term liabilities               |   | (556                               | )       | (1,122 | ) |
| Net cash provided by (used in) operating  activities                            |   | 7,454                              |    | (2,426 | ) |
|                                                                            |   |                               |    |   |   |
| Cash flows from investing activities:                                           |   |                               |    |   |   |
| Capital expenditures for property and  equipment                                |   | (1,922                             | )       | (973 | ) |
| Purchases of investments                                                        |   | (59,444                            | )       | (31,855 | ) |
| Proceeds from sales and maturities of  investments                              |   | 69,339                             |    | 32,488 |   |
| Net cash provided by (used in) investing  activities                            |   | 7,973                              |    | (340 | ) |
|                                                                            |   |                               |    |   |   |
| Cash flows from financing activities:                                           |   |                               |    |   |   |
| Proceeds from issuance of common stock                                          |   | 2,138                              |    | 108 |   |
| Installment payment on purchased core  technology                               |   | —                             |    | (1,500 | ) |
| Net cash provided by (used in) financing  activities                            |   | 2,138                              |    | (1,392 | ) |
|                                                                            |   |                               |    |   |   |
| Net increase (decrease) in cash and cash  equivalents                           |   | 17,565                             |    | (4,158 | ) |
|                                                                            |   |                               |    |   |   |
| Cash and cash equivalents at beginning of  period                               |   | 47,994                             |    | 31,607 |   |
|                                                                            |   |                               |    |   |   |
| Cash and cash equivalents at end of period                                      |   | $                                  | 65,559  |   | $ | 27,449 |   |

 

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

 

5

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**ZORAN CORPORATION**

**NOTES TO CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

**(unaudited)**

 

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

 

The accompanying unauditedcondensed consolidated financial statements of Zoran Corporation andsubsidiaries (“Zoran” or the “Company”) have been prepared in conformity withaccounting principles for interim financial information generally accepted inthe United States of America.  However,certain information or footnote disclosures normally included in financialstatements prepared in accordance with accounting principles generally acceptedin the United States of America have been condensed or omitted pursuant to therules and regulations of the Securities and Exchange Commission (the“Commission”).  In the opinion ofmanagement, the condensed consolidated financial statements reflect all adjustmentsconsidered necessary, consisting only of normally occurring adjustments, for afair presentation of the consolidated financial position, operating results andcash flows for the periods presented. The results of operations for the interim periods presented are notnecessarily indicative of the results that may be expected for the full fiscalyear or in any future period.  Thisquarterly report on Form 10-Q should be read in conjunction with the audited consolidatedfinancial statements and notes thereto for the year endedDecember 31, 2003, included in the Zoran Corporation 2003 AnnualReport on Form 10-K filed with the Commission.

 

***Reclassifications***

 

Certain prior period amountshave been reclassified to conform to the current period presentation.

 

***RecentlyIssued Accounting Standards***

 

In January 2003, the FASBissued FASB Interpretation No. 46 (“FIN 46”), “Consolidation of VariableInterest Entities, an Interpretation of ARB No. 51.” FIN 46 requirescertain variable interest entities to be consolidated by the primarybeneficiary of the entity if the equity investors in the entity do not have thecharacteristics of a controlling financial interest or do not have sufficientequity at risk for the entity to finance its activities without additional subordinatedfinancial support from other parties. FIN 46 is effective immediately for allnew variable interest entities created or acquired after January 31, 2003.For variable interest entities created or acquired prior to February 1,2003, the provisions of FIN 46 must be applied for the first interim or annualperiod beginning after March 15, 2004. The Company does not expect thatthe adoption of FIN 46 will have a material impact on its financial position,results of operations, or cash flows.

 

In March 2004, the EmergingIssues Task Force (“EITF”) reached a consensus on Issue No. 03-01, “The Meaningof Other-Than-Temporary Impairment and Its Application to CertainInvestments.”  EITF No. 03-01 providesguidance on recording other-than-temporary impairments of cost methodinvestments and requires additional disclosures for those investments.  The recognition and measurement guidance inEITF No. 03-01 should be applied to other-than-temporary impairments evaluationsin reporting periods beginning after June 15, 2004.  The disclosure requirements are effective for fiscal years endingafter June 15, 2004 and are required only for annual periods.  The Company does not believe that theadoption of this standard will have a material impact on its consolidated balancesheet or statement of operations.

 

**2.     Stock Based Compensation**

 

Zoran applies AccountingPrinciples Board Opinion No. 25, “Accounting for Stock Issued to Employees,”and related interpretations in accounting for its stock plans.  Stock options are generally granted withexercise prices equivalent to fair market value of the underlying common stockon the date of grant, and no compensation cost is recognized.  In connection with stock options grantedthrough the acquisition of Nogatech, Inc. during 2000 and Oak Technology, Inc.during 2003, the Company recorded deferred stock-based compensation which isbeing amortized over the vesting period of the options.  Amortization of deferred stock compensationexpense recognized as a result of the amortization of these options during thequarter ended March 31, 2004 and 2003 was approximately $2,531,000 and $10,000,respectively.

 

6

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Had compensation cost for theCompany’s option and stock purchase plans been determined based on the fairvalue of the options at the grant date, as prescribed in Statement of FinancialAccounting Standards No. 123 “Accounting for Stock Based Compensation” (“SFAS123”), the Company’s net loss and net loss per share for the three monthperiods ended March 31, 2004 and 2003 would have been as follows (in thousands,except per share data):

 
|                                                                                                |   | **Three  Months Ended  March 31,** |    |
|-----------------------------------------------------------------------------------------------------|--------|------------------------------------|---------|
|                                                                                                |   | **2004**                           |    | **2003** |   |
|                                                                                                |   |                               |    |   |   |
| Net income (loss) attributable to common  stockholders, as reported                                 |   | $                                  | (10,689 | ) | $ | 193 |   |
|                                                                                                |   |                               |    |   |   |
| Add:                                                                                                |   |                               |    |   |   |
| Employee stock-based compensation expense  included in net income (loss), net of tax                |   | 2,531                              |    | 10 |   |
|                                                                                                |   |                               |    |   |   |
| Total employee stock-based compensation  expense determined under the fair value method, net of tax |   | (11,844                            | )       | (6,284 | ) |
|                                                                                                |   |                               |    |   |   |
| Pro forma net loss attributable to common  stockholders                                             |   | $                                  | (20,002 | ) | $ | (6,081 | ) |
|                                                                                                |   |                               |    |   |   |
| Pro forma net loss per share attributable  to common stockholders:                                  |   |                               |    |   |   |
| Basic                                                                                               |   | $                                  | (0.47   | ) | $ | (0.22 | ) |
| Diluted                                                                                             |   | $                                  | (0.47   | ) | $ | (0.22 | ) |
|                                                                                                |   |                               |    |   |   |
| Net income (loss) per share as reported:                                                            |   |                               |    |   |   |
| Basic                                                                                               |   | $                                  | (0.25   | ) | $ | 0.01 |   |
| Diluted                                                                                             |   | $                                  | (0.25   | ) | $ | 0.01 |   |

 

For purposes of the disclosurerequired under SFAS 123, the fair value of each option grant is estimated onthe date of grant using the Black-Scholes option pricing model with thefollowing assumptions used for options and purchase grants during theapplicable periods.

 
|                    |   | **Stock Option Plans**                    |   | **Employee Stock Purchase Plans**         |   |
|-------------------------|--------|-------------------------------------------|--------|-------------------------------------------|--------|
|                    |   | **Three Months  Ended****March 31, 2004** |   | **Three Months  Ended****March 31, 2003** |   | **Three Months  Ended****March 31, 2004** |   | **Three Months****Ended  March 31, 2003** |   |
|                    |   |                                      |   |                                      |   |   |   |   |   |
| Expected life (years)   |   | 5.0                                       |   | 5.0                                       |   | 0.5 |   | 0.5 |   |
| Expected volatility     |   | 85                                        | %      | 93                                        | %      | 91 | % | 93 | % |
| Risk-free interest rate |   | 3.0                                       | %      | 4.7                                       | %      | 1.0 | % | 2.8 | % |

 

TheBlack-Scholes option pricing model was developed for use in estimating thevalue of traded options that have no vesting restrictions and are fullytransferable. In addition, option pricing models require the input of highlysubjective assumptions including the expected stock price volatility. TheCompany uses projected data for expected volatility and expected life of itsstock options based upon historical and other economic data trended into futureyears. Because the Company’s employee stock options have characteristicssignificantly different from those of traded options, and because changes inthe subjective input assumptions can materially affect the estimate, inmanagement’s opinion, existing valuation models, including the Black-Scholesmodel, do not necessarily provide a reliable measure of the fair value of theCompany’s stock options.

 

7

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

 

The following table presentsthe calculation of comprehensive income (loss) as required by SFAS 130(“Reporting Comprehensive Income”).  Thecomponents of comprehensive income (loss), net of tax, are as follows (inthousands):

 
|                                                  |   | **Three  Months Ended  March 31,** |         |
|-------------------------------------------------------|--------|------------------------------------|--------------|
|                                                  |   | **2004**                           |         | **2003** |   |
|                                                  |   |                               |         |   |   |
| Net income (loss)                                     |   | $                                  | (10,698      | ) | $ | 193 |   |
| Change in unrealized gain on investments,  net of tax |   | 2,464                              |         | 125 |   |
| Total comprehensive income (loss)                     |   | $                                  |  (8,234 | ) | $ |  318 |   |

 

The components of accumulatedother comprehensive income (loss) are unrealized gain (loss) on short-term andlong-term marketable securities.

 

**4.****              Inventories**

 

Inventories are stated at thelower of cost (first in, first out) or market and consisted of the following(in thousands):

 
|                                |   | **March 31,  2004** |   | **December  31,  2003** |   |
|-------------------------------------|--------|---------------------|--------|-------------------------|--------|
|                                |   |                |   |                    |   |
| Purchased parts and work in process |   | $                   | 9,662  |                    | $      | 5,701 |   |
| Finished goods                      |   | 8,337               |   | 11,104                  |   |
|                                |   | $                   | 17,999 |                    | $      | 16,805 |   |

 

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

 

The Company adopted Statementof Financial Accounting Standards No. 142, “Goodwill and Other IntangibleAssets”, or SFAS 142, as of January 1, 2002. In accordance with SFAS 142,goodwill is not amortized, but is required to be reviewed periodically forimpairment on at least an annual basis. For the year ended December 31, 2003, the Company performed the annualanalysis as of September 30, 2003 and concluded that goodwill was not impaired,as the fair value of each reporting unit exceeded its carrying value, includinggoodwill.

 

**Componentsof Acquired Intangible Assets**(in thousands):

 
|                         |   |              |   | **March 31,  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 |                          | $      | (40,147 | ) | $ | 136,573 |   | $ | 176,720 |   | $ | (31,792 | ) | $ | 144,928 |   |
| Patents                      |   | 3-5               |   | 27,900                      |    | (4,346                        | )      | 23,554 |   | 27,900 |   | (2,996 | ) | 24,904 |   |
| Customer base                |   | 3-5               |   | 13,010                      |    | (3,023                        | )      | 9,987 |   | 13,010 |   | (2,450 | ) | 10,560 |   |
| Tradename and others         |   | 3-5               |   | 2,100                       |    | (965                          | )      | 1,135 |   | 2,100 |   | (900 | ) | 1,200 |   |
| Purchased core technology *  |   | 4-5               |   | 8,799                       |    | (1,920                        | )      | 6,879 |   | 8,799 |   | (1,506 | ) | 7,293 |   |
| Total                        |   |              |   | $                           | 228,529 |                          | $      | (50,401 | ) | $ | 178,128 |   | $ | 228,529 |   | $ | (39,644 | ) | $ | 188,885 |   |

 

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(*) The Company records theamortization of purchased core technology as cost of hardware product revenues.

 

8

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Estimated future intangibleamortization expense, based on current balances, as of March 31, 2004 is asfollows (in thousands):

 
|                          |   | **Amount** |    |
|-------------------------------|--------|------------|---------|
|                          |   |       |    |
| Remaining nine months of 2004 |   | $          | 32,419  |   |
| Year ending December 31, 2005 |   | 43,401     |    |
| Year ending December 31, 2006 |   | 42,130     |    |
| Year ending December 31, 2007 |   | 38,623     |    |
| Year ending December 31, 2008 |   | 21,555     |    |
| Total                         |   | $          | 178,128 |   |

 

Changes in the carrying amountof goodwill for the three months ended March 31, 2004 were as follows (inthousands):

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

 

Goodwill by reporting unit atMarch 31, 2004 and December 31, 2003 was as follows:

 
|    |   | **March 31,  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 taxesreflects the estimated annualized effective tax rate applied to earningsexcluding charges for amortization of goodwill and other intangibles for theinterim periods.  The effective tax ratediffers from the U.S. statutory rate due to utilization of net operatinglosses, adjustments for the nondeductible amortization of goodwill and otherintangibles and income tax rate differences on foreign earnings.  The Company has provided for tax on incomein excess 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 establishesstandards for the reporting by public business enterprises of information aboutoperating segments, products and services, geographic areas, and majorcustomers. The method for determining what information to report is based onthe way that management organizes the operating segments within the Company formaking operational decisions and assessments of financial performance. TheCompany’s chief operating decision-maker is considered to be the ChiefExecutive 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). The DVD group provides video and audiocompression and decompression products based on MPEG, Dolby Digital and DTSstandards for use in DVD players and DVD recorders. The Imaging group providesimaging systems, including products used in digital laser copiers and printersas well as multifunction peripherals. The DC group focuses on video compressionand decompression products based on JPEG technology and

 

9

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CMOS sensors. The DTV groupprovides highly integrated application-specific integrated circuits, or ASICs,and system-on-a-chip, or SOC, solutions for standard and high definitiondigital television products including televisions, set top boxes, personalvideo recorders, digital video recorders, and recordable DVD as well asplatforms, drivers and software stacks for a variety of operating systemsrequired for these digital television products.

 

The Company evaluates operatingsegment performance based on net revenues and operating expenses of thesesegments. The accounting policies of the operating segments are the same asthose described in the summary of accounting policies. No reportable segmentshave been aggregated.

 

Information about reportedsegment income or loss is as follows for the three months ended March 31,2004 and 2003 (in thousands):

 
|                 |   | **Three  Months Ended  March 31,** |   |
|----------------------|--------|------------------------------------|--------|
|                 |   | **2004**                           |   | **2003** |   |
| Net revenues:        |   |                               |   |   |   |
| DVD                  |   | $                                  | 47,223 |   | $ | 31,211 |   |
| Imaging              |   | 18,188                             |   | — |   |
| DC                   |   | 7,855                              |   | 6,622 |   |
| DTV                  |   | 7,371                              |   | — |   |
|                 |   | $                                  | 80,637 |   | $ | 37,833 |   |
|                 |   |                               |   |   |   |
| Operating expenses:  |   |                               |   |   |   |
| DVD                  |   | $                                  | 48,062 |   | $ | 31,244 |   |
| Imaging              |   | 10,508                             |   | — |   |
| DC                   |   | 7,900                              |   | 6,887 |   |
| DTV                  |   | 12,321                             |   | — |   |
|                 |   | $                                  | 78,791 |   | $ | 38,131 |   |
|                 |   |                               |   |   |   |
| Contribution margin: |   |                               |   |   |   |
| DVD                  |   | $                                  | (839   | ) | $ | (33 | ) |
| Imaging              |   | 7,680                              |   | — |   |
| DC                   |   | (45                                | )      | (265 | ) |
| DTV                  |   | (4,950                             | )      | — |   |
|                 |   | $                                  | 1,846  |   | $ | (298 | ) |

 

A reconciliation of the totalsreported for the operating segments to the applicable line items in theconsolidated financial statements for the three months ended March 31,2004 and 2003 is as follows (in thousands):

 
|                                        |   | **Three  Months Ended  March 31,** |    |
|---------------------------------------------|--------|------------------------------------|---------|
|                                        |   | **2004**                           |    | **2003** |   |
| Contribution margin from operating segments |   | $                                  | 1,846   |   | $ | (298 | ) |
| Amortization of intangibles                 |   | 10,343                             |    | 943 |   |
| Amortization of deferred stock compensation |   | 2,531                              |    | 10 |   |
| Total operating loss                        |   | $                                  | (11,028 | ) | $ | (1,251 | ) |

 

Zoran maintains operations inthe United States, Israel, Canada, the United Kingdom, Germany, China, Taiwan,Korea and Japan. Activities in the United States and Israel consist ofcorporate administration, product development, logistics and worldwide salesmanagement. Other foreign operations consist of sales, product development, andtechnical support.

 

10

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The distribution of totalrevenues for the three months ended March 31, 2004 and 2003 was as follows(in thousands):

 
|                                                       |   | **Three  Months Ended  March 31,** |       |
|------------------------------------------------------------|--------|------------------------------------|------------|
|                                                       |   | **2004**                           |       | **2003** |   |
| **Revenue from unaffiliated customers  originating from:** |   |                               | ** ** |   | ** ** |
| China                                                      |   | $                                  | 28,807     |   | $ | 15,267 |   |
| Japan                                                      |   | 23,837                             |       | 5,379 |   |
| Korea                                                      |   | 10,438                             |       | 10,434 |   |
| Taiwan                                                     |   | 4,786                              |       | 4,052 |   |
| North America                                              |   | 8,824                              |       | 911 |   |
| Other                                                      |   | 3,945                              |       | 1,790 |   |
|                                                       |   | $                                  | 80,637     |   | $ | 37,833 |   |

 

For the three months endedMarch 31, 2004, two customers each accounted for 11% of total revenues. For thesame period of 2003, three customers accounted for 26%, 14% and 10% of totalrevenues, respectively.

 

As of March 31, 2004, onecustomer accounted for 11% of total net accounts receivable and as of December31, 2003, two customers accounted for 14% and 10% of total net accountsreceivable, respectively.

 

**8.****              Acquisition**

 

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

 

The transaction was accountedfor under SFAS No. 141, “Business Combinations,” using the purchase methodof accounting and accordingly the results of operations of Oak have beenincluded in the Company’s financial statements since the date of acquisition.

 

Zoran’s primary objective inacquiring Oak was based on the Company’s belief that the combined company wouldbenefit 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;

 

•                  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 thenet assets acquired resulting in the recognition of goodwill and otherintangible assets.

 

The financial statementsreflect a purchase price of approximately $392.7 million, determined asfollows (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 |   |

 

11

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The cash payment and fair valueof common stock issued represents the conversion of each outstanding share ofOak common stock into $1.78 in cash and 0.2323 of a share of Zoran commonstock. As a result of the acquisition, 56,737,298 shares of Oak common stockwere converted into $101.0 million in cash and 13,180,074 shares of Zorancommon with a fair value of $227.5 million based on the fair market valueof Zoran common stock for the period two days before and after the date onwhich the terms of agreement were finalized and announced, May 5, 2003.

 

Non-qualified options topurchase approximately 4.5 million shares of Zoran common stock with aterm of ten years were granted to Oak employees as part of the acquisition. Thecorresponding fair value of these options of $57.4 million was estimatedbased on the fair value of the Zoran common stock as of the acquisition dateusing the Black-Scholes option pricing model applying the followingassumptions: expected life of 50 months, risk-free interest rate of 3.65%,expected volatility of 93% and no expected dividend yield. The intrinsic valueof the unvested options, totaling approximately $19.2 million, has beenrecorded as deferred stock compensation and will be amortized over the vestingperiod using the multiple option approach.

 

Acquisition costs include$3.3 million of investment banker fees, $1.7 million of insurancecosts, $1.1 million of legal and accounting fees and $0.7 million inother acquisition related expenses.

 

The purchase price allocationwas 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 |   |

 

The following table summarizesthe estimated fair value of the tangible assets acquired and liabilitiesassumed at the date of acquisition (in thousands):

 
| 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 atestimates of their current fair values. The valuation of the acquiredintangible assets which was based on management’s estimates and consideredvarious factors including appraisals, resulted in a value of purchasedtechnology of approximately $157.9 million, patents of $27.0 million,customer base of $11.5 million and trademarks and tradenames ofapproximately $1.3 million. Purchased technology is being amortized over aweighted average estimated life of 4.8 years and patents, customer base,trademarks and tradenames are being amortized over their estimated useful livesof five years with no residual values.

 

During the periodAugust 11, 2003 through March 31, 2004, we revised estimates relatedto certain assets and liabilities, and as a result, we decreased the purchaseprice and goodwill by $3.4 million.

 

Approximately$60.0 million of the purchase price was allocated to goodwill. Goodwillrepresents the excess of the purchase price over the fair value of the nettangible and identifiable intangible assets acquired. In accordance withSFAS 142, “Goodwill and Other Intangible Assets”, goodwill will not beamortized and will be tested for impairment at least annually. We do not expectgoodwill to be deductible for tax purposes.

 

Approximately$50.1 million of the purchase price was allocated to in-process researchand development which had not yet reached technological feasibility and had noalternative future use. Accordingly, this amount was immediately expensed uponthe acquisition date. This amount was determined using management’s estimatesincluding consultation with an independent appraiser. The value of thein-process research and development was determined using a discounted cash flowmethod and factors including projected financial results, relative risk ofsuccessful development, time-value of money and level of completion.

 

12

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The Company expects that thein-process technologies will be successfully completed by the second quarter ofcalendar 2005 with approximately $30.0 million in remaining costs. At thetime of acquisition, Oak had five material development projects in process asfollows:

 

•                  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 inkjet 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-processresearch and development was determined using the multi-period excess earningsmethod by estimating the expected net cash flows from the projects oncecommercially viable and discounting the net cash flows back to their presentvalue using a discount rate of 22%. This rate was based on the industry segmentfor the technology, nature of the products to be developed, length of time tocomplete the project and overall maturity and history of the development team.The net cash flows from the identified projects were based on estimates ofrevenue, cost of revenue, research and development expenses, selling generaland administrative expenses, and applicable income taxes. These estimates didnot take into account any potential synergies that could be realized as aresult of the acquisition. Revenues for the incremental core technologiesdeveloped are expected to commence in the fourth quarter of 2005 and extendthrough 2011. Revenue projections were based on estimates of market size andgrowth, expected trends in technology and the expected timing of new productintroductions.  As of March 31,2004, 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 formafinancial information presents the combined results of operations of Zoran andOak as if the acquisition had occurred as of the beginning of fiscal 2003 and2002, after giving effect to certain adjustments, including amortization ofintangibles. The in-process research and development charge of$50.1 million is not reflected in the unaudited pro forma combinedcondensed statement of operations. The unaudited pro forma financialinformation does not necessarily reflect the results of operations that wouldhave occurred had the combined companies constituted a single entity duringsuch periods, and is not necessarily indicative of results which may beobtained in the future.

 
|                                        |   | **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 | ) |

 

13

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

 

Basic and diluted net income(loss) per share have been computed using the weighted average number of sharesof common stock and dilutive common equivalent shares from stock options andwarrants outstanding during the period in accordance with Statement ofFinancial Accounting Standards (SFAS) No. 128, “Earnings per Share.”  The following table provides areconciliation of the components of the basic and diluted net income (loss) pershare computations (in thousands, except per share data):

 
|                                          |   | **Three  Months Ended  March 31,** |    |
|-----------------------------------------------|--------|------------------------------------|---------|
|                                          |   | **2004**                           |    | **2003** |   |
|                                          |   |                               |    |   |   |
| Net income (loss) from continuing  operations |   | $                                  | (10,689 | ) | $ | 193 |   |
|                                          |   |                               |    |   |   |
| Basic common shares                           |   | 42,522                             |    | 27,396 |   |
| Effect of dilutive securities:                |   |                               |    |   |   |
| Common stock options                          |   | —                             |    | 700 |   |
| Dilutive weighted average shares              |   | 42,522                             |    | 28,096 |   |
|                                          |   |                               |    |   |   |
| Net income (loss) per share:                  |   |                               |    |   |   |
| Basic                                         |   | $                                  | (0.25   | ) | $ | 0.01 |   |
| Diluted                                       |   | $                                  | (0.25   | ) | $ | 0.01 |   |

 

Stock options to purchase13,426,000 shares of common stock were outstanding during the three monthsended March 31, 2004, but were not included in the computation of diluted netloss per share as the Company had a net loss for the three months ended March31, 2004.  Stock options to purchase3,108,000 shares of common stock were outstanding during the three months endedMarch 31, 2003 but were not included in the computation of diluted net loss pershare as they would have had an anti-dilutive effect.

 

14

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

 

*This report includes a number offorward-looking statements which reflect the Company’s current views withrespect to future events and financial performance. These forward-lookingstatements are subject to certain risks and uncertainties, including thosediscussed below under the heading “Future Performance and Risk Factors” and in“Item 7—Management’s Discussion and Analysis of Financial Condition and Resultsof Operations—Future Performance and Risk Factors” included in the**Company’sAnnual Report on Form 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 OakTechnology, Inc. on August 11, 2003, our products consisted of integratedcircuits and related products used in 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, wenow also provide integrated circuits, software and platforms for digitaltelevision applications that enable the delivery and display of digital videocontent through a set-top box or television as well as digital imaging productsconsisting of semiconductor hardware and software that enable users to print,scan, process and transmit documents to computer peripherals that performprinting functions.

 

We derive most of our revenuesfrom the sale of our integrated circuit products. Historically, average sellingprices in the semiconductor industry in general, and for our products inparticular, have decreased over the life of a particular product. Averageselling prices for our hardware products have fluctuated substantially fromperiod to period, primarily as a result of changes in our customer mix oforiginal equipment manufacturer, or OEM, sales versus sales to resellers andthe transition from low-volume to high-volume production. In the past, we haveperiodically reduced the prices of some of our products in order to betterpenetrate the consumer market. We believe that, as our product lines continueto mature and competitive markets evolve, we are likely to experience furtherdeclines in the average selling prices of our products, although we cannotpredict the timing and amount of such future changes with any certainty.

 

Our cost of hardware productrevenues consists primarily of fabrication costs, assembly and test costs, andthe cost of materials and overhead from operations. If we are unable to reduceour cost of hardware product revenues to offset anticipated decreases inaverage selling prices, our product gross margins will decrease. Our hardwareproduct gross margin is also dependent on product mix and on the proportion ofproducts sold directly to our OEM customers versus indirectly through ourmarketing partners. These marketing partners purchase our products at lowerprices but absorb most of the associated marketing and sales support expenses,maintain inventories and provide customer support and training. As a result,lower gross margins on sales to these resellers are partially offset by reducedselling and marketing expenses related to such sales.  Hardware product sales in Japan are primarily made throughdistributors including Fujifilm, our strategic partner and reseller in Japanprimarily for the DVD segment.  Fujifilmprovides more sales and marketing support than our other resellers. We expectboth product and customer mix to continue to fluctuate in future periods,causing further fluctuations in margins.

 

We also derive revenue fromlicensing our software and other intellectual property. Licensing revenueincludes one-time license fees and royalties based on the number of unitsdistributed by the licensee. Quarterly licensing revenue can be significantlyaffected by the timing of a small number of licensing transactions.Accordingly, licensing revenues have fluctuated, and will continue tofluctuate, on a quarterly basis. In addition, we have historically generated aportion of our total 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 providefor license and milestone payments which are recorded as development revenue.We classify all development costs, including costs related to these developmentcontracts, as research and development expenses. We retain ownership of theintellectual property developed by us under these development contracts. Whilewe intend to continue to enter into development contracts with certainstrategic partners, we expect development revenue to continue to decline as apercentage of total revenues.

 

Our research and developmentexpenses consist of salaries and related costs of employees engaged in ongoingresearch, design and development activities and costs of engineering materialsand supplies. We are also a party to research and development agreements withthe Chief Scientist in Israel’s Ministry of Industry and Trade and theIsrael-United States Binational Industrial Research and Development Foundation,which fund up to 50% of incurred project costs for approved products up tospecified contract maximums. These agreements require us to use our bestefforts to achieve specified results and require us to pay royalties at ratesof 3% to 5% of resulting product sales, and up to 30% of resulting licenserevenues, up to a maximum of 100% to 150% of total funding received. Reportedresearch and development expenses are net of these grants, which fluctuate fromperiod to period. We believe that significant investments in research anddevelopment are required for us to remain competitive, and we expect tocontinue to devote significant resources to product development, although suchexpenses as a percentage of total revenues may fluctuate.

 

15

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Our selling, general andadministrative expenses consist primarily of employee-related expenses,royalties, sales commissions, product promotion and other professionalservices. We expect that selling, general and administrative expenses willcontinue to increase to support our anticipated growth.

 

We conduct a material amount ofour research and development and certain sales and marketing and administrativeoperations in Israel through our wholly-owned Israeli subsidiary.  As a result, some of our expenses areincurred in New Israeli Shekels. To date, substantially all of our productsales and our development and licensing revenue have been denominated in U.S.dollars and most costs of product sales have been incurred in U.S. dollars. Weexpect that most of our sales and costs of sales will continue to bedenominated and incurred in U.S. dollars for the foreseeable future. We havenot experienced material losses or gains as a result of currency exchange ratefluctuations and have not engaged in hedging transactions to reduce ourexposure to such fluctuations. We may in the future elect to take action toreduce our foreign exchange risk.

 

Our effective income tax ratehas benefited from the availability of net operating losses which we haveutilized to reduce taxable income for U.S. federal income tax purposes and byour Israeli subsidiary’s status as an “Approved Enterprise” under Israeli law,which provides a ten-year tax holiday for income attributable to a portion ofour operations in Israel. Our U.S. federal net operating losses expire atvarious times between 2004 and 2020, and the benefits from our subsidiary’sApproved Enterprise status expire at various times beginning in 2004.

 

**Statement Regarding Use of Non-GAAP FinancialMeasures**

 

To supplement the consolidatedfinancial results prepared under generally accepted accounting principles(“GAAP”) we include non-GAAP financial measures in our Management’s Discussionand Analysis, our quarterly press releases regarding operating results and ourpresentations to investors.  Thesenon-GAAP financial measures consist of GAAP financial measures adjusted toinclude or exclude certain revenues, costs, expenses and gains.  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, wecompleted our acquisition of Oak through the merger of Oak with a wholly-ownedsubsidiary of Zoran.  The acquisitionwas accounted for under the purchase method of accounting.

 

Following the completion of theacquisition, the results of operations of Oak have been included in ourconsolidated financial statements. Accordingly, our results of operations for the three month periods endedMarch 31, 2004 and December 31, 2003 each reflect a full quarter of Oak’soperations, while our results of operations for the first quarter of 2003reflect only Zoran’s historical operations.

 

Subsequent to the acquisitionof Oak, we determined that Zoran has four operating segments: Digital VersatileDisc (DVD), Imaging, Digital Camera (DC) and Digital Television (DTV). The DVDgroup provides video and audio compression and decompression products based onMPEG, Dolby Digital and DTS standards for use in DVD players and DVD recorders.The Imaging group provides imaging systems, including products used in digitallaser copiers and printers as well as multifunction peripherals. The DC groupfocuses on video compression and decompression products based on JPEGtechnology and CMOS sensors. The DTV group provides highly integratedapplication-specific integrated circuits, or ASICs, and system-on-a-chip, orSOC, solutions for standard and high definition digital television productsincluding televisions, set top boxes, personal video recorders, digital videorecorders, and recordable DVD as well as platforms, drivers and software for avariety of operating systems required for these digital television products.

 

16

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**Resultsof Operations**

 

The following table sets forthcertain consolidated statement of operations data as a percentage of totalrevenues for the periods indicated and percentage changes from period toperiod: 

 
|                                        |   | **Three Months Ended** |   | **Percentage Change Between Three Months  Ended March 31, 2004 and Three Months Ended** |   |
|---------------------------------------------|--------|------------------------|--------|-----------------------------------------------------------------------------------------|--------|
|                                        |   | **March 31,****2004**  |   | **March 31,****2003**                                                                   |   | **December 31,****2003** |   | **March 31,  2003** |   | **December 31,****2003** |   |
| Revenues:                                   |   |                   |   |                                                                                    |   |   |   |   |   |   |   |
| DVD hardware products                       |   | 56.3                   | %      | 80.5                                                                                    | %      | 55.6 | % | 49.0 | % | 22.7 | % |
| DTV hardware products                       |   | 8.7                    | %      | —                                                                                  |   | 10.6 | % | — |   | (0.5 | )% |
| DC hardware products                        |   | 9.7                    | %      | 17.5                                                                                    | %      | 10.8 | % | 18.6 | % | 9.7 | % |
| Imaging hardware products                   |   | 9.7                    | %      | —                                                                                  |   | 8.7 | % | — |   | 34.2 | % |
| Total hardware product revenues             |   | 84.4                   | %      | 98.0                                                                                    | %      | 85.6 | % | 83.4 | % | 19.4 | % |
| Imaging software                            |   | 12.9                   | %      | —                                                                                  |   | 8.0 | % | — |   | 94.0 | % |
| IP licensing                                |   | 2.2                    | %      | 0.6                                                                                     | %      | 5.6 | % | 734.8 | % | (50.9 | )% |
| Development and other                       |   | 0.5                    | %      | 1.4                                                                                     | %      | 0.7 | % | (28.2 | )% | (18.0 | )% |
| Total software and other revenues           |   | 15.6                   | %      | 2.0                                                                                     | %      | 14.4 | % | 1,613.0 | % | 31.8 |   |
| Total revenues                              |   | 100.0                  | %      | 100.0                                                                                   | %      | 100.0 | % | 113.1 | % | 21.2 | % |
|                                        |   |                   |   |                                                                                    |   |   |   |   |   |   |   |
| Costs and expenses:                         |   |                   |   |                                                                                    |   |   |   |   |   |   |   |
| Cost of hardware product revenues           |   | 56.2                   | %      | 70.6                                                                                    | %      | 56.7 | % | 69.7 | % | 20.2 | % |
| Research and development                    |   | 23.1                   | %      | 11.8                                                                                    | %      | 26.2 | % | 316.3 | % | 6.5 | % |
| Selling and administrative                  |   | 18.4                   | %      | 18.3                                                                                    | %      | 21.6 | % | 113.4 | % | 3.3 | % |
| Amortization of intangible assets           |   | 12.9                   | %      | 2.6                                                                                     | %      | 15.8 | % |   | * | (1.9 | )% |
| Amortization of deferred stock compensation |   | 3.1                    | %      | —                                                                                  |   | 5.8 | % |   | * | (34.0 | )% |
| Acquisition related expense                 |   | —                 |   | —                                                                                  |   | 2.1 | % | — |   |   | * |
| Total costs and expenses                    |   | 113.7                  | %      | 103.3                                                                                   | %      | 128.2 | % | 134.5 | % | 7.4 | % |
|                                        |   |                   |   |                                                                                    |   |   |   |   |   |   |   |
| Operating loss                              |   | (13.7                  | )%     | (3.3                                                                                    | )%     | (28.2 | )% |   | * |   | * |
| Interest and other income                   |   | 0.9                    | %      | 4.1                                                                                     | %      | 1.5 | % | (53.9 | )% | (29.1 | )% |
| Income (loss) before income taxes           |   | (12.8                  | )%     | 0.8                                                                                     | %      | (26.7 | )% |   | * |   | * |
| Provision for income taxes                  |   | 0.5                    | %      | 0.3                                                                                     | %      | 0.2 | % |   | * |   | * |
|                                        |   |                   |   |                                                                                    |   |   |   |   |   |   |   |
| Net income (loss)                           |   | (13.3                  | )%     | 0.5                                                                                     | %      | (26.9 | )% |   | * |   | * |
|                                        |   |                   |   |                                                                                    |   |   |   |   |   |   |   |
| Supplemental information:                   |   |                   |   |                                                                                    |   |   |   |   |   |   |   |
| Hardware product gross margin               |   | 33.4                   | %      | 28.0                                                                                    | %      | 33.8 | % | 118.5 | % | 17.9 | % |
| Regional revenue:                           |   |                   |   |                                                                                    |   |   |   |   |   |   |   |
| China                                       |   | 35.7                   | %      | 40.4                                                                                    | %      | 36.1 | % | 88.7 | % | 20.0 | % |
| Japan                                       |   | 29.6                   | %      | 14.2                                                                                    | %      | 21.1 | % | 343.1 | % | 70.1 | % |
| Korea                                       |   | 12.9                   | %      | 27.6                                                                                    | %      | 18.3 | % | 0.0 | % | (14.4 | )% |
| Taiwan                                      |   | 5.9                    | %      | 10.7                                                                                    | %      | 9.2 | % | 18.1 | % | (22.1 | ) |
| North America                               |   | 10.9                   | %      | 2.4                                                                                     | %      | 10.3 | % | 868.6 | % | 28.2 | % |
| Other                                       |   | 4.9                    | %      | 4.7                                                                                     | %      | 5.0 | % | 120.4 | % | 19.7 | % |
|                                        |   | 100.0                  | %      | 100.0                                                                                   | %      | 100.0 | % | 113.1 | % | 21.2 | % |

 

----

(*) Not meaningful

 

17

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*Revenues*

Total revenues increased 113%to $80.6 million for the three months ended March 31, 2004 compared to $37.8million for the three months ended March 31, 2003.  Approximately $18.2 million of the increase was from the Imagingsegment and $6.4 million was from the DTV segment which were acquired as aresult of the Oak acquisition in August 2003 and which were not included in ourrevenues for the three months ended March 31, 2003.  Total revenues for the three months ended March 31, 2004increased by $14.1 million, or 21.2%, from the $66.5 reported for the threemonths ended December 31, 2003. Approximately 60% of this growth was driven byincreased DVD product revenues.  Webelieve that the overall market for DVD players continued to grow at asubstantial rate during the three months ended March 31, 2004.  In addition, we believe that we arecontinuing to gain market share in certain geographic regions, includingChina.  Approximately 26% of thesequential increase was from the inclusion of Imaging revenue streams acquiredfrom Oak that were previously excluded due to purchase accounting requirements.The balance of the sequential increase, 14%, was largely attributable to growthin the Imaging and Digital Camera segments. 

 

Hardware product revenues forthe three months ended March 31, 2004 were $68.0 million compared to the $37.1million recorded in the comparable period of the prior year.  Excluding the impact of the Oak acquisition,hardware product revenues increased by $17 million, or 46%, driven by $15million in increased revenue  in our DVDsegment and approximately $1 million each in the Digital Camera and DTVsegments.  DVD hardware product revenuescomprised 56.3% of total revenues in the three months ended March 31, 2004compared to 80.5% of total revenues in the same period one year ago. Theproduct line diversification achieved through the acquisition of Oak reducedthe concentration of revenues from DVD products to 56.3% in the first quarterof 2004, from what would have been 83.7%, based on Zoran’s historicaloperations.

 

Hardware product revenuesincreased $11.6 million, or 19.4%, sequentially from $57.0 million for thefourth quarter of 2003 to $68.0 million for the first quarter of 2004.  Approximately $7.1 million of this increaseresulted from increased sales of DVD products. Approximately $1.3 million was due to discounts recorded in the fourth quarterof 2003 that related to prior periods. Approximately $2.0 million wasattributable to increased Imaging hardware product revenues as a result of thecontinued ramp of our new Quatro-based imaging products. The remaining $700,000of sequential growth came from the Digital Camera segment. DVD hardwareproducts accounted for the majority of our total hardware product sales,representing 56.3% of total revenues for the first quarter of 2004 compared to55.6% in the fourth quarter of 2003. We expect DVD sales to continue tocomprise a majority of our revenues for the balance of 2004.

 

Software and other revenueswere $12.6 million and $736,000 for the three months ended March 31, 2004 and2003, respectively.  The increaseincludes additional revenues of $10.4 million attributable to the Imagingsegment acquired in  the Oakacquisition, $1.1 million attributable to the DVD segment primarily as a resultof  increased IP licensing, and $400,000of development revenue attributable to the DTV segment. 

 

Software and otherrevenues  increased $3.0 million on asequential basis from $9.6 million for the fourth quarter of 2003 to $12.6million for the first quarter of 2004. The principal reason for this increase was the inclusion ofapproximately $3.6 million in Imaging software royalty streams acquired fromOak that were excluded in the fourth quarter of 2003 due to the requirements ofpurchase accounting. Absent the inclusion of this royalty revenue, Imagingrevenues grew approximately $1.4 million or 16% over the fourth quarter of2003.  This growth was offset  in part by a relative decline in DVD relatedIP license revenues.  As a percentage oftotal revenues, software and other revenues increased from 14.4% for the fourthquarter of 2003 to 15.6% for the first quarter of 2004. 

 

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*Regional Revenue*

 

During the first three monthsof 2004, approximately 36% of our total revenues, or $28.8 million, was derivedfrom sales to customers in China, compared to 40%, or $15.3 million, for thecomparable period in 2003.  The increaseof $13.5 million, or 88.7%, was due primarily to increased sales of DVDproducts.  Sequentially, sales tocustomers in China grew by 20.0% in the first quarter of 2004 compared to theimmediately preceding quarter.

 

Revenues from sales tocustomers in Japan accounted for 30% of our total  revenues for the three months ended March 31, 2004, compared to14% in the comparable period in 2003. This increase was attributable to the inclusion of revenues from theformer Oak Imaging business. Sequentially, revenue in Japan driven by DVD grew by 70.1%, or $9.8million, in the first quarter of 2004 to approximately 30% of total revenues,compared to 21% in the immediately preceding quarter.

 

Revenues from sales tocustomers in Korea and Taiwan were 18.8% of total revenues for the firstquarter of 2004 compared to 38.3% of total revenues in the same quarter oneyear ago.  This reduced concentrationwas due to growth in total revenues as a result of the acquisition of Oak. Onan absolute basis, revenues from Korea were flat and revenues in Taiwan grew by18.1% compared to the same quarter one year ago. The growth in Taiwan was theresult of new product introductions and design wins ramping into production inthe Digital Camera segment. Sequentially, revenues from these regions decreasedto 18.8% of total revenues for the first quarter of 2004 compared to 27.5% oftotal revenues during the fourth quarter of 2003 due to other seasonal factorsand greater relative growth of sales to customers.

 

North American revenuesincreased to 10.9% of our total revenues from 2.4% in the same period of theprior year, due to the inclusion of revenues from the former Oak HDTV andImaging businesses. North American revenues increased sequentially by $1.9million or 28.2% compared to the immediately preceding quarter. Approximately$1.2 million of this increase was driven primarily by growth in revenues inImaging software royalties. 

 

*Cost of Hardware Product Revenues*

 

Cost of hardware productrevenues was $45.3 million for the quarter ending March 31, 2004 compared to$26.7 million for the same period in 2003. The increase in costs was related to the corresponding increase inrevenues during the period.  As apercentage of hardware product revenues, cost of hardware product revenuesdecreased from 72.0% for the three months ended March 31, 2003 to 66.6% for thethree months ended March 31, 2004.  Thisrelative decrease in costs (and corresponding increase in gross profit) was dueprimarily to the impact of the relatively higher Imaging hardware productsacquired from Oak in August 2003, and accordingly, are not reflected in ourrevenues for the first quarter of 2003. These products command a higher margin than our more mature products,which in turn improves our gross margin. Absent the acquisition of Oak, theZoran cost of hardware products decreased in both DVD and Digital Camera byapproximately 1% on a blended basis.

 

Cost of hardware productrevenues for the three months ended March 31, 2004 also increased from the$37.7 million recorded during the three months ended December 31, 2003, againdue to the corresponding increase in revenues. As a percentage of hardware product revenues, cost of hardware productrevenues were relatively unchanged at 66.6% for the three months ended March31, 2004 compared to 66.2% for the fourth quarter of 2003.  Revenue during the current quarter includeda greater proportion of sales of our new Quatro-based imaging products,consistent with our expectations. Unlike our other imaging hardware products, these devices are sold intoconsumer markets, which command lower average selling prices.   The impact of these new imaging productswas largely offset by an increase in volumes of a number of newer DVD products,which command higher selling prices and have lower manufacturing costs.

 

*Research and Development*

 

Research and development(“R&D”) expenses were $18.6 million for the three months ended March 31,2004, compared to $4.5 million for the same period of 2003. This increase wasprimarily a result of the inclusion of the former Oak operations as well ascontinued investments in research and development across all of oursegments.  In addition, in the first quarterof 2003, we recorded approximately $1.5 million in grants from the ChiefScientist in Israel’s Ministry of Industry and Trade as an offset to R&Dexpense.  R&D expenses were 23% oftotal revenues for the three month period ended March 31, 2004, compared to 12%for the same period of 2003.

 

R&D expenses for the threemonths ended March 31, 2004 increased by approximately 6.5%, or $1.1 million,compared to the fourth quarter of 2003 as the Company continued to invest inthe development of new products and additional DVD recording development.

 

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*Selling, General and Administrative*

 

Selling, general andadministrative (“SG&A”) expenses were $14.8 million for the three monthsended March 31, 2004 compared to $6.9 million for the same period of 2003.  This increase was primarily a result of theinclusion of the former Oak operations as well as the continued increase inmarketing and field application support expenses to support planned revenuegrowth in our Asia Pacific markets. SG&A expenses were relatively unchanged at 18.4% of total revenuesfor the three months ended March 31, 2004 and 18.3% for the three months endedMarch 31, 2003.

 

SG&A expenses decreased asa percentage of revenues from 21.6% for the fourth quarter of 2003 to 18.4% forthe first quarter of 2004.  In absolutedollars the expenses increased by approximately $500,000.  This increase was driven by increased patentlitigation costs, continued investment in sales resources and  costs associated with the implementation ofan Oracle information system across the Company.

 

*Amortization of Deferred Stock Compensation*

 

For the three months endedMarch 31, 2004, we incurred charges of $2.5 million related to the amortizationof deferred stock compensation compared to $10,000 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 whichis being amortized over the remaining vesting period.  The amortization of deferred stock compensation decreased by $1.3million from the $3.8 million recorded during the quarter ended December 31,2003 due to the accelerated multiple option method.

 

*Amortization of Intangible Assets*

 

During the three months endedMarch 31, 2004, we incurred charges of $10.3 million related to theamortization of intangible assets compared to $900,000 for the three monthsended March 31, 2003. This increase was due to the addition of approximately$198 million of amortizable intangible assets acquired in the Oak acquisition.Amortization declined 1.9% compared to the quarter ended December 31, 2003 dueto the final installment of amortization of intangible assets associated withthe 2000 Nogatech acquisition being recorded during the three months endedDecember 31, 2003.

 

*Operating Loss*

 

The significant operating lossof $11.0 million for the first quarter of 2004 was driven primarily bycharges of $10.3 million and $2.5 million for the amortization of intangible assets and deferred stockcompensation, each related primarily to the Oak acquisition.  Excluding these charges, our operatingincome would have been $1.8 million, or 2.3% of total revenues, for the threemonths ended March 31, 2004.  On acomparable basis, excluding the amortization of intangible assets of $943,000and deferred stock compensation, of $2.5 million we would have recorded anoperating loss of $298,000, or (0.8%) of total revenues, for the same period ofthe prior year.  This $10,000 improvementin adjusted operating income was primarily due to the net contribution ofproduct  segments acquired in the Oakacquisition.  Zoran’s legacy productsegments contributed approximately the same level of operating loss as in thefirst quarter of the previous year. Continued investment in DVD recordingtechnology and advanced sensor technology adversely affected the profitabilityof the DVD and Digital Camera segments, respectively.

 

Sequentially, our operatingloss improved to by $7.1 million from the fourth quarter ended December 31,2003. This improvement was the result of higher revenues and slightly loweramortization of intangible assets and deferred stock compensation associatedwith the Oak acquisition. The fourth quarter of 2003 operating loss was $18.8million which, when adjusted to exclude: amortization of intangibles of $10.5 million, amortization of deferredstock compensation of $3.8 million, acquisition related expenses of $1.4million, discounts recorded in the fourth quarter that relate to previousperiods of $1.3 million, and includes additional revenue of $3.6 million inImaging software royalty streams acquired from Oak excluded under purchaseaccounting - would have resulted in a level of operating income of $1.9 millionor 2.6% of total revenues. This was similar to the 2.3% or $1.8 million levelof operating income recorded in the first quarter of 2004 as adjusted on acomparable basis. Research and development expense and selling, general andadministrative expense increased sequentially in the first quarter of 2004 inline with the increase in total revenues and aggregate gross margins ascompared to the fourth quarter of 2003.

 

*Interest and Other Income*

 

Interest and other income was$700,000 for the three month period ended March 31, 2004, compared to $1.6million for the same period of 2003. The decrease was primarily due to adecline in interest rates and a decrease in our cash balances due primarily tothe use of cash in the Oak acquisition. Interest and other income was $1.0 million for the three months endedDecember 31, 2003.

 

20

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*Provision for Income Taxes*

 

Excluding charges related to the amortization of goodwill and otherintangibles, our estimated effective tax rate was 15% for the first quarter of2004.  We have booked 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.

 

At March 31, 2004, we continueto carry a full valuation allowance against our net deferred tax assets asmanagement has determined that it is more likely than not that our deferred taxassets may not be realized.

 

**Liquidity and Capital Resources**

 

At March 31, 2004, we had $65.6million of cash and cash equivalents, $59.7 million of short-term investmentsand $140.9 million of working capital. In addition, we had $75.0 million ofinvestments in long-term marketable securities which are included in otherassets on our consolidated balance sheet.

 

Net cash provided by operatingactivities during the first three months of 2004 was $7.5 million.  While we recorded a net loss of $10.7million, this loss included non-cash charges of approximately $15.4 million comprisedof depreciation of property and equipment of $2.5 million, amortization ofintangible asset of $10.3 million and amortization of deferred stockcompensation of $2.5 million, resulting in net income adjusted for non-cashcharges of approximately $4.7 million for the three months ended March 31,2004.  Additional cash from operatingactivities was provided by a $4.6 million increase in accounts payable,partially offset by a $1.2 million increase in inventory.

 

Cash provided by investingactivities was $8.0 million during the three months ended March 31, 2004,reflecting the net sale of investments of $9.9 million offset by the purchaseof $1.9 million of property and equipment.

 

Cash provided by financingactivities was $2.1 million during the three months ended March 31, 2004attributable to the issuance of common stock during the period.

 

At March 31, 2003, we had $27.4million of cash and cash equivalents, $109.4 million of short-term investmentsand $165.3 million of working capital. In addition, we had $72.7 million oflong-term investments in marketable securities.

 

Our operating activities usedcash of $2.4 million during the three months ended March 31, 2003, primarilydue to our net income of $193,000 offset by an increase of $11.6 million inaccounts receivable. Partially offsetting the increase in accounts receivablewas a $5.0 million decrease in inventory and a $4.3 million increase inaccounts payable. The decrease in inventory was primarily associated with areduction in DVD inventory. The increase in accounts payable was due to normaltiming differences in our payment patterns.

 

Cash used in investingactivities was $340,000 during the three months ended March 31, 2003,principally reflecting capital expenditures for property and equipment.

 

Cash used by financingactivities was $1.4 million for the three months ended March 31, 2003, andprincipally reflected installment payments on core technology.

 

At March 31, 2004, we did nothave any relationships with unconsolidated entities or financial partnerships,such as entities often referred to as structured finance or special purposeentities, established for the purpose of facilitating off-balance sheetarrangements or other contractually narrow or limited purposes. Accordingly, weare not exposed to the type of financing, liquidity, market or credit risk thatcould arise if we had engaged in such relationships.

 

We believe that our currentbalances of cash, cash equivalents and short-term investments, and anticipatedcash flow from operations, will satisfy our anticipated working capital andcapital expenditure requirements at least through the next 12 months.Nonetheless, our future capital requirements may vary materially from those nowplanned and will depend on many factors including, but not limited to:

 

•                  the levels atwhich we maintain inventory and accounts receivable;

 

•                  the marketacceptance of our products;

 

•                  unanticipatedexpenses associated with the recently completed acquisition of Oak;

 

21

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•                  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.

 

•                  Transactioncosts associated with the merger were included as part of the total purchasecost for accounting purposes. In addition, we incurred charges to operations inthe quarter in which the merger was completed. We may incur additional charges,in amounts not currently estimable, in future quarters to reflect costsassociated with integrating the two companies. These costs could adverselyaffect our future liquidity and operating results.

 

•                  Historically,Oak depended largely on its optical storage business, which during its 2002fiscal year accounted for approximately 67% of Oak’s revenues. As a result ofthe sale of certain assets of its optical storage business in April 2003,Oak’s digital imaging and digital television businesses now represent theprimary source of revenue from the ongoing Oak operations, and revenues fromthese emerging businesses are difficult to forecast. As a result, it is notpossible to use Oak’s historical financial information to predict itscontribution to the future operating results of the combined company.

 

**Ourquarterly revenues and operating results fluctuate due to a variety of factors,which may result in volatility or a decline in the prices of our stock.**

 

Our historical operatingresults, and those of Oak, have varied significantly from quarter to quarterdue to a number of factors, including:

 

•                  fluctuation indemand for their products;

 

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

 

•                  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 indemand for 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 operatingresults of the combined company will continue to fluctuate in the future as aresult of these factors and a variety of other factors, including:

 

•                  the cost andavailability of adequate foundry capacity;

 

•                  fluctuations inmanufacturing yields;

 

•                  changes in orthe emergence of new industry standards;

 

22

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•                  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 thecombined 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 inthe markets for our customers’ products, particularly the consumer electronicsmarket.

 

These factors are difficult orimpossible to forecast. We place orders with independent foundries severalmonths in advance of the scheduled delivery date, often in advance of receivingnon-cancelable orders from our customers. This limits our ability to react tofluctuations in demand for their products. If anticipated shipments in anyquarter are canceled or do not occur as quickly as expected, or if we fail toforesee a technology change that could render a product obsolete, expense andinventory levels could be disproportionately high. If anticipated licenserevenues in any quarter are canceled or do not occur, gross margins may bereduced. A significant portion of our expenses are relatively fixed, and thetiming of increases in expenses is based in large part on our forecast offuture revenues. As a result, if revenues do not meet our expectations, we maybe unable to quickly adjust expenses to levels appropriate to actual revenues,which could harm our operating results.

 

Product supply and demandfluctuations common to the semiconductor industry are historicallycharacterized by periods of manufacturing capacity shortages immediatelyfollowed by periods of overcapacity, which are caused by the addition ofmanufacturing capacity in large increments. We cannot predict whether we willachieve timely, cost-effective access to that capacity when needed, or if therewill be a capacity shortage again in the future.

 

As a result of these factors,our operating results may vary significantly from quarter to quarter. Thesefluctuations may be more pronounced in the future as a result of the challengeswe face in integrating the operations of Zoran and Oak. Any shortfall inrevenues or net income from levels expected by the investment community couldcause a decline in the trading price of our stock.

 

**Ourcustomers experience fluctuating product cycles and seasonality, which causestheir sales to fluctuate.**

 

Because the markets that ourcustomers serve are characterized by numerous new product introductions andrapid product enhancements, our operating results may vary significantly fromquarter to quarter. During the final production of a mature product, ourcustomers typically exhaust their existing inventory of our products.Consequently, orders for our products may decline in those circumstances, evenif the products are incorporated into both mature products and replacementproducts. A delay in a customer’s transition to commercial production of areplacement product would delay our ability to recover the lost sales from thediscontinuation of the related mature product. Our customers also experiencesignificant seasonality in the sales of their consumer products, which affectstheir orders of our products. Typically, the second half of the calendar yearrepresents a disproportionate percentage of sales for our customers due to theholiday shopping period for consumer electronics products, and therefore, adisproportionate percentage of our sales. We expect these seasonal salesfluctuations to continue for the foreseeable future.

 

**Productsupply and demand in the semiconductor industry is subject to cyclical variations.**

 

The semiconductor industry issubject to cyclical variations in product supply and demand. Downturns in theindustry often occur in connection with, or anticipation of, maturing productcycles for both semiconductor companies and their customers and declines ingeneral economic conditions. These downturns have been characterized by abruptfluctuations in product demand, production over-capacity and accelerateddecline of average selling prices. In some cases, these downturns have lastedmore than one year. A downturn in the semiconductor industry could harm oursales and revenues if demand drops, or our gross margins if average sellingprices decline.

 

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**Oursuccess for the foreseeable future will be dependent on growth in demand forintegrated circuits for a limited number of applications.**

 

In recent years, we havederived a substantial majority of our product revenues from the sale ofintegrated circuits for DVD and digital camera applications. We expect thatsales of our products for these applications will continue to account for asignificant portion of our revenues for the foreseeable future. As a result ofOak’s sale of its optical storage business, the future financial performance ofthe former Oak operations will depend on our ability to successfully developand market new products in the digital television, HDTV and digital imagingmarkets. If the markets for these products and applications decline or fail todevelop as expected, or we are not successful in our efforts to market and sellour products to manufacturers who incorporate integrated circuits into theseproducts, our financial results will be harmed.

 

**Ourfinancial performance is highly dependent on the timely and successful introductionof new and enhanced products.**

 

Our financial performancedepends in large part on our ability to successfully develop and marketnext-generation and new products in a rapidly changing technologicalenvironment. If we fail to successfully identify new product opportunities andtimely develop and introduce new products that achieve market acceptance, wemay lose our market share and our future revenues and earnings may suffer. Inrecent years, our success has been dependent on our successful development andtimely introduction of integrated circuits for DVD players, DVD recorders anddigital cameras. These markets are characterized by the incorporation of asteadily increasing level of integration and numbers of features on a chip atthe same or lower system cost, enabling original equipment manufacturers, orOEMs, to continually improve the features or reduce the prices of the systemsthey sell. If we are unable to continually develop and introduce integratedcircuits with increasing levels of integration and new features at competitiveprices, our operating results will suffer.

 

In the consumer electronicsmarket, Oak’s performance has been highly dependent upon the successfuldevelopment and timely introduction of new products and solutions for broadbanddigital television and HDTV. In the digital office market, Oak’s performancehas been dependant on its ability to successfully develop embedded imageprocessing system on a chip, or SOC, solutions for the digital office market,in particular, embedded digital color copier technology and image processingchips for a variety of imaging peripherals, including printers andmulti-function peripherals, or MFPs. Among other technological changes,embedded PDF and color capability are rapidly emerging as market requirementsfor printers and other imaging devices. Some of Oak’s competitors have thecapacity to supply these solutions, and some of their solutions have been wellreceived in the marketplace. We face the challenge of continuing Oak’sdevelopment of digital television and HDTV solutions as well as developing newimaging products with the capability to handle greater color and imagecomplexity, including web-based documents, and work with higher-performingdevices in networked environments. If we are unable to meet these challengeswith the development of products that can effectively compete in the OEMsoftware and solutions market, our future operating results could suffer.

 

**Wemust keep pace with rapid technological changes and evolving industry standardsto remain competitive.**

 

Our future success will dependon our ability to anticipate and adapt to changes in technology and industrystandards and our customers’ changing demands. The consumer electronics market,in particular, is characterized by rapidly changing technology, evolvingindustry standards, frequent new product introductions, short product lifecycles and increasing demand for higher levels of integration. Our ability toadapt to these changes and to anticipate future standards, and the rate ofadoption and acceptance of those standards, will be a significant factor inmaintaining or improving our competitive position and prospects for growth. Ifnew industry standards emerge, our products or the products of our customerscould become unmarketable or obsolete, and we could lose market share or berequired to incur substantial unanticipated costs to comply with these newstandards.

 

Our success will also depend onthe successful development of new markets and the application and acceptance ofnew technologies and products in those new markets. For example, our successwill depend on the ability of our customers to develop new products and enhanceexisting products in the recordable DVD player market and products for thebroadband digital television and HDTV markets and to introduce and promotethose products successfully. These markets may not continue to develop to theextent or in the time periods that we currently anticipate due to factorsoutside our control, such as delays in implementation of FCC 02-320 requiringall new televisions to include a digital receiver. If new markets do notdevelop as we anticipate, or if our products do not gain widespread acceptancein these markets, our business, financial condition and results of operationscould be materially and adversely affected. The emergence of new markets forour products is also dependent in part upon third parties developing andmarketing content in a format compatible with commercial and consumer productsthat incorporate our products. If this content is not available, manufacturersmay not be able to sell products incorporating our products, and our saleswould suffer.

 

**Werely on independent foundries and contractors for the manufacture, assembly andtesting of our integrated circuits and other hardware products, and the failureof any of these third parties to deliver products or otherwise perform asrequested could damage our relationships with our customers and harm our salesand financial results.**

 

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We do not operate anymanufacturing facilities, and we rely on independent foundries to manufacturesubstantially all of our products. These independent foundries fabricateproducts for other companies and may also produce products of their own design.From time to time, there are manufacturing capacity shortages in thesemiconductor industry. We do not have long-term supply contracts with any ofour suppliers, including our principal supplier, Taiwan SemiconductorManufacturing Company, or TSMC. Therefore, TSMC and our other suppliers are notobligated to manufacture products for us for any specific period, in anyspecific quantity or at any specified price, except as may be provided in aparticular purchase order.

 

Our reliance on independentfoundries 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 ofour other foundries are located in areas of the world that are subject tonatural disasters such as earthquakes. While the 1999 earthquake in Taiwan didnot have a material impact on our independent foundries, a similar eventcentered near TSMC’s facility could severely reduce TSMC’s ability tomanufacture our integrated circuits. The loss of any of our manufacturers as asupplier, our inability to expand the supply of their products in response toincreased 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.

 

We also rely on a limitednumber of independent contractors for the assembly and testing of our products.Our reliance on independent assembly and testing houses limits our control overdelivery schedules, quality assurance and product cost. Disruptions in theservices provided by our assembly or testing houses or other circumstances thatwould require them to seek alternative sources of assembly or testing couldlead to supply constraints or delays in the delivery of our products. Theseconstraints or delays could damage our relationships with current andprospective customers and harm our financial results.

 

**Becausefoundry capacity is limited from time to time, we may be required to enter intocostly long-term supply arrangements to secure foundry capacity.**

 

If we are not able to obtainadditional foundry capacity as required, our relationships with our customerswould be harmed and our sales would likely be reduced. In order to secureadditional foundry capacity, we have considered, and may in the future need toconsider, various arrangements with suppliers, which could include, amongothers:

 

•                  option paymentsor 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.

 

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We may not be able to make anysuch arrangement in a timely fashion or at all, and such arrangements, if any,may not be on terms favorable to us. Moreover, if we are able to secure foundrycapacity, we may be obligated to utilize all of that capacity or incurpenalties. Such penalties may be expensive and could harm our financialresults.

 

**Ifour independent foundries do not achieve satisfactory yields, our relationshipswith our customers may be harmed.**

 

The fabrication of siliconwafers is a complex process. Minute levels of contaminants in the manufacturingenvironment, defects in photo masks used to print circuits on a wafer,difficulties in the fabrication process or other factors can cause asubstantial portion of the integrated circuits on a wafer to be non-functional.Many of these problems are difficult to detect at an early stage of themanufacturing process and may be time consuming and expensive to correct. As aresult, foundries often experience problems achieving acceptable yields, whichare represented by the number of good integrated circuits as a proportion ofthe number of total integrated circuits on any particular wafer. Poor yieldsfrom our independent foundries would reduce our ability to deliver our productsto customers, harm our relationships with our customers and harm our business.

 

**Weface competition or potential competition from companies with greater resourcesthan ours, and if we are unable to compete effectively with these companies,our market share may decline and our business could be harmed.**

 

We face intense competition inthe markets in which we compete. We expect that the level of competition willincrease in the future from existing competitors and from other companies thatmay enter our existing or future markets with solutions that may be less costlyor provide higher performance or additional features.

 

Competition in Zoran’s corecompression technology market has historically been dominated by largecompanies, such as ST Microelectronics, and companies that develop and usetheir own integrated circuits, such as Sony and Matsushita. As this marketcontinues to develop, we face competition from other large semiconductorvendors.

 

The DVD market continues toexpand, and additional competitors are expected to enter the market for DVDplayers and software. Some of these potential competitors may develop captiveimplementations for use only with their own PC and consumer electronicsproducts. It is also possible that application software vendors, such asMicrosoft, may attempt to enter the DVD application market in the future. Thisincreased competition may result in price reductions, reduced profit marginsand loss of market share.

 

We face competition fromseveral large semiconductor companies in the broadband digital television andset-top box markets. We expect competition to continue to increase in thesemarkets as industry standards become well known and as other competitors enterthese markets.

 

We also face significantcompetition in the digital office market. The future growth of the digitaloffice market is highly dependent on OEMs continuing to outsource anincreasing portion of their product development work. While the trend towardoutsourcing on the part of our OEM customers in this market has accelerated inrecent years, any reversal of this trend, or a change in the way theyoutsource, could seriously harm our business.

 

Many of our existingcompetitors, as well as OEM customers that are expected to compete with us inthe future, have substantially greater financial, manufacturing, technical,marketing, distribution and other resources, broader product lines and longerstanding relationships with customers than we have. In addition, much of ourfuture success is dependent on the success of our OEM customers. If we or ourOEM customers are unable to compete successfully against current and futurecompetitors, we could experience price reductions, order cancellations andreduced gross margins, any one of which could harm our business.

 

**Ourproducts are characterized by average selling prices that decline overrelatively short time periods; if we are unable to reduce our costs orintroduce new products with higher average selling prices, our financialresults will suffer.**

 

Average selling prices for ourproducts decline over relatively short time periods, while many of ourmanufacturing costs are fixed. When our average selling prices decline, ourrevenues decline unless we are able to sell more units, and our gross marginsdecline unless we are able to reduce our manufacturing costs by a commensurateamount. Our operating results suffer when gross margins decline. We haveexperienced these problems, and we expect to continue to experience them in thefuture, although we cannot predict when they may occur or how severe they willbe.

 

**Wederive most of our revenue from sales to a small number of large customers, andif we are not able to retain these customers, or they reschedule, reduce orcancel orders, our revenues would be reduced and our financial results wouldsuffer.**

 

Zoran’s and Oak’s largestcustomers have accounted for a substantial percentage of their revenues. In2003, sales to Fujifilm accounted for approximately 14% of Zoran’s totalrevenues, and Zoran’s four largest customers accounted for approximately 46% ofits total

 

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revenues. Similarly, duringOak’s fiscal 2002, Oak’s top 10 customers accounted for approximately 69% ofits total revenues. Sales to these large customers have varied significantlyfrom year to year and will continue to fluctuate in the future. These salesalso may fluctuate significantly from quarter to quarter. We may not be able toretain our key customers, or these customers may cancel purchase orders or rescheduleor decrease their level of purchases from us. Any substantial decrease or delayin sales to one or more of our key customers could harm our sales and financialresults. In addition, any difficulty in collecting amounts due from one or morekey customers could harm our financial results.

 

Fujifilm has been our largestcustomer over the last six years. Fujifilm purchases our products primarily asa reseller. Fujifilm acts as the primary reseller in Japan of productsdeveloped by us under development contracts with Fujifilm. We may sell theseproducts directly in Japan only to specified customers with Fujifilm’s consent.Fujifilm provides more sales and marketing support than our other resellers.Fujifilm has also provided funding to support Zoran’s development efforts. Ifour relationship with Fujifilm were terminated, our business could be harmed.

 

**Ourproducts generally have long sales cycles and implementation periods, whichincreases our costs in obtaining orders and reduces the predictability of our operatingresults.**

 

Our products aretechnologically complex. Prospective customers generally must make asignificant commitment of resources to test and evaluate our products and tointegrate them into larger systems. As a result, our sales processes are oftensubject to delays associated with lengthy approval processes that typicallyaccompany the design and testing of new products. The sales cycles of ourproducts often last for many months or even years. Longer sales cycles requireus to invest significant resources in attempting to make sales and delay thegeneration of revenue.

 

Long sales cycles also subjectus to other risks, including customers’ budgetary constraints, internalacceptance reviews and cancellations. In addition, orders expected in one quartercould shift to another because of the timing of customers’ purchase decisions.The time required for our customers to incorporate our products into their owncan vary significantly with the needs of our customers and generally exceedsseveral months, which further complicates our planning processes and reducesthe predictability of our operating results.

 

**Weare not protected by long-term contracts with our customers.**

 

We generally do not enter intolong-term purchase contracts with our customers, and we cannot be certain as tofuture order levels from our customers. Customers generally purchase ourproducts subject to cancelable short-term purchase orders. We cannot predictwhether our current customers will continue to place orders, whether existingorders will be canceled, or whether customers who have ordered products willpay invoices for delivered products. When we do enter into a long-termcontract, the contract is generally terminable at the convenience of thecustomer. In the event of an early termination by one of our major customers,it is unlikely that we will be able to rapidly replace that revenue source,which would harm our financial results.

 

**Regulationof our customers’ products may slow the process of introducing new products andcould impair our ability to compete.**

 

The Federal CommunicationsCommission, or FCC, has broad jurisdiction over our target markets in thedigital television business we acquired from Oak. Various internationalentities or organizations may also regulate aspects of our business or thebusiness of our customers. Although our products are not directly subject toregulation by any agency, the transmission pipes, as well as much of theequipment into which our products are incorporated, are subject to direct governmentregulation. For example, before they can be sold in the United States, advancedtelevisions and emerging interactive displays must be tested and certified byUnderwriters Laboratories and meet FCC regulations. Accordingly, the effects ofregulation on our customers or the industries in which our customers operatemay in turn harm our business. FCC regulatory policies affecting the ability ofcable operators or telephone companies to offer certain services and otherterms on which these companies conduct their business may impede sales of ourproducts. In addition, our digital television business may also be adverselyaffected by the imposition of tariffs, duties and other import restrictions onour suppliers or by the imposition of export restrictions on products that wesell internationally. Changes in current laws or regulations or the impositionof new laws or regulations in the United States or elsewhere could harm ourbusiness. For example, any delays by the FCC in imposing its pending requirementthat all new televisions have a digital receiver could have an adverse effecton our HDTV business.

 

**Weare dependent upon our international sales and operations; economic, politicalor military events in a country where we make significant sales or have significantoperations could interfere with our success or operations there and harm ourbusiness.**

 

During 2003, 97% of our totalrevenues and 89% of Oak’s total revenues were derived from international sales.We anticipate that international sales will continue to account for themajority of our total revenues for the foreseeable future. In addition,substantially all

 

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of our semiconductor productsare manufactured, assembled and tested outside of the United States byindependent foundries and subcontractors.

 

We are subject to the risksinherent 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 ourresearch and development personnel and facilities and a portion of our salesand marketing personnel are located in Israel. Political, economic and militaryconditions in Israel directly affect our operations. Some of our officers andemployees in Israel are obligated to perform up to 39 days of militaryreserve duty annually. The absence of these employees for significant periodsduring the work week may cause us to operate inefficiently during theseperiods.

 

Our operations in China aresubject to the economic and political uncertainties affecting that country. Forexample, the Chinese economy has experienced significant growth in the pastdecade, but such growth has been uneven across geographic and economic sectors.This growth may decrease and any slowdown may have a negative effect on ourbusiness. We also maintain offices in Taipei, Taiwan, Hong Kong and Seoul,Korea, and our operations are subject to the economic and politicaluncertainties affecting these countries as well.

 

The significant concentrationof our manufacturing activities with third party foundries in Taiwan exposes usto the risk of political instability in Taiwan, including the potential forconflict between Taiwan and China. We have several significant OEM customers inJapan, Korea and other parts of Asia. Adverse economic circumstances in Japanand elsewhere in Asia could affect these customers’ willingness or ability todo business with us in the future or their success in developing and launchingdevices containing our products.

 

**Ourbusiness and future operating results could be harmed by terrorist activity orarmed conflict.**

 

Our business and operatingresults are subject to uncertainties arising out of possible terrorist attackson the United States and other regions of the world including locations wherewe maintain operations and by armed conflict in the Middle East and relatedeconomic instability. Our operations could be harmed 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.

 

**Theprices of our products may become less competitive due to foreign exchange fluctuations.**

 

Foreign currency fluctuationsmay affect the prices of our products. Prices for our products are currentlydenominated in U.S. dollars for sales to our customers throughout the world. Ifthere is a significant devaluation of the currency in a specific country, theprices of our products will increase relative to that country’s currency, andour products may be less competitive in that country. Also, we cannot be surethat our international customers will continue to be willing to place orders denominatedin U.S. dollars. If they do not, our revenue and operating results will besubject to foreign exchange fluctuations.

 

**Ourability to compete could be jeopardized if we are unable to protect ourintellectual property rights.**

 

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Our success and ability tocompete depend in large part upon protection of our proprietary technology. Werely on a combination of patent, trade secret, copyright and trademark laws,non-disclosure and other contractual agreements and technical measures toprotect our proprietary rights. These agreements and measures may not besufficient to protect our technology from third-party infringement, or toprotect us from the claims of others. Monitoring unauthorized use of our productsis difficult, and we cannot be certain that the steps we have taken willprevent unauthorized use of our technology, particularly in foreign countrieswhere the laws may not protect our proprietary rights as fully as in the UnitedStates. The laws of certain foreign countries in which our products are or maybe developed, manufactured or sold, including various countries in Asia, maynot protect our products or intellectual property rights to the same extent asdo the laws of the United States and thus make the possibility of piracy of ourtechnology and products more likely in these countries. If competitors are ableto use our technology, our ability to compete effectively could be harmed.

 

The protection offered bypatents is subject to numerous uncertainties. For example, our competitors maybe able to effectively design around our patents, or the patents may bechallenged, invalidated or circumvented. Those competitors may alsoindependently develop technologies that are substantially equivalent orsuperior to our technology. Moreover, while we hold, or have applied for,patents relating to the design of our products, some of our products are basedin part on standards, for which we do not hold patents or other intellectualproperty rights.

 

Oak has generally limitedaccess to and distribution of the source and object code of its software andother proprietary information. With respect to its page description languagesoftware and drivers for the digital office market and in limited circumstanceswith respect to firmware and platforms for its HDTV products, Oak has grantedlicenses that give its customers access to and restricted use of the sourcecode of Oak’s software. This access increases the likelihood ofmisappropriation or misuse of our technology.

 

**Weare involved in several lawsuits.**

 

Zoran andOak are  parties to various legalproceedings, including a number of patent-related lawsuits. In connection withthese lawsuits, management time has been, and will continue to be, expended. Inaddition, both Oak and Zoran have incurred, and we expect to continue to incur,substantial legal and other expenses in connection with these pending lawsuits.No provision for any liability that may result upon adjudication of theselawsuits has been made in our financial statements.

 

**Wecould become subject to claims and litigation regarding intellectual propertyrights, which could seriously harm its business and require it to incursignificant costs.**

 

In recent years, there has beensignificant litigation in the United States involving patents and otherintellectual property rights. In the past, Zoran and Oak have been subject toclaims and litigation regarding alleged infringement of other parties’intellectual property rights, and both Oak and Zoran are currently parties to anumber of patent-related lawsuits. We could become subject to additionallitigation in the future, either to protect our intellectual property or as aresult of allegations that we infringe others’ intellectual property rights.Claims that our products infringe proprietary rights would force us to defendourselves and possibly our customers or manufacturers against the allegedinfringement. These claims and any resulting lawsuit, if successful, couldsubject us to significant liability for damages or invalidation of ourproprietary rights. These lawsuits, regardless of their success, would likelybe time-consuming and expensive to resolve and would divert management time andattention. Any potential intellectual property litigation could force us to doone 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 thesemiconductor industry have often been settled through cross-licensingarrangements, we may not be able in any or every instance to settle an allegedpatent infringement claim through a cross-licensing arrangement. We have a morelimited patent portfolio than many of our competitors. If a successful claim ismade against us or any of our customers and a license is not made available tous on commercially reasonable terms or we are required to pay substantialdamages or awards, our business, financial condition and results of operationswould be materially adversely affected.

 

**Ifnecessary licenses of third-party technology are not available to us or arevery expensive, our products could become obsolete.**

 

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From time to time, we may berequired to license technology from third parties to develop new products orproduct enhancements. Third party licenses may not be available on commerciallyreasonable terms, if at all. If we are unable to obtain any third-party licenserequired to develop new products and product enhancements, we may have toobtain substitute technology of lower quality or performance standards or atgreater cost, either of which could seriously harm the competitiveness of ourproducts.

 

Certain technology used in ourproducts is licensed from third parties, and in connection with these licenses,we are required to fulfill confidentiality obligations and, in some cases, payroyalties. Some of our products require various types of copy protectionsoftware that we must license from third parties. If we are unable to obtain ormaintain our right to use the necessary copy protection software, we would beunable to sell and market these products.

 

**Ifwe are not able to apply our net operating losses against taxable income infuture periods, our financial results will be harmed.**

 

Our future net income and cashflow will be affected by our ability to apply our net operating losses, orNOLs, against taxable income in future periods. Our NOLs totaled approximately$261 million for federal and $83 million for state tax reportingpurposes as of December 31, 2003. As a result of the change of controlresulting from our initial public offering in 1995, the amount of NOLs that wecan use to reduce future taxable income for federal tax purposes is limited toapproximately $3.0 million per year. The Internal Revenue Code contains anumber of provisions that could limit the use of NOLs against income of thecombined company as a result of the merger or as a result of the combination ofthese transactions. Our utilization of Oak’s NOLs may be further limited due toprior Oak transactions. No opinion or IRS ruling has been sought regarding thepotential application of any of these provisions. Changes in tax laws in theUnited States may further limit our ability to utilize these NOLs. Any furtherlimitation on our ability to utilize these respective NOLs could harm ourfinancial condition.

 

**Anyadditional acquisitions we make could disrupt our business and severely harmour financial condition.**

 

We have made investments in,and acquisitions of, other complementary companies, products and technologies.We have recently completed the acquisition of Oak, and we may acquireadditional businesses, products or technologies in the future. In the event ofany future acquisitions, 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 otheracquired business will also involve numerous risks, 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 tosuccessfully complete the integration of the business, products or technologiesor personnel that we might acquire in the future, and any failure to do socould disrupt our business and seriously harm our financial condition.

 

In addition, we have mademinority equity investments in early-stage companies, and we expect to continueto review opportunities to make additional investments in such companies wherewe believe such investments will provide us with opportunities to gain access toimportant technologies or otherwise enhance important commercial relationships.We have little or no influence over the early-stage

 

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companies in which we have madeor may make strategic, minority equity investments. Each of these investmentsinvolves a high degree of risk. We may not be successful in achieving thetechnological or commercial advantage upon which any given investment ispremised, and failure by the early-stage company to achieve its own businessobjectives could result in a loss of all or part of our invested capital andrequire us to write off all or a portion of such investment.

 

**Ourproducts could contain defects, which could reduce sales of those products orresult in claims against us.**

 

We develop complex and evolvingproducts. Despite testing by us and our customers, errors may be found inexisting or new products. This could result in, among other things, a delay inrecognition or loss of revenues, loss of market share or failure to achievemarket acceptance. These defects may cause us to incur significant warranty,support and repair costs, divert the attention of our engineering personnelfrom our product development efforts and harm our relationships with customers.The occurrence of these problems could result in the delay or loss of marketacceptance of our products and would likely harm our business. Defects,integration issues or other performance problems in our products could resultin financial or other damages to customers or could damage market acceptance ofsuch products. Our customers could also seek damages from us for their losses.A product liability claim brought against us, even if unsuccessful, wouldlikely be time consuming and costly to defend.

 

**Ifwe do not maintain current development contracts or are unable to enter intonew development contracts, our business could be harmed.**

 

We historically have generateda portion of our total revenues from development contracts, primarily with keycustomers. These development contracts have provided us with partial fundingfor the development of some of our products. Under these contracts, we receivepayments upon reaching certain development milestones. If we fail to achievethe milestones specified in our existing development contracts, if our existingcontracts are terminated or if we are unable to secure future developmentcontracts, our ability to cost-effectively develop new products would bereduced and our business would be harmed.

 

**Wemay need additional funds to execute our business plan, and if we are unable toobtain such funds, we will not be able to expand our business as planned.**

 

We may require substantialadditional capital to finance our future growth, secure additional foundrycapacity and fund our ongoing research and development activities beyond 2004.Our capital requirements will depend on many 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 existingsources of liquidity and cash flow from operations are insufficient to fund ouractivities, we may need to raise additional funds. If we raise additional fundsthrough the issuance of equity securities, the percentage ownership of ourexisting stockholders would be reduced. Further, such equity securities mayhave rights, preferences or privileges senior to those of our common stock.Additional financing may not be available to us when needed or, if available,it may not be available on terms favorable to us.

 

**Ifwe fail to manage our future growth, if any, our business would be harmed.**

 

We anticipate that our futuregrowth, if any, will require us to recruit and hire a substantial number of newengineering, managerial, sales and marketing personnel. Our ability to managegrowth successfully will also require us to expand and improve administrative, operational,management and financial systems and controls. Many of our key operations,including a material portion of our research and development operations and asignificant portion of our sales and administrative operations are located inIsrael. A majority of our sales and marketing and certain of our research anddevelopment and administrative personnel, including our President and ChiefExecutive Officer and other officers, are based in the United States. Thegeographic separation of these operations places additional strain on ourresources and our ability to manage growth effectively. If we are unable tomanage growth effectively, our business will be harmed.

 

**Werely on the services of our executive officers and other key personnel, whoseknowledge of our business and industry would be extremely difficult to replace.**

 

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Our success depends to asignificant degree upon the continuing contributions of our senior management.Management and other employees may voluntarily terminate their employment withus at any time upon short notice. The loss of key personnel could delay productdevelopment cycles or otherwise harm our business. We believe that our futuresuccess will also depend in large part on our ability to attract, integrate andretain highly-skilled engineering, managerial, sales and marketing personnel,located in the United States, Israel and China. Competition for such personnelis intense, and we may not be successful in attracting, integrating andretaining such personnel. Failure to attract, integrate and retain keypersonnel could harm our ability to carry out our business strategy and competewith other companies.

 

**TheIsraeli rate of inflation may negatively impact our costs if it exceeds therate of devaluation of the new Israeli shekel against the United States dollar.**

 

A portion of the cost of ouroperations, relating mainly to our personnel and facilities in Israel, isincurred in new Israeli shekels. As a result, we bear the risk that the rate ofinflation in Israel will exceed the rate of devaluation of the new Israelishekel in relation to the United States dollar, which will increase our costsas expressed in United States dollars. To date, we have not engaged in hedgingtransactions. In the future, we may enter into currency hedging transactions todecrease the risk of financial exposure from fluctuations in the exchange rateof the United States dollar against the new Israeli shekel. These measures maynot adequately protect us from the impact of inflation in Israel.

 

**Thegovernment programs in which we participate and tax benefits we receive requireus to meet several conditions and may be terminated or reduced in the future,which would increase our costs.**

 

Historically, we have financeda portion of our research and development activities with grants for researchand development from the Chief Scientist in Israel’s Ministry of Industry andTrade. Although we did not receive proceeds from such grants in 2001 or 2002,we did earn such proceeds in 2003 and we plan to seek additional grants fromthe Chief Scientist in the future. To be eligible for these grants, ourdevelopment projects must be approved by the Chief Scientist on a case-by-casebasis. If our development projects are not approved by the Chief Scientist, wewill not receive grants to fund these projects, which would increase ourresearch and development costs. We also receive tax benefits, in particularexemptions and reductions as a result of the “Approved Enterprise” status ofour existing operations in Israel. To be eligible for these tax benefits, wemust maintain our Approved Enterprise status by meeting conditions, includingmaking specified investments in fixed assets located in Israel and investingadditional equity in our Israeli subsidiary. If we fail to meet theseconditions in the future, the tax benefits would be canceled and we could berequired to refund the tax benefits already received. These tax benefits maynot be continued in the future at their current levels or at any level. Israeligovernmental authorities have indicated that the government may reduce oreliminate these benefits in the future, which would harm our business.

 

**Provisionsin our charter documents and Delaware law could prevent or delay a change incontrol of Zoran.**

 

Our certificate ofincorporation and bylaws and Delaware law contain provisions that could make itmore difficult for a third party to acquire us, even if doing so would bebeneficial to our stockholders. These include prohibitions:

 

•                  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.

 

**Ourstock price has fluctuated and may continue to fluctuate widely.**

 

The market price of our commonstock has fluctuated significantly since our initial public offering in 1995.Between January 1, 2003 and March 31, 2004, the closing sale price ofour common stock, as reported on The Nasdaq National Market, ranged from a lowof $10.85 to a high of $27.28. The market price of our common stock is subjectto significant fluctuations in the future in response to a variety of factors,including:

 

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

 

•                  quarterlyvariations in operating results;

 

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•                  changes inanalysts’ earnings estimates;

 

•                  announcements oftechnological innovations;

 

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

 

•                  loss of keypersonnel;

 

•                  proprietaryrights or other litigation;

 

•                  generalconditions in the semiconductor industry; and

 

•                  developments inthe financial markets.

 

In addition, the stock markethas, from time to time, experienced extreme price and volume fluctuations thathave particularly affected the market prices for semiconductor companies ortechnology companies generally and which have been unrelated to the operatingperformance of the affected companies. Broad market fluctuations of this typemay reduce the future market price of our common stock.

 

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

 

We are exposed to financialmarket risks including changes in interest rates and foreign currency exchangerates.

 

The fair value of ourinvestment portfolio or related income would not be significantly impacted byeither a 10% increase or decrease in interest rates due mainly to theshort-term nature of the major portion of our investment portfolio.

 

A majority of our revenue andcapital spending is transacted in U.S. dollars, although a portion of the costof our operations, relating mainly to our personnel and facilities in Israel,is incurred in New Israeli Shekels. We have not engaged in hedging transactionsto reduce our exposure to fluctuations that may arise from changes in foreignexchange rates. Based on our overall currency rate exposure at March 31,2004, a near-term 10% appreciation or depreciation of the New Israeli Shekelwould have an immaterial affect on our financial condition.

 

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

 

***DisclosureControls 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 Officer****concludedthat our disclosure controls and procedures were effective as of the end of theperiod covered by this quarterly report.

 

***Internal ControlsOver Financial Reporting****.*  In connection withour year-end closing process and the audit of our financial statements for theyear ended December 31, 2003, we reviewed the nature, timing andaccounting treatment of obligations to certain customers. As a result of thereview, we determined that a substantial portion of these obligations wererelated to transactions prior to the fourth quarter. However, since the impacton any given period would have been immaterial, we recorded a charge of $1.3million against revenues in the fourth quarter to reflect these obligations.

 

In connection with its audit,our independent auditors, PricewaterhouseCoopers LLP, advised management andour Audit Committee that they considered our lack of formal policies andinternal communications surrounding the administration and documentation ofcertain contractual arrangements with customers, including the contractualarrangements to which the obligations discussed in the prior paragraph relate,to constitute material weaknesses in our internal control over financialreporting.  During the quarter endedMarch 31, 2004, both management and our Audit Committee conducted a review ofthese matters. As a result of these reviews, we have implemented additionalcontrols and procedures to improve the administration and documentation ofcertain contractual arrangement with our customers. We believe that theseadditional controls and procedures address the weaknesses noted and that ourcurrent internal controls are sufficient to provide reasonable assurance thatour financial statements are fairly presented in conformity with generallyaccepted accounting principles.

 

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**PART II. OTHER INFORMATION**

 

**Item1.****           Legal Proceedings**

 

We and our Oak subsidiary haveinitiated two legal actions against MediaTek, Inc. and customers ofMediaTek alleging that products incorporating certain MediaTek componentsinfringe three patents co-owned by Zoran and Oak relating to optical drive controllerdesign and integrated DVD/CD controller design.

 

OnMarch 11, 2004, Zoran and Oak filed a complaint with the United StatesInternational Trade Commission alleging that certain MediaTek DVD player andoptical disk controller chips and chipsets, and products in which they areused, infringe Zoran's and Oak's patents. In addition to MediaTek, thecomplaint named 10 other proposed defendants that sell products, including DVDplayers and PC optical storage devices that use MediaTek's chips and chipsets.The other proposed defendants are ASUSTek Computer, Inc., CreativeLabs, Inc., Creative Technology, Ltd., Jiangsu Shinco ElectronicGroup Co., Ltd., LITE-ON Information Technology Corporation, MintekDigital, Shinco International AV Co., Ltd., TEAC Corporation, TEACAmerica, Inc., and Terapin Technology Corporation. The complaint requested thatthe ITC institute an immediate investigation of the accused products and issueexclusion and cease and desist orders prohibiting the importation into theUnited States of the infringing MediaTek devices and products that containthem.  On April 8, 2004, the ITCinstituted an investigation based on Zoran's complaint.  The respondents served their initialresponse to the complaint on May 4, 2004. Discovery is currently underway. The ITC has not yet set a schedule for the completion of theinvestigation.  On April 28, 2004, Zoranand Oak reached a settlement with respondents Creative Technology, Ltd. andCreative Labs, Inc., and on May 6, 2004, these parties filed a joint motionwith the ITC to dismiss the Creative respondents from the investigationpursuant to the terms of the settlement agreement and a consent order. On April28, 2004, Zoran and Oak reached a settlement with respondents CreativeTechnology, Ltd. and Creative Labs, Inc., and on May 6, 2004, these partiesfiled a joint motion with the ITC to dismiss the Creative respondents from theinvestigation pursuant to the terms of the settlement agreement and a consentorder.

 

On March 15, 2004, Zoranand Oak filed a complaint against MediaTek and Mintek Digital in the UnitedStates District Court, Central District of California alleging similar factsregarding infringement by MediaTek’s chips and chipsets and products in whichthey are used. The lawsuit seeks both monetary damages and an injunction tostop the importation and sale of infringing products. MediaTek and Mintek are due torespond to the complaint on May 24, 2004.

 

**Item 6.****           Exhibits and Reports onForm 8-K**

 
| (a)    |   | Exhibits:                                                                            |
|--------|--------|--------------------------------------------------------------------------------------|
|   |   |                                                                                 |
| 31.1   |   |  Certification  of Chief Executive Officer pursuant to Rule 13a-14(a).          |
| 31.2   |   |  Certification  of Chief Financial Officer pursuant to Rule 13a-14(a).          |
| 32.1   |   |  Certification  of Chief Executive Officer, pursuant to 18 U.S.C. Section 1350. |
| 32.2   |   |  Certification  of Chief Financial Officer, pursuant to 18 U.S.C. Section 1350. |

 

(b)           On February 23, 2004, we filed a Report on Form 8-K,pursuant to Item 12 thereof, relating to financial information for the quarterand year ended December 31, 2003 and the outlook for the first quarter of 2004,as presented in a press release dated February 23, 2004.

 

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**SIGNATURES**

 

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

 

 
|                     | **ZORAN CORPORATION**                         |
|--------------------------|-----------------------------------------------|
|                     |                                          |
|                     |                                          |
| Date:  May 10, 2004 | /s/  Karl Schneider                      |   |
|                     | Karl  Schneider                               |
|                     | Senior Vice  President, Finance               |
|                     | and Chief  Financial Officer                  |
|                     | (Principal  Financial and Accounting Officer) |

 

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