**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

----

 

**FORM 10-K**

 
| **ý** | ** ** | **ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934**                                                         |
|------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** | ** ** | ** **                                                                                                                                        |
| ** ** | ** ** | **For The  Fiscal Year Ended December 31, 2005**                                                                                             |
| ** ** | ** ** | ** **                                                                                                                                        |
| ** ** | ** ** | **Or**                                                                                                                                            |
| ** ** | ** ** | ** **                                                                                                                                        |
| **o**      | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934**                                                     |
|       | ** ** | ** **                                                                                                                                        |
| ** ** | ** ** | **For the  transition period from         to         ** |

 

**CommissionFile Number: 0-27246**

 

----

 

**ZORANCORPORATION**

(Exact Name of registrant as specified in itscharter)

 

 
| **Delaware**                                                                      |       | **94-2794449**                           |
|-----------------------------------------------------------------------------------|------------|------------------------------------------|
| (State or other jurisdiction of  incorporation or organization)                   |       | (I.R.S. Employer  Identification No.)    |
|                                                                              |       |                                     |
| **1390 Kifer Road, Sunnyvale, California**                                        |       | **94086**                                |
| (Address of principal executive offices)                                          | ** ** | (Zip Code)                               |
|                                                                              |       |                                     |
| Registrant’s telephone number, including  area code: **(408) 523-6500** |
|                                                                              |       |                                     |
| Securities registered pursuant to  Section 12(b) of the Act: **None**        |
|                                                                              |       |                                     |
| Securities registered pursuant to  Section 12(g) of the Act:                 |
|                                                                              |
| **Title of each class**                                                           | ** ** | **Name of Exchange on which registered** |
| None                                                                              |       | None                                     |
|                                                                              |       |                                     |
| Securities registered pursuant to  Section 12(g) of the Act:                 |
| **Common Stock, $.001 par value**                                                 |
| (Title of Class)                                                                  |

 

Indicateby check mark if the registrant is a well-known seasoned issuer, as defined inRule 405 of the Securities Act. Yes   o  No   ý

 

Indicateby check mark if the registrant is not required to file reports pursuant toSection 13 or Section 15(d) of the Act. Yes   o  No   ý

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes   ý  No   o

 

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to thebest of registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K.   ý

 

Indicateby check mark whether registrant is a large accelerated filer, an acceleratedfiler or a non-accelerated filer (as defined by Rule 12b-2 of the Act).

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

 

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

 

Theaggregate market value of registrant’s voting stock held by non-affiliates ofregistrant based upon the closing sale price of the Common Stock onJune 30, 2005, as reported on the Nasdaq National Market, wasapproximately $593,000,000. Shares of Common Stock held by each officer,director and holder of 10% or more of the outstanding Common Stock have beenexcluded in that such persons may be deemed to be affiliates. Thisdetermination of affiliate status is not necessarily a conclusive determinationfor other purposes.

 

Outstandingshares of registrant’s Common Stock, $0.001 par value, as of March 10,2006: 46,601,981

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Partsof the definitive proxy statement for registrant’s 2005 Annual Meeting ofStockholders to be filed with the Commission pursuant to Regulation 14Anot later than 120 days after the end of the fiscal year covered by thisReport are incorporated by reference into Part III of this Report.

 

 

----

 

**ZORANCORPORATION**

**INDEXTO**

**ANNUALREPORT ON FORM 10-K**

**FORYEAR ENDED DECEMBER 31, 2005**

 
| ** **   | ** **                                                                                                         | **Page** |
|--------------|--------------------------------------------------------------------------------------------------------------------|----------|
|         |                                                                                                               |     |
| **PART I**   |                                                                                                               |
| Item 1.      | Business                                                                                                           | 2        |
| Item 1A.     | Risk  factors                                                                                                 | 17       |
| Item 1B.     | Unresolved   Staff Comments                                                                                   | 28       |
| Item 2.      | Properties                                                                                                         | 28       |
| Item 3.      | Legal Proceedings                                                                                                  | 28       |
| Item 4.      | Submission  of Matters to a Vote of Security Holders                                                               | 29       |
|         |                                                                                                               |     |
| **PART II**  |                                                                                                               |
| Item 5.      | Market for Registrant’s Common Equity,  Related Stockholder Matters and Issuer Purchases of Equity Securities | 30       |
| Item 6.      | Selected Financial Data                                                                                            | 30       |
| Item 7.      | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                        | 31       |
| Item 7A.     | Quantitative  and Qualitative Disclosures About Market Risk                                                        | 40       |
| Item 8.      | Financial Statements and Supplementary Data                                                                        | 41       |
| Item 9.      | Changes in and Disagreements with  Accountants on Accounting and Financial Disclosure                              | 72       |
| Item 9A.     | Controls and Procedures                                                                                            | 72       |
| Item 9B.     | Other Information                                                                                                  | 72       |
|         |                                                                                                               |     |
| **PART III** |                                                                                                               |
| Item 10.     | Directors and Executive Officers of the  Registrant                                                                | 73       |
| Item 11.     | Executive Compensation                                                                                             | 73       |
| Item 12.     | Security Ownership of Certain Beneficial  Owners and Management and Related Stockholder Matters                    | 73       |
| Item 13.     | Certain Relationships and Related  Transactions                                                                    | 73       |
| Item 14.     | Principal Accountant Fees and Services                                                                             | 73       |
|         |                                                                                                               |     |
| **PART IV**  |                                                                                                               |
| Item 15.     | Exhibits and Financial Statement Schedules                                                                         | 74       |
| Signatures   | 75                                                                                                                 |
|         |                                                                                                               |     |

 

----

 

**PART I**

 

***This report includesa number of forward-looking statements which reflect the Company’s current viewswith respect to future events and financial performance. These forward-lookingstatements are subject to certain risks and uncertainties, including thosediscussed in “Item 7—Management’s Discussion and Analysis of FinancialCondition and Results of Operations—Future Performance and Risk Factors” andelsewhere in this report, that could cause actual results to differ materiallyfrom historical results or those currently anticipated. In this report, thewords “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.***

 

**Item1—Business**

 

**Company Overview**

 

Wedevelop and market integrated circuits, or ICs, and related products used indigital versatile disc players, or DVDs, movie and home theater systems,digital cameras and video editing systems. We also provide integrated circuits,software and platforms for digital television applications that enable thedelivery and display of digital video content through a set-top box ortelevision as well as digital imaging products consisting of semiconductorhardware and software that enable users to print, scan, process and transmitdocuments to computer peripherals that perform printing functions. Subsequentto our acquisition of Emblaze Semiconductor Ltd. on July 8, 2004, we alsoprovide high performance, low-power applicationprocessors, technology and products for the multimedia mobile telephone market.Through our acquisition of Oren Semiconductor, Inc. on June 10, 2005,we obtained Oren’s demodulator IC technology for theglobal high definition television market. We sell our products to originalequipment manufacturers, or OEMs, who incorporate them in digital video andaudio products for consumer and commercial applications.

 

We were incorporated in California in December 1981 andreincorporated in Delaware in November 1986. Our corporate headquartersare located at 1390 Kifer Road, Sunnyvale, California 94086, and our telephonenumber is (408) 523-6500. Our website can be found at *www.zoran.com*. Our annual reports onForm 10-K, quarterly reports on Form 10-Q, current reports on Form8-K, and any amendments to those reports, are available free of charge on ourwebsite under “Investors / SEC Filings” as soon as reasonably practicable afterthey are filed with the Securities and Exchange Commission.  Investors can also obtain copies of our SECfilings from the SEC Web site at www.sec.gov.

 

**Industry Background**

 

Until the mid-1990s, video images and audio soundtracks weretransmitted, edited and stored almost exclusively using analog formats. Sincethen, advances in technology have allowed audio and video to be processed andstored in digital form. Unlike analog formats, which are inherently unstableand difficult to edit and enhance, digital formats permit the manipulation ofaudio and video signals through digital signal processing and offer a number offundamental advantages over analog technologies. Through complex digital signalprocessing operations, digital audio and video signals may be compressed,providing significant storage and transmission efficiencies. They also may befiltered, allowing for noise reduction, and they may be transmitted andreproduced without perceptible image or sound degradation. Digital formatsprovide users with additional benefits, including random access to data,superior editing capabilities and enhanced security features such as protectionagainst unauthorized copying and controlled and secure access.

 

One of the most significant barriers to the widespread adoption ofdigital technology had been the huge amount of data required to representimages and sounds in a digital format, making cost-effective storage ortransmission impractical. Through digital compression techniques, a substantialnumber of the redundancies inherent in audio and video data can be identifiedand eliminated, significantly reducing the overall amount of data which needsto be retained. Compression techniques introduced in the early 1990s allowed atwo-hour movie to be compressed and stored on only two video CDs with videoresolution comparable to that of a standard VHS tape. More recent techniquesallow the storage of a full-length movie of more than three hours on a singleDVD, with substantially improved audio and video quality and the incorporationof additional data, such as additional languages, scenes and director and actorcommentary. Additionally, digital compression of video data allows previouslyunmanageable amounts of data to be stored in the memory of a disk drive,thereby permitting the data to be accessed and edited easily. It also allowsfor easier transmission of sharper resolution pictures through a standarddefinition or high definition television or set-top box. Digital audiocompression allows efficient storage and delivery of multi-channel audio,making possible high-quality special effects such as multi-channel surroundsound, virtual surround sound and wireless audio delivery via two speakers orheadphones. In the field of still photography, digital compression allowsdozens or hundreds of digital pictures to be stored on a single memory card,depending on the resolution desired.

 

2

----

 

To drive the implementation and speed the adoption of products based ondigital formats, industry participants organized committees to defineinternational compression standards. The principal standards in use todayinclude the following:

 

•                  The JointPhotographic Experts Group, or JPEG, standard for the high quality compressionof still images and the real-time, low-cost compression and decompression ofmoving images;

 

•                  The MPEG 1standard, adopted by the Moving Pictures Experts Group, or MPEG, for thecompression of both audio and video data at the high compression ratiosnecessary for the limited storage capacity of the CD-ROM format;

 

•                  The MPEG 2standard, subsequently adopted by the Motion Pictures Experts Group, for thecompression of both audio and video data, designed to provide improved qualityin broadcast and video playback applications;

 

•                  The MPEG 4standard, which is an extension of MPEG 1 and MPEG 2 that provides the abilityto view, access and manipulate objects rather than pixels, which is especiallysignificant in video streaming, digital television, mobile multimedia and videogame applications. MPEG 4 part 10 standard, also known as Advanced Video Codec(AVC) or H.264,  is a recent addition tothe MPEG 4 standard, offering significantly improved compression efficiencies;

 

•                  DivX standard, which is a proprietary codecsimilar to MPEG-4 used for encoding high quality digital video at low bit rates.DivX encoded content can be viewed on the PC with a software player, on selectDVD Players, portable media players and is used by some internet-based video ondemand services;

 

•                  Windows Media,Microsoft’s standard digital media software platform for developing digitalmedia products and services; and

 

•                  Dolby Digital,developed by Dolby Laboratories, an industry standard for the compression ofaudio for use in multi-channel digital surround sound systems.

 

These industry standard techniques have enabled the dramatic growth indigital multimedia markets, including the following:

 

*DVD Players and Recorders.*DVDplayers and recorders primarily use MPEG 2 video compression and Dolby Digitalaudio technology to provide significantly higher quality playback or recordingthan is possible with VCR or video CD technology. According to InternationalData Corporation, or IDC, sales of DVD players totaled approximately124 million units in 2005 and shipments of DVD recorders increased to over17.7 million units, from a base of 4.2 million units in 2003. DVDrecorders are expected to gradually overtake the DVD player in combinationproducts, such as DVD+VCR, DVD+HtiB and TV+DVD.

 

*Standard Definition and High DefinitionTelevisions and Set Top Boxes.*Digital televisionsreceive digital content and process that content to display a picture which hasfar greater resolution and sharper, more clearly defined images thantelevisions based on the older analog technology. Standard definitiontelevisions generally contain 480 lines with 720 pixels per line. Highdefinition television, or HDTV, television sets contain 1280 to 1920 pixels perline and up to 1080 lines. The aspect ratio of standard definition sets is 4:3,compared to 16:9 for HDTV. The lines may be displayed using differenttechniques, often referred to as interlacing or alternatively progressive scan.The functionality to receive and process digital television signals can becontained in a set-top box which then drives a television display that iscapable of displaying digital content. Alternatively, this functionality can beintegrated into a digital television that does not require a set-top box. Digitalcontent is broadcast via satellite, cable networks or over the air (terrestrialbroadcast) in various markets throughout the world.  Intex Management Services, LTD., or IMS,estimates that over 77 million digital televisions and set-top boxes wereshipped worldwide in 2005 and that over 94 million units will be shipped in2006.

 

*Mobile Products.*Digitalcameras use JPEG compression technology to capture high resolution still imagesthat can be viewed, edited and stored on a computer system on a recordable DVDand transmitted over telephone lines and computer networks. Recently, digitalcameras have been introduced that are capable of capturing and playing backquality video, using the MPEG 4 algorithm. According to IDC, sales of megapixel digital cameras exceeded 80 million units in 2005 and are expectedto exceed 96 million units during 2006. The multimedia mobile phonemarket segment is expected to increase from 88 million units in 2005 to about269 million units in 2008, according to IDC.

 

Additional products and markets are developing based on theseestablished compression standards and additional compression technologies suchas Meridian Lossless PCM, or MLP, a new standard for DVD audio, Super Audio, orSACD, Microsoft Windows Media Audio, or WMA, Advanced Audio Codec (AAC) used inconjunction with the MPEG-4 video standard and MP3, a compression standard forthe download of audio recordings from the Internet.

 

These established and emerging compression standards specify dataformats in which compressed data must be presented in order to enable productsfrom different vendors to interact and permit the capture, transmission,storage and display of audio and video data in digital

 

3

----

 

format. These standards do not specify the compression methodologies tobe employed or additional functionality which may be used to enhance ormanipulate digital signals. These standards, therefore, do not determine imageor sound quality or compression efficiency. For example, data compression maycomply with relevant standards despite being poorly processed and containingartifacts which result in image degradation in video applications or poor soundquality in audio applications. As a result, there can be significantdifferences in overall image or sound quality between two solutions based onthe same standard. Therefore, integrated circuit manufacturers candifferentiate their products on the basis of the quality of their compressionsolution.

 

Historically, as system vendors sought compression solutions, the cost,complexity and time required to compress and decompress data have imposedsignificant limitations on the use of digital compression. Over the lastseveral years, as cost-effective compression solutions have emerged, productmanufacturers have increasingly sought to design and market lower-cost digitalaudio and video systems and products to address an increasing number of highvolume consumer applications. In addition, product manufacturers are facingcompetitive pressure to introduce their products more rapidly. To address theseissues, OEMs continually seek to integrate more and more functions onindividual chips in order to reduce their costs, speed time-to-market andproduce smaller products with reduced power consumption. They also seeksolutions that can be easily integrated into their commercial and consumerproducts. The current challenge to manufacturers of compression integratedcircuits is, therefore, to provide product manufacturers with high-quality,cost-effective, standards-based solutions that deliver flexible control, imageenhancement, audio effects and other functions in addition to high qualitycompression solutions.

 

**Zoran Solutions**

 

We provide feature-rich, cost-effective, standards-based solutions fora broad range of digital video, audio and imaging applications. We were apioneer in the development of high performance digital signal processorproducts, and have developed expertise in integrated mixed signal circuitdesign, mathematical algorithms and software development, as well asproprietary digital signal processing, and video and audio compressiontechnologies. We apply our multi-disciplinary expertise and proprietary technologiesto the development of fully-integrated solutions for high-growth multimediamarkets. The key elements of our solutions are the following:

 

*Standards-Plus Methodology.*Wehave leveraged our broad multi-disciplinary expertise and proprietary digital signalprocessing and compression technologies to develop what we refer to as “standards-plus”solutions. We have enabled OEMs to improve image and sound quality anddeliver superior products to end users by adding more features aroundcompression standards, such as more efficient use of memory, processing andcommunication resources, as well as audio and image enhancement algorithms. Wehave also provided OEMs the ability to include OEM-programmable effectsand features, as well as variable compression ratios for video. These “standards-plus”features allow our customers to differentiate their products from those oftheir competitors.

 

*Expandable and Programmable Architectures.*Wedesign our integrated circuits to enable easy adaptation for a broad range of specificapplications. We can vary the architecture of our chips by adding or deletingmodules, and we can also modify the software embedded in the chips themselvesto address specific applications. We also license ready-to-manufacture “cores”—buildingblocks of integrated circuits—that can be integrated into our customers’ chips.Combined with the enhanced functionality of our “standards-plus” technology,our expandable and programmable architecture facilitates product design,upgrades and customization, substantially accelerating our customers’ time tomarket with differentiated products.

 

*Integrated System Solutions.*Wehelp our customers meet their total system requirements by providing integratedproducts that combine hardware and software to address required systemfunctions and features on a single integrated circuit or chip set, reducing thenumber of integrated circuits, and in some cases providing a complete solutionon a single chip. As a result, our customers’ total system cost can be reducedand they can concentrate on differentiating their products from those of theircompetitors. For example, our COACH chip, includes most of the electronics of a digital camera on a single chip.

 

*Cost-Effective Products.*Wefocus on reducing the feature size, power requirements and number of integratedcircuits necessary to perform required system functions, including compressionfunctions. This reduces our customers’ manufacturing costs for their productswhich incorporate our integrated circuits, and also reduces the operating costsfor these products, enabling the use of our products in a broader range of highvolume applications. The modular nature of our architecture reduces our newproduct development costs, and enables our design engineers to meet our customers’new product specifications and cost parameters.

 

*Near Production Ready System ReferenceDesigns.*We provide our customers with a broad rangeof engineering reference boards and products complete with device driversoftware, embedded software and detailed schematics. These productssubstantially shorten our customers’ product design time.

 

4

----

 

**Strategy**

 

We provide cost-effective, high-performance digital audio, video andimaging solutions addressing selected high-growth applications enabled bycompression in evolving multimedia markets. Key elements of our strategyinclude the following:

 

*Focus on High-Growth and High VolumeApplications.*Our strategy is to focus on providingdigital video, audio and imaging solutions for high-growth consumer electronicsand printing applications. Our current focus markets include DVD players andrecorders, digital cameras, digital television, multimedia portable devices andmultifunction digital print devices.

 

*Leverage Existing Technology and Expertise.*Weintend to continue to identify those markets that we believe have the highestgrowth potential for our products and to actively pursue those markets. Ourproprietary digital signal processing and compression technologies can be usedto serve a number of emerging markets for digital video and audio. Potentialmarkets include home network audio and video appliances, as well as personaldigital video, audio and imaging devices.

 

*Further Penetrate Key International Markets.*Between1998 and 2005, we opened offices in Hong Kong, Shanghai and Shenzhen, China,Japan, Korea, and Taiwan. We now have a total of 416 full-time, part-time andcontract employees working in these offices. We believe that by opening andexpanding our presence in these offices we are better able to provide marketingand application support for these growing consumer electronics markets.

 

*Extend Technological Leadership.*Ouryears of experience in the fields of digital signal processing, integratedcircuit design, algorithms and software development have enabled us to become aleader in the development of digital audio and video solutions enabled bycompression. Using our multi-disciplinary expertise, we have developed newtechnologies for compression of digital audio, video and imaging. In August2004, we acquired Emblaze Semiconductor which provided us importanttechnologies for extending our capabilities into the growing multimedia mobiletelephone market. In June 2005, we acquired OrenSemiconductor, Inc. which provided us demodulator IC technology for the global high definitiontelevision market. We intend to continue to invest in our research anddevelopment, and to evaluate opportunities to acquire additional technologiesin order to maintain and extend our technological leadership.

 

*Expand Strategic Partnerships.*Wework closely in the product development process with leading manufacturers ofproducts that incorporate our integrated circuits. We also work closely withkey customers and provide them early access to our technologies. Potentialproducts are designed to meet customer-driven product requirements definedjointly by us and our partners with the partner providing technological inputand, in selected cases, a portion of the development funding. This strategy hasenabled us to develop products with substantial financial and other assistancewhile retaining ownership of the technology and ensuring an establishedcustomer for the product once development is completed. In some cases, ourstrategic partners also provide sales and marketing support. We have alsoestablished long-term relationships with strategic partners that providemanufacturing capacity and will seek to develop additional strategicrelationships with manufacturers.

 

**Markets and Applications**

 

Our products are currently used in a variety of consumer multimediaapplications, including the following:

 

*Consumer Video Playback Systems*

 

DVD players primarily use MPEG 2 video compression and Dolby Digital orsimilar audio technology to provide significantly higher quality playback thanis possible with earlier generation products such as VCRs, Video CD or SuperVideo CD players. DVD players are sold as stand-alone products and are alsobundled with other functions including DVD+VCR combinations, DVD-receivers andDVD+TV combinations. In addition, the DVD player can act as a platform forplayback and editing of digital still images from digital cameras throughintegrated memory card slots or via direct connection to digital cameras.

 

*Digital Video Recording Systems*

 

Digital video recording systems are expected to replace the analog VCR.Digital video recording systems not only store home movies and TV programs butallow them to be easily edited. In addition, digital video recording systemsenable high quality time shifting of TV program viewing by recording theprogram so that it can be watched simultaneously or on a delayed basis. Therecording media used in digital video recording systems includes DVD recordablemedia and hard disks. Digital video recording systems use MPEG 2 as the videocompression format and Dolby Digital or MPEG audio as the audio format.

 

5

----

 

*Digital Television*

 

The digital television market represents the most significant technologicalshift in the television segment of the consumer electronics market since colortelevisions were introduced in the late 1950s. In the digital televisionmarket, digital content providers broadcast programming via satellite, cable orterrestrial (over-the-air) networks. The mix of broadcast networks varies bygeographic region. For example, most digital television content in Japan andKorea is broadcast via terrestrial networks, while cable networks currentlypredominate in the United States. Satellite networks offer an alternativesource of content to consumers and are continuing to grow in each of thesemarkets. Each geographic market is subject to regulation that requirescompliance with different governmental standards applicable to broadcasttechnology and content format. In each market, individual broadcasters alsohave developed their own proprietary standards for content, security andconditional access. The digital television market requires television products,set-top boxes, personal video recorders and other digital consumer appliancesto include sophisticated integrated circuits and embedded software that addressthe emerging requirements of multiple broadcast networks throughout the world. Therequirement by the U.S. Federal Communications Commission, or FCC, that all newtelevisions contain a built-in digital receiver, has accelerated the growth ofthe digital television market, which we expect to continue over the nextseveral years.

 

*Digital Imaging Print Products*

 

The market for personal printers is beginning to undergo a shift fromtraditional PC-centric peripherals toward new PC-independent printingappliances. Fueling this shift is the rapid growth of digital photography, homeInternet and wireless connectivity. As these new technologies make their wayinto the home, they are creating demand for a new class of appliance-typeprinters that allow image rich content such as web pages, digital photos, andscanned documents to be printed without using a PC. According to IDC, ICcontrollers for multifunction print devices are addressing a market estimatedat 37 million units in 2005 and growing to over 46 million units in2007.

 

The market for embedded software for page description languages issomewhat more mature than other areas of the imaging market. It ischaracterized by a small number of suppliers selling to very large OEMcustomers designing print devices that need to be connected to a network. Thepage description language, or PDL, enables the printer to receive a file or jobfrom a PC and translate that file into a set of instructions that the printercan understand and lay down on paper with a great deal of precision. Ingeneral, applications are designed to send jobs to printers using one or bothof two major protocols or languages. Print Control Language, or PCL, originatedas a Hewlett Packard developed protocol for page printers and has become anindustry standard in office environments. In addition, the application may alsouse postscript-based protocols originally developed by Adobe, which tend to befocused more on graphic arts and Apple operating system environments.

 

*Mobile Products*

 

Digital cameras allow the capture of high resolution images, theviewing, editing and storage of such images on a computer system and theirtransmission over telephone lines and computer networks. High quality copies ofthese images can be printed using color printers. Recently, digital camerashave added video capture and compression capability enabling them to providebasic camcorder functionality. Digital cameras can be connected directly to aPC for downloading of pictures or movies and to a television for display. Theoriginal digital cameras were developed for the professional market, and thesecameras currently sell at prices of $1,000 to $3,000. As technology hasadvanced and manufacturing costs have decreased, digital cameras for theconsumer market have been introduced in the $69 to $600 price range.

 

Many mobile telephones now incorporate digital still camerafunctionality, including high resolution still pictures and sometimes evenvideo clips. These phones can be connected to a PC for downloading the picturesor video clips or they can be transmitted over the mobile phone network toanother mobile phone or sent to an e-mail account. Digital camera functionalitywas originally included in mobile phones that sold for $500 to $800. With thespread of the technology and decreased manufacturing costs, digital cameraenabled mobile phones now are available in every price range.

 

**Image and Video Technology**

 

*The JPEG Standard.*In1991, the Joint Photographic Experts Group, or JPEG, Committee of theInternational Standards Organization completed a technical specification for astandard to compress individual digitized images, which may consist of stillimages or consecutive frames of video data. JPEG has been widely adopted forvideo editing applications, since each frame in the video is individuallycompressed, allowing cutting and pasting of sequences as well as modificationof individual frames. Images are compressed through elimination of spatialredundancies within an image and the filtering of high frequency areas to whichthe eye is less sensitive. Using these techniques, the JPEG compressionstandard is able to reduce the data necessary to represent an image withoutsignificant degradation of image quality. Still images or motion video can becompressed to varying degrees using JPEG, with greater compression resulting inlower quality. Typically, four-to-one or five-to-one compression yields broadcastimage quality while 20-to-1 compression is similar to VHS

 

6

----

 

quality.

 

*Zoran JPEG Technology.*OurJPEG technology incorporates a proprietary bit rate control algorithm thatenables our JPEG-based products to compress any image to a predetermined sizewhile optimizing video quality using pre-selected parameters. Without thisfeature, the JPEG compression process results in compressed data files ofvarious sizes based on the actual content of the original image given aconstant degree of compression. An image with large amounts of visual detailwill generate a larger data file than that generated from an image with lessdetail. Performance of many video applications is hampered by variability inthe size of the compressed images in a video sequence, which can result ininefficient use of available memory, bus speed or communication channelcapacity or even the loss of images. Our bit rate control is a “standards-plus”solution that uses real-time digital signal processing algorithms to optimizevideo quality based on pre-selected parameters, which can be programmed byOEMs, without the loss of any image or video frame. Our bit rate control hasbeen incorporated in our JPEG-based devices that are used in digital cameras,video editing systems, color scanners, PC-based security systems, videoconferencing and other applications. Other features of our JPEG-based productsinclude their ability to handle a wide range of compression ratios, to performa “lossless” compression algorithm in the same JPEG device, to rapidly scan orbrowse a large number of images and utilize advanced image processingalgorithms that enable bit rate control of USB data, vertical blank intervaldetection, infrared remote control detection and scene analysis for computercontrol applications. We implement these functions in a single integratedcircuit while we believe most other manufacturers either offer fewer functionsor require multiple chips, resulting in higher manufacturing costs and greaterpower consumption.

 

*The MPEG Standards.*In1991, the Moving Pictures Expert Group, or MPEG, Committee of the InternationalStandards Organization completed a technical specification for a standard tocompress moving audio and video into a single data stream. Like JPEG, MPEG 1removes spatial redundancies from single frames of video data. MPEG 1 improveson JPEG by also removing redundancies that occur between consecutive videoframes. Because video represents movement, it is possible to detect and estimatethe movement of similar picture elements between video frames, a process calledmotion estimation. MPEG motion estimation uses the content of previous andfuture frames to predict the content of the current frame without using itsfull content. MPEG 1 implements audio compression by exploiting psycho-acousticmasking, taking advantage of the fact that the ear is less sensitive to a quietnote at one frequency when a much louder note is present at a nearby frequency.MPEG 1 often achieves audio compression ratios of six-to-one and videocompression ratios of over 100-to-1. MPEG 1 is particularly suitable forlow-cost CD-ROM applications due to its low-cost implementation.

 

In 1993, the MPEG 2 video committee completed a technical specificationto address the more stringent requirements of the broadcast industry. MPEG 2provides more sophisticated prediction techniques, enabling a compressionsolution to comprehend video as interlaced fields of data, rather thanindividual frames. MPEG 2 also allows for operation at higher resolution and athigher bit rates than MPEG 1, resulting in improved image quality for highmotion, high detail video. MPEG 2 typically achieves compression ratios of50-to-1. Because of its higher bit rate, MPEG 2 technology cannot be used instandard CD-ROM applications, but can be used in DVD players.

 

MPEG 4 builds on the experience of the MPEG 1 and MPEG 2 standards,which are currently used in digital video applications. MPEG 4 is rich infeatures, and can be customized to serve the needs of specific industries whilepreserving a high level of interoperability across a variety of applications. Itallows a new level of interaction with visual content, providing the ability toview access and manipulate objects rather than pixels. MPEG 4’s impact isespecially significant in video streaming, digital television, and gameapplications.

 

*DivX*. DivX is a proprietary codec similar to MPEG-4 used for encoding highquality digital video at low bit rates. DivX encoded content can be viewed onthe PC with a software player and on select DVD Players and portable mediaplayers and is used by some internet-based video-on-demand services.

 

*Zoran MPEG Technology.*Beginningin 1997, we established ourselves as a leading provider of MPEG 2 technologyfor DVD and Super Video CD applications. Another important technology is MPEG 4decoding, which is embodied in the DivX and XVID file formats. These files arecommonly used for file sharing of video content on the PC. We have added to theMPEG 2 decoders used on the PC the capability to decode MPEG 4 files, allowingconsumers to display content stored on their PCs using a television. We havealso introduced MPEG 2 encoding ICs. This technology is an important part ofthe DVD recorder system. With the acquisition of Oak Technologies we obtainedthe MPEG-2 technologies required for high definition television applicationsincluding set-top boxes and televisions. We have also developed MPEG 4technology - both for compression and decompression - enabling the capture andplayback of high quality video clips for portable applications includingdigital still cameras and digital tape-less camcorders. With the acquisition ofEmblaze Semiconductor, we obtained MPEG-4 part 10 compression and decompressiontechnologies, also known as the Advanced Video Codec, or AVC, that are used inmobile telephone applications for video conferencing and video capture.

 

7

----

 

**Audio Technology**

 

 *TheDolby Digital Standard.*In 1992, Dolby Laboratories launched DolbyDigital, an audio compression technique which has emerged as an industrystandard. Dolby Digital was developed as a successor to Dolby’s Pro Logicanalog technique for use in multi-channel digital surround sound systems. It iscurrently used in most movie theaters in the developed nations worldwide and isalso used in home theater and computer multimedia applications.  Digital compression of audio data allows thestorage of full quality multi-channel audio playback in the limited spaceallocated for audio in video-oriented formats. It also facilitates the seamlessintegration of sound with compressed video. The Dolby Digital audio compressionstandard is currently the principal audio compression technique used in DVDplayers. Dolby Digital has also been adopted as a standard for use inhigh-definition television and digital cable systems.

 

*Other Audio Standards.*Otherdigital audio compression standards currently in use include: DTS, an audiocompression standard that competes with Dolby Digital; MLP, a compressionstandard for DVD audio; Windows Media Audio, or WMA, a standard developed byMicrosoft; Advance Audio Codec, or AAC, a compression standard used in HDTV andMP3, used for the download of audio recordings from the Internet.

 

*Zoran Audio Technology.*Workingclosely with Dolby Laboratories, we have developed a programmable audio digitalsignal processing engine with an architecture optimized for Dolby Digital andother demanding audio applications, and we were the first to develop asingle-chip solution for Dolby Digital decoding. Our family of Vaddis® DVDdecoders and audio processors incorporate this engine to allow systemsmanufacturers to replace system components with software modules, differentiatetheir products from their competition, use Zoran’s SiliconSoftware® library ofadvanced audio algorithms, and reduce system costs and time to market. Inaddition to Dolby Digital, our DVD decoders and audio processors support allprincipal audio compression standards, including DTS, MLP and MP3. Zoran’sintegrated circuits also include additional functions such as VirtualMulti-Channel Digital, surround sound for headphones, high definition CD,karaoke processing and speaker equalization. Our audio technology is integratedwith our video technology in many of our products. Multiple audio algorithmslike AAC, Dolby Digital and others are embedded in our DTV ICs, and otheralgorithms are included in our digital camera ICs.

 

**Printing Technology**

 

*Zoran Controller Technology.*Asa result of our acquisition of Oak in August 2003, we obtained Oak’sIC-based controller technology that enables users of our customers’ computerperipheral products such as printers, copiers and multi-function peripherals,or MFPs, that perform multiple document imaging functions such as print, scan,copy, process and transmit. For hardware-based printing solutions, our Imagingdivision designs high-performance, full-featured compression applicationspecific integrated circuits, or ASICs, imaging DSP ICs, resolution-enhancementASICs and system-on-a-chip, or SOC, solutions for digital copiers, printers,scanners, fax machines and MFPs.

 

*Zoran Digital Page Processing Technology.*Alsoas a result of the Oak acquisition, we obtained Oak’s digital page processingtechnology, used to create software for processing page description languagessuch as Postscript and PCL. For software-based printing solutions, our ImagingDivision offers integrated, modular, embedded software products, intended toprovide the performance, output, quality, compatibility and networkconnectivity required for today’s printing peripheral market. In addition, weprovide complementary personal computer software products, including printerdrivers and standards-based technology to enable manufacturers of peripheralsto design and develop differentiated products.

 

8

----

 

**Products**

 

Our product offerings consist of four principal product families:

 

•                  DVD—high-performanceintegrated system-on-a-chip solutions, including video and audio compressionand decompression products based on MPEG, Dolby Digital and DTS standards andfront-end technology for use in DVD players and DVD recorders.

 

•                  DTV—high-performance,highly integrated ASICs and system-on-a-chip, or SOC, solutions for standardand high definition digital television products including televisions, set topboxes, personal video recorders, digital video recorders, and recordable DVDs,as well as platforms, drivers and software stacks for a variety of operatingsystems required for these digital television applications.

 

•                  Mobile—highlyintegrated digital camera processor and multimedia mobile phone processorsincluding image signal processing, image and video compression anddecompression products based on JPEG, MPEG 4 and other technologies for thedigital camera and multimedia mobile phone markets.

 

•                  Digitalimaging—IC-based controller products and digital page processing software forthe digital imaging, production and printing market.

 

9

----

 

The following table lists our principal multimedia integrated circuitscurrently in production, including the months in which initial production unitswere first made available to customers:

 
| **Product Family** | ** ** | **Products**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 | ** ** | **Initial  Commercial   Shipment**                                                                    | ** ** | **Principal  Applications**                                                                                                                                                                                                                                                         |
|-------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| DVD                     |       | Vaddis® 5R video playback chip (ZR36750)

Activa® 100–MPEG 2 encoder (ZR35100)

Vaddis® 7 integrated DVD decoder (ZR36776)

HDXtreme® (ZR36721)

Vaddis® 8 integrated DVD decoder (ZR36868)

Vaddis® 9 integrated DVD processor  (ZR36966)                                                                                                                                                                                                                                                                                |       | July 2003

February 2004

March 2004

March 2004

August 2004

December 2005                               |       | DVD recorders

DVD recorders

DVD players

DVD players and recorders

DVD players

DVD players                                                                                                                                                                                      |
|                    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |       |                                                                                                       |       |                                                                                                                                                                                                                                                                                |
| DTV                     |       | Generation 9® integrated HD decoder with 64  Bit CPU and Audio DSP Core (TL 955)

Generation 9® integrated HD decoder with 64  bit CPU and audio DSP core (TL 945)

SupraTV®  integrated SD decoder with 32-bit CPU and audio DSP core (ZR39140)

Generation 9® Elite integrated HD decoder  with dual 32 bit CPU and audio DSP core (ZR 391055)

Cascade Demodulator (CAS-220)

SupraHD® integrated decoder (ZR39640 and  ZR39660)                                                                                                 |       | June 2002

July 2002

September 2003

October 2004

June 2005 (a)

August 2005                             |       | HDTV and HD set-top boxes 

HDTV and HD set-top boxes

 

SDTV and SD set-top boxes

HDTV and HD set-top boxes

HDTV and HD set-top boxes

HDTV and HD set-top boxes                                                                                                           |
|                    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |       |                                                                                                       |       |                                                                                                                                                                                                                                                                                |
| Mobile                  |       | Digital camera processor–COACH 5  (ZR36430)

Digital camera processor–COACH 6  (ZR36440)

Digital camera processor–COACH 7  (ZR36450)

ApproachTM multimedia application coprocessor- (ER4521)

ApproachTM multimedia application accelerator- (ER4525 and ER 4527)

Digital camera processor—COACH  8 (ZR36460)                                                                                                                                                                                                                 |       | June 2002

October 2003

July 2004

July 2004 (b)

July 2004 (b)

May 2005                                 |       | Digital cameras, security

Digital cameras, security

Digital cameras, security

Wireless and multi-media applications

Wireless and multi-media applications

Digital cameras, security                                                                                            |
|                    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |       |                                                                                                       |       |                                                                                                                                                                                                                                                                                |
| Digital Imaging         |       | Quatro® 4110 Inkjet and laser high  performance mid range print head controller platform

Quatro® 4100 Inkjet high performance low  cost print head controller platform

Integrated Print SystemTM (IPSTM) 6.0  Embedded Software

 

IPSTM/Conductor  (IPSTM/DDK)

 

Quatro® 4200 Full feature, highly  integrated SOC with high quality scanner analog front-end, USB high speed  host and color LCD interface

Quatro® 4050 Ultra-low-cost SOC for  all-in-one printers and direct-connect photo printers. |       | March 2003

October 2003

April 2003

 

September 2004

 

April 2005

 

 

May 2005 |       | Mid range inkjet MFPs and laser printers

Low cost inkjet MFPs

 

Print devices connected to a network

Print devices connected to Microsoft  operating systems

Print devices connected directly or to a  network

 

Print devices connected directly or to a  network |

 

----

(a)**-** Available as a result of the acquisition of OrenSemiconductor, Inc.

 

(b) -Available as a result of the acquisition of Emblaze Semiconductor, Ltd.

 

10

----

 

*DVD.*Our Vaddis®processors perform all the audio and video decoding and display requirements ofthe DVD specification, including MPEG 2 audio and video decoding, DolbyDigital, DTS and MLP audio decoding, on-screen display, decryption required forcopyright protection and presentation of graphic information. The Vaddis®processor has additional computational power that can be utilized for customerdifferentiation features. For example, it can incorporate virtual surroundsound algorithms without the addition of hardware. This allows the user toenjoy the theater-like sound obtained from six speakers using a system thatincludes only two speakers. The Vaddis® 7 processor incorporates all the functionsof previous generations with the addition of MPEG 4 decoding and an interfacethat can support high definition television. The Vaddis® 8 adds Super Audio CD,or SACD, upscaler and HDMI transmitter functionality. In 2004, we introducedHDXtreme® technology that allows DVD play back and the viewing of JPEG pictureson an HDTV with an HDMI interface. The Activa® 200 product, announced inDecember 2005, delivers the entire DVD recorder capability on a singlesystem-on-a-chip, integrating the front-end and back-end functions to greatlyreduce system costs and chip count in DVD recorders. We also provide DVD playerand DVD recorder reference designs based on our Vaddis and Activa® productfamilies that help our customers accelerate the time to market for theirproducts.

 

*DTV.*Our DTVDivision offers integrated circuit products for both high definition andstandard definition formats for digital televisions, set top boxes and relatedapplications, including personal video recorders. In 2004, we introduced the Generation9® Elite system-on-a-chip which utilizes dual CPUs resulting in higherperformance with lower power consumption compared to its forerunner, theGeneration 9®. During 2005, we began shipping our highly integrated SurpaHD®product line that addresses the mainstream market segment as well as high-endand entry-level segments of the flat panel display and analog-to-digitalbroadcast transition markets. We also shipped production volumes of our SupraTV®150 ICs for use in the worldwide standard definition digital terrestrial,satellite and cable broadcast markets. As a result of the Oren acquisition in June 2005, weoffer the Cascade 2 TV demodulator with our SupraHD® and Generation 9® back-end decoderand end-to-end solution for the US Advanced Television Systems Committee market. The Cascade 2 product is also sold to TVtuner suppliers as an integrated tuner and demodulator solution.

 

*Mobile.*Our COACHprocessors are integrated system-on-a-chip solutions that include most of theelectronics of a digital camera, which can be connected directly to ahigh-resolution CCD or CMOS sensor. The COACH IC processes the videoinformation in real time, compresses the captured image in real time, whileinterfacing to an LCD or micro display and to all types of flash memory. Amongthe unique capabilities of the COACH is the ability to transfer in real time,over a USB bus, high quality video to the PC and function as a PC video camera.The COACH also allows for direct connection to a printer, including colorcorrection and special effects, for the non-PC consumer environment. The COACHis supplemented by digital camera reference designs, “CamON” and “CamMini,”products shorten the time to market for Zoran’s customers. The newest COACHprocessors utilize MPEG-4 Codecs to incorporate basic digital camcordercapabilities for displaying video clips on a PC or TV. As a result of ouracquisition of Emblaze Semiconductor in July 2004, our Mobile Products Divisionalso offers mobile multimedia telephone products.

 

*Digital Imaging.*OurQuatro® addresses the consumer market for personal printers and the increasingdemand for PC-independent printing appliances. The Quatro® is a programmableSOC solution for consumer oriented imaging and printing appliances, includingmultifunction color inkjet and laser devices that feature print, copy, scan andfax capabilities and that allow image-rich content such as web pages, digitalphotos and scanned documents to be printed without the use of a PC. Quatro®ASICs are designed for mid-range and entry level inkjet printers, color photoprinters, laser printers and the new generation of dye sublimation printers. TheIntegrated Print SystemTM, or IPSTM 7.0, is a modular, scalable embedded softwareproduct that provides processing and control functions for document imagingperipheral devices. IPSTM was developed based on a long standing expertise inpage description language interpreters such as PCL and Postscript. The IPSTMproduct line gives the OEM the ability to build high performance, networkenabled devices quickly and cost effectively.

 

11

----

 

**Customers**

 

The following table lists representative customers, as well as otherOEMs who purchase our products through our resellers. Each of thesecustomers and OEMs purchased, directly or indirectly, at least $500,000 ofZoran products during 2005:

 
| **Product Family** | ** ** | **Direct Customers and Resellers**                                                                                                                                                                                                                                                                             | ** ** | **Other OEMs**                                                                                                                                                                                                                                                     |
|-------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| DVD                     |       | Alco Electronics LTD.  Anam Electronics Co. LTD.  Citron Electronics Co. LTD.  Dalian Golden Hualu Digital Tech. Co. LTD.  Eastech Electronics (hui Yang) Co. LTD.  Everbest Industrial (HK) LTD.  Fly Ring Digital Technology LTD.  Goodsino Technology  LG Electronic Inc.  Marubun Corporation  Maxi World Technology LTD. |       | Mico Electric  Orient Power  Samsung Electronics  Shenzhen Kaixinda Multi-Media  Co. LTD.

Tecobest Digital LTD.  Thomson Hong Kong Holdings LTD.

Universal Pacific Co. LTD.  Zenitron Corporation  Zhongshan Dingcai AV Technology  Zhongshan E-Tek Co. LTD.          |   | Orion  Sanyo  Sharp  Toshiba |
|                    |       |                                                                                                                                                                                                                                                                                                                          |       |                                                                                                                                                                                                                                                                    |   |   |
| DTV                     |       | 3S Digital  Beijing Orient Top Victory  Dae Jin Semiconductor Co. LTD.  Daewoo Electronics Co. LTD.  Digital Stream Technology  Ever Best Industrial (HK) LTD.  Homecast Co. LTD.  Humax Co. LTD.  Kanematsu Corporation  Lacewood International Corp.  Marubun Corporation  Maxtek Technology Co. LTD.                       |       | Mico Electric (HK) LTD.

Paramit Corporation

Pinnacle Systems Inc.

Samsung Electronics

Shenzhen MTC Multi-Media Co LTD.

Sichuan Changhong Network

Sunplus Technology Co., Ltd

Trident Microsystems Inc.

TVIA Inc.

TTE Technology Inc.

Zhongshan E-Tek Co. LTD. |   | Funai  JVC  Mitsubishi  MitsumiPanasonic  Sony |
|                    |       |                                                                                                                                                                                                                                                                                                                          |       |                                                                                                                                                                                                                                                                    |   |   |
| Mobile                  |       | Aiptek International Inc.  ASD Technology LTD.  Bellwave Co. LTD.  Chicony Electronics Co. LTD.  CK Telecom Eastern Communications Co. LTD.  Ever Best Industrial (HK) LTD.  Grandtech Industrial LTD.  Kyoshin Technosonic (Asia) LTD.  Maxtek Technology Co. LTD.  Newell Hong long LTD.                                    |       | Newgen Telecom Inc.

Ningbo Guangbo Digital Technology Olympus

Pentax Corporation

Premier

Samsung Electronics

Shenzhen Xinlikang Industrial Co. Skanhex  Technology Inc.

Tekom Technologies Inc.

Zenitron Corporation                                             |   |   |
|                    |       |                                                                                                                                                                                                                                                                                                                          |       |                                                                                                                                                                                                                                                                    |   |   |
| Digital Imaging         |       | Avision Enterprise (BVI) Inc.  Benq Co.  Celestica Corp.  Canon Inc. Seiko Epson Corporation  Fuji Xerox  Hewlett Packard  Kanematsu Corporation  Lexmark International, Inc.  Lite-On Technology Co                                                                                                                          |       | Nexpress Solutions

OkiData Corporation

Ricoh Company Ltd.

Samsung Electronics Co., Ltd. Sanmina SCI  Corporation

Sharp Electronics Corporation

TECO Imaging Systems Co. LTD. Toshiba  Corporation

Xerox                                                           |   | Panasonic  Kyocera Mita  Kodak |

 

12

----

 

In2005, no single customer accounted for more than 10% of our total revenues, andsales to our four largest customers accounted for 29% of our total revenues. In2004, Samsung Electronicsaccounted for 11% of our total revenues, while sales to our four largestcustomers accounted for 35% of our total revenues.

 

**Research and Development**

 

We believe that our future success depends on our ability to continueto enhance our existing products and to develop new products that maintaintechnological competitiveness and compliance with new standards in rapidlyevolving consumer-oriented digital audio and video markets. We attempt toleverage our expertise in the fields of digital signal processing, integratedcircuit design, algorithms and software development to maintain our position asa leader in the development of digital audio, video and imaging solutions. Accordingly,we devote a significant portion of our resources to maintaining and upgradingour products to reduce integrated circuit cost, feature size, power consumptionand the number of integrated circuits required to perform compression and otherfunctions necessary for the evolving digital audio, video and imagingapplication markets. In addition, we seek to design integrated circuits andcores, as well as near production ready reference designs which can reduce thetime needed by manufacturers to integrate our ICs into their own products.

 

We have historically generated a portion of our revenues fromdevelopment contracts with our strategic partners. These development contractsprovide that we will receive payments upon reaching certain developmentmilestones and that we will retain ownership of the intellectual propertydeveloped. Development contracts have enabled us to fund portions of ourproduct development efforts, to respond to the feature requirements of ourcustomers, to accelerate the incorporation of our products into our customers’products and to accelerate the time-to-market of our customers’ products. Weanticipate, however, that in the future development contracts with strategicpartners will fund a smaller portion of our development efforts than in thepast.

 

We are a party to research and development agreements with the ChiefScientist in Israel’s Ministry of Industry and Trade and the Israel-UnitedStates Bi-national Industrial Research and Development Foundation. Theseorganizations fund up to 50% of incurred project costs for approved projects upto contract maximums. The agreements require us to use our best efforts toachieve specified results and to pay royalties at rates of 3% to 5% ofresulting product sales and up to 30% of resulting license revenues, up to amaximum of 100% to 150% of the total funding received. Reported research anddevelopment expenses are net of these grants, which fluctuate from period toperiod. In 2004, we earned grants totaling $1.5 million. There were nogrant receipts in 2005. The terms of Israeli Government participation includerestrictions on the location of research and development activities, and theterms of the grants from the Chief Scientist prohibit the transfer oftechnology developed pursuant to these grants to any person without the priorwritten consent of the Chief Scientist.

 

As of December 31, 2005, we had a staff of 511 full-time, 121part-time and contract research and development personnel for a total of 632research and development personnel.

 

**Sales and Marketing**

 

Our sales and marketing strategy is to focus on providing solutions tomanufacturers seeking to design audio, video and imaging products for existingand emerging high volume consumer applications. In cooperation with leadingmanufacturers of audio, video and imaging equipment in the commercial andconsumer markets, we attempt to identify market segments which have thepotential for substantial growth. To implement our strategy, we haveestablished a worldwide direct sales force in several sales and marketingoffices located near our key customers and strategic partners, and a worldwidenetwork of independent sales representatives and resellers. In some cases, ourstrategic partners also provide sales and marketing support.

 

We work closely in the product development process with strategicpartners to incorporate our integrated circuits and software into theirproducts. Potential products are designed to meet customer-specific productrequirements defined jointly by us and our strategic partners with our partnersproviding technological input, and in some cases, a portion of the developmentfunding. This strategy has permitted us to develop products with substantialfinancial and other assistance, while retaining ownership of the technology andensuring an established customer for the product once development is completed.In addition, our application engineers assist customers in designing theirproducts to incorporate our integrated circuits.

 

Our sales are generally made pursuant to purchase orders receivedbetween one and six months prior to the scheduled delivery date. We sell ourproducts primarily through our 113-person direct sales staff, of whom 11 arelocated in the United States and 102 are located internationally. Our UnitedStates sales staff is primarily responsible for sales in North America, Europeand South America. Sales management and sales operations staff also reside inthe United States. Our marketing staffs in China, Japan, Korea and Taiwan areresponsible for marketing in their respective regions. In addition, we sell ourproducts indirectly through five commissioned sales representatives as well asselected resellers. We typically warrant our products for a 12-month period. Todate, we have not experienced material product returns or warranty expense.

 

13

----

 

We have opened offices in other parts of the world in order to betteraddress specific markets. During 1998, we opened an office in Shenzhen, Chinaas part of our effort to capture a leadership position in the Chinese digitalaudio and video markets. During 2000, we opened an office in Taipei, Taiwan inan effort to better address the digital camera market. As of December 31,2005, we had a staff of 275 employees and 16 contractors in our China officeand 49 employees in our Taiwan office, including sales, applications andcustomer support employees. In addition, in 2001 we opened offices in Hong Kongand Korea, which had staffs of 3 employees and 20 employees, respectively, asof December 31, 2005. These offices also provide sales, applications andcustomer support.

 

We distribute our products in Japan primarily through resellers. Wealso operate an office in Tokyo to help promote our products in Japan, assistwith the marketing of products not sold through resellers, such as integratedcircuit cores and certain digital camera, digital video, digital television,imaging and JPEG products, and provide applications support for some of ourcustomers. At December 31, 2005, we had 32 employees and 21 contractors inour Tokyo office.

 

We sell our Dolby technology enabled products under a perpetual,non-exclusive license from Dolby to sell products that incorporate the DolbyDigital algorithm. We are not required to pay license fees or royalties toDolby under this agreement. Our customers enter into license agreementsdirectly with Dolby, pursuant to which they pay royalties to Dolby. Under ouragreement with Dolby, we may sell our Dolby Digital-based products only tocustomers who are licensees of Dolby. To date, most potential customers for ourDolby Digital-based products are licensees of Dolby. However, the failure orrefusal of potential customers to enter into license agreements with Dolby inthe future could harm our sales.

 

We sell our DTS Technology-based products under a non-exclusive licensefrom DTS Technology LLC to sell products that incorporate the DTS algorithm. Weare not required to pay royalties to DTS Technology under this agreement. Ourcustomers enter into license agreements directly with DTS, pursuant to whichthey pay royalties to DTS. Under our agreement with DTS, we may sell ourDTS-based products only to customers who are licensees of DTS. The failure orrefusal of potential customers to enter into license agreements with DTS in thefuture could harm our sales.

 

**Backlog**

 

Sales of our products are made pursuant to firm purchase orders. However,sometimes we allow customers to cancel or reschedule deliveries. In addition,purchase orders are subject to price renegotiations and to changes inquantities of products ordered as a result of changes in customers’requirements and manufacturing availability. Our ability to order products cancarry lead times of between four and 16 weeks; however, most of our business ischaracterized by short lead times and quick delivery schedules. As a result ofthese factors, we do not believe that backlog at any given time is a meaningfulindicator of future sales.

 

**Manufacturing**

 

We contract our wafer fabrication, assembly and testing to independentfoundries and contractors, which enables us to focus on our design strengths,minimize fixed costs and capital expenditures and gain access to advancedmanufacturing facilities. Our engineers work closely with our foundry partnersand subcontractors to increase yields, lower manufacturing costs and assurequality.

 

Our primary foundry is Taiwan Semiconductor Manufacturing Company, orTSMC, which has manufactured integrated circuits for us since 1987. TSMC,Philips and Samsung are currently manufacturing our DVD, JPEG, DTV, imaging andsome of our mobile products. Fujitsu manufactures our USB multimedia controllerchips. Our independent foundries fabricate products for other companies and mayalso produce products of their own design.

 

All of our devices are currently fabricated using standardcomplementary metal oxide semiconductor process technology with 0.13 micron to0.18 micron feature sizes. Most of our semiconductor products are currentlybeing assembled by one of five independent contractors and tested by thosecontractors or other independent contractors.

 

We currently purchase products from all of our foundries underindividually negotiated purchase orders. We do not currently have a long-termsupply contract with TSMC, and therefore TSMC is not obligated to manufactureproducts for us for any specific period, in any specific quantity or at anyspecified price, except as may be provided in a particular purchase order.

 

14

----

 

**Competition**

 

Our existing and potential competitors include many large domestic andinternational companies that have substantially greater resources in thefollowing areas:

 

•                  finance;

 

•                  manufacturing;

 

•                  technology;

 

•                  marketing; and

 

•                  distribution.

 

Some of these competitors also have broader product lines and longerstanding relationships with customers than we do. Some of our principalcompetitors maintain their own semiconductor foundries and may thereforebenefit from capacity, cost and technical advantages. ALi Corporation,Broadcom, Cheertek, Cirrus Logic, ESS, LSI Logic, Matsushita, MediaTek, NEC,SigmaDesigns, Sony, STMicroelectronics, Sunplus and Texas Instruments haveintroduced integrated audio and video devices for DVD applications. In themarkets for JPEG-based products for use in digital cameras, our principalcompetitors are in-house solutions developed and used by major Japanese OEMs,as well as products sold by Sunplus and Texas Instruments. In the market forJPEG-based products for desktop video editing applications, our principalcompetitor is Sunplus. Cirrus Logic (Crystal Semiconductor), Fujitsu, Motorola,STMicroelectronics and Yamaha are currently shipping Dolby Digital-based audiocompression products. Our principal competitors for digital semiconductordevices in the digital television market include ATI Technologies, Broadcom,Conexant and ST Microelectronics. Others who also participate in this marketare Ali Corporation, Fujitsu, Genesis Microchip, Haier, IBM, LSI, NEC, Philips,Sigmatel, Inc., Peerless Systems, TAK Imaging and in-house captive suppliers.

 

We believe that our ability to compete successfully in the rapidlyevolving markets for high performance audio, video and imaging technologydepends on a number of factors, including the following:

 

•                  price, quality,performance and features of our products;

 

•                  the timing andsuccess of new product introductions by itself, our customers and ourcompetitors;

 

•                  the emergence ofnew industry standards;

 

•                  its ability toobtain adequate foundry capacity;

 

•                  the number andnature of our competitors in a given market; and

 

•                  general marketand economic conditions.

 

The markets in which we compete are intensely competitive and arecharacterized by rapid technological change, declining average unit sellingprices and rapid product obsolescence. We expect competition to increase in thefuture from existing competitors and from other companies that may enter ourexisting or future markets with solutions which may be less costly or providehigher performance or more desirable features than our products.

 

We believe that growth of the DVD player marketwill be modest in the forseeable future, and that continued strong competition inthat market will lead to further price reductions, and reduced profit margins. We believe that the DVD recorder market will continue to grow and that astechnology barriers become higher, fewer competitors will enter this market.

 

Historically, average unit selling prices in the semiconductor industryin general, and for our products in particular, have decreased over the life ofa particular product. We expect that the average unit selling prices of ourproducts will continue to be subject to significant pricing pressures. In orderto offset expected declines in the average unit selling prices of our products,we will need to continually reduce the cost of our products and continue tointegrate additional functions into our ICs. We intend to accomplish this byimplementing design changes that integrate additional functionality, lower thecost of manufacturing, assembly and testing, by negotiating reduced charges byour foundries as and if volumes increase, and by successfully managing our manufacturingand subcontracting relationships. Since we do not operate our ownmanufacturing, assembly or testing facilities, we may not be able to reduce ourcosts as rapidly as companies that operate their own facilities. If we fail tointroduce lower cost versions of our products in a timely manner or tosuccessfully manage our

 

15

----

 

manufacturing, assembly and testing relationships, our business wouldbe harmed.

 

**Proprietary Rights and Licenses**

 

Our ability to compete successfully is dependent in part upon ourability to protect our proprietary technology and information. Although we relyon a combination of patents, copyrights, trademarks, trade secret laws andlicensing arrangements to protect some of our intellectual property, we believethat factors such as the technological and creative skills of our personnel andthe success of our ongoing product development efforts are more important inmaintaining our competitive position. We generally enter into confidentialityor license agreements with our employees, resellers, customers and potentialcustomers and limit access to our proprietary information. We currently holdapproximately 265 patents worldwide, and have additional patent applicationspending. Our intellectual property rights, if challenged, may not be upheld asvalid, may not be adequate to prevent misappropriation of our technology or maynot prevent the development of competitive products. Additionally, we may notbe able to obtain patents or other intellectual property protection in thefuture. In particular, the existence of several consortiums that licensepatents relating to the MPEG standard has created uncertainty with respect tothe use and enforceability of patents implementing that standard. Furthermore,the laws of certain foreign countries in which our products are or may be developed,manufactured or sold, including various countries in Asia, may not protect ourproducts or intellectual property rights to the same extent as do the laws ofthe United States and thus make the possibility of piracy of our technology andproducts more likely in these countries.

 

We sell our Dolby Digital-based products under a perpetualnon-exclusive license from Dolby which permits us to incorporate the DolbyDigital algorithm into our products. Our customers enter into licenseagreements with Dolby pursuant to which they pay royalties directly to Dolby. Underour agreement with Dolby, we may sell our Dolby Digital-based products only tocustomers who are licensees of Dolby. To date, most potential customers for ourDolby Digital- based products are licensees of Dolby. However, the failure orrefusal of potential customers to enter into license agreements with Dolby inthe future could harm our business. We sell our DTS Technology-based productsunder a non-exclusive license from DTS Technology LLC to sell products thatincorporate the DTS algorithm. We are not required to pay royalties to DTSunder this agreement. Our customers enter into license agreements directly withDTS, pursuant to which they pay royalties to DTS. Under our agreement with DTS,we may sell our DTS-based products only to customers who are licensees of DTS. Thefailure or refusal of potential customers to enter into license agreements withDolby in the future could harm our sales.

 

The semiconductor industry is characterized by vigorous protection andpursuit of intellectual property rights, which have resulted in significant andoften protracted and expensive litigation. We or our foundries from time totime are notified of claims that we may be infringing patents or otherintellectual property rights owned by third parties. We have been subject tointellectual property claims and litigation in the past, and we and our Oaksubsidiary were recently engaged in such litigation. See Item 3—LegalProceedings. We may be subject to additional claims and litigation in thefuture. In particular, given the uncertainty discussed above regarding patentsrelating to the MPEG standard, it is difficult for us to assess the possibilitythat our activities in the MPEG field may give rise to future patentinfringement claims. Litigation by or against us relating to patentinfringement or other intellectual property matters could result in significantexpense to us and divert the efforts of our technical and management personnel,whether or not such litigation results in a determination favorable to us. Inthe event of an adverse result in any such litigation, we could be required topay substantial damages, cease the manufacture, use and sale of infringingproducts, expend significant resources to develop non-infringing technology,discontinue the use of certain processes or obtain licenses to the infringingtechnology. Licenses may not be offered or the terms of any offered licensesmay not be acceptable to us. If we fail to obtain a license from a third partyfor technology that it uses, we could incur substantial liabilities and beforced to suspend the manufacture of products, or the use by our foundries ofcertain processes.

 

**Employees**

 

As of December 31, 2005, we had 1,094 full-time and 152 part-timeand contract employees, including 632 full-time, part-time and contractemployees primarily involved in research and development activities, 464 inmarketing and sales, 100 in finance, human resources, information systems,legal and administration, and 50 in manufacturing control and quality assurance.We have 343 full-time employees and 70 part-time and contract employees basedin Israel, of which 352 employees, including both full time and contractemployees, are involved in engineering and research and development. We have188 full-time employees and 36 part-time and contract employees at ourfacilities in Sunnyvale, California, 148 full-time employees and 7 part-timeand contract employees at our facility in Woburn Massachusetts, and 275full-time employees and 16 part-time contract employees at our facilities inShenzhen and Shanghai, China. The remaining employees are located in ourinternational offices in Canada, England, Germany, Hong Kong, Japan, Korea andTaiwan. We believe that our future success will depend in large part on ourability to attract and retain highly-skilled, engineering, managerial, salesand marketing personnel. Competition for such personnel is intense. Ouremployees are not represented by any collective bargaining unit, and we havenever experienced a work stoppage. We believe that our employee relations aregood.

 

16

----

 

**Item 1A —****Risk Factors**

 

Ourfuture business, operating results and financial condition are subject tovarious risks and uncertainties, including those described below.

 

**Our annual revenues and operating results fluctuatedue to a variety of factors, which may result in volatility or a decline in theprices of our stock.**

 

Ourhistorical operating results have varied significantly from year over year dueto a number of factors, including:

 

•                  fluctuation in demand for our products;

 

•                  the timing of new product introductions orenhancements by us and our competitors;

 

•                  the level of market acceptance of new andenhanced versions of our products and our customers’ products;

 

•                  the timing or cancellation of large customerorders;

 

•                  the length and variability of the sales cyclefor our products;

 

•                  pricing policy changes by us and by ourcompetitors and suppliers;

 

•                  the cyclical nature of the semiconductorindustry;

 

•                  the availability of development funding andthe timing of development revenue;

 

•                  changes in the mix of products sold;

 

•                  seasonality in demand for our products;

 

•                  increased competition in product lines, andcompetitive pricing pressures; and

 

•                  the evolving and unpredictable nature of themarkets for products incorporating our integrated circuits and embeddedsoftware.

 

Weexpect that our operating results will continue to fluctuate in the future as aresult of these factors and a variety of other factors, including:

 

•                  the cost and availability of adequate foundrycapacity;

 

•                  fluctuations in manufacturing yields;

 

•                  changes in or the emergence of new industrystandards;

 

•                  failure to anticipate changing customerproduct requirements;

 

•                  the loss or gain of important customers;

 

•                  product obsolescence; and

 

•                  the amount of research and developmentexpenses associated with new product introductions.

 

Ouroperating results could also be harmed by:

 

•                  economic conditions generally or in variousgeographic areas where we or our customers do business;

 

•                  terrorism and international conflicts orother crises;

 

17

----

 

•                  other conditions affecting the timing ofcustomer orders;

 

•                  changes in governmental regulations thatcould affect our products; or

 

•                  a downturn in the markets for our customers’products, particularly the consumer electronics market.

 

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

 

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

 

Asa result of these factors, our operating results may vary significantly fromquarter to quarter. Any shortfall in revenues or net income from levelsexpected by the investment community could cause a decline in the trading priceof our stock.

 

**Our customers experience fluctuating product cyclesand seasonality, which causes their sales to fluctuate.**

 

Becausethe markets that our customers serve are characterized by numerous new productintroductions and rapid product enhancements, our operating results may varysignificantly from quarter to quarter. During the final production of a matureproduct, our customers typically exhaust their existing inventory of ourproducts. Consequently, orders for our products may decline in thosecircumstances, even if the products are incorporated into both mature productsand replacement products. A delay in a customer’s transition to commercialproduction of a replacement product would delay our ability to recover the lostsales from the discontinuation of the related mature product. Our customersalso experience significant seasonality in the sales of their consumerproducts, which affects their orders of our products. Typically, the secondhalf of the calendar year represents a disproportionate percentage of sales forour customers due to the holiday shopping period for consumer electronicsproducts, and therefore, a disproportionate percentage of our sales. We expectthese seasonal sales fluctuations to continue for the foreseeable future.

 

**Product supply and demand in the semiconductorindustry is subject to cyclical variations.**

 

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

 

**Our success for the foreseeable future will bedependent on growth in demand for integrated circuits for a limited number ofapplications.**

 

Inrecent years, we have derived a substantial majority of our product revenuesfrom the sale of integrated circuits for DVD and digital camera applications. Weexpect that sales of our products for these applications will continue toaccount for a significant portion of our revenues for the foreseeable future. Ourfuture financial performance will also depend on our ability to successfullydevelop and market new products in the digital television, HDTV and digitalimaging markets. If the markets for these products and applications decline orfail to develop as expected, or we are not successful in our efforts to marketand sell our products to manufacturers who incorporate integrated circuits intothese products, our financial results will be harmed.

 

18

----

 

**Our financial performance is highly dependent on thetimely and successful introduction of new and enhanced products.**

 

Ourfinancial performance depends in large part on our ability to successfullydevelop and market next-generation and new products in a rapidly changingtechnological environment. If we fail to successfully identify new productopportunities and timely develop and introduce new products that achieve marketacceptance, we may lose our market share and our future revenues and earningsmay suffer.

 

Inthe consumer electronic market, our performance has been dependent on oursuccessful development and timely introduction of integrated circuits for DVDplayers, DVD recorders, digital cameras, broadband digital television and HDTV.These markets are characterized by the incorporation of a steadily increasinglevel of integration and numbers of features on a chip at the same or lowersystem cost, enabling original equipment manufacturers, or OEMs, to continuallyimprove the features or reduce the prices of the systems they sell. If we areunable to continually develop and introduce integrated circuits with increasinglevels of integration and new features at competitive prices, our operatingresults will suffer.

 

Inthe digital office market, our performance has been dependant on our ability tosuccessfully develop embedded image processing system on a chip, or SOC,solutions for the digital office market, in particular, embedded digital colorcopier technology and image processing chips for a variety of imagingperipherals, including printers and multi-function peripherals, or MFPs. Amongother technological changes, embedded PDF and color capability are rapidlyemerging as market requirements for printers and other imaging devices. Some ofour competitors have the capacity to supply these solutions, and some of theirsolutions have been well received in the marketplace. We face the challenge ofdeveloping new imaging products with the capability to handle greater color andimage complexity, including web-based documents, and work withhigher-performing devices in networked environments. If we are unable to meetthese challenges with the development of products that can effectively competein the OEM software and solutions market, our future operating results couldsuffer.

 

**We must keep pace with rapid technological changes andevolving industry standards to remain competitive.**

 

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

 

Oursuccess will also depend on the successful development of new markets and theapplication and acceptance of new technologies and products in those newmarkets. For example, our success will depend on the ability of our customersto develop new products and enhance existing products in the recordable DVDplayer market and products for the broadband digital television and HDTVmarkets and to introduce and promote those products successfully. These marketsmay not continue to develop to the extent or in the time periods that wecurrently anticipate due to factors outside our control, such as delays inimplementation of FCC 02-320 requiring all new televisions to include a digitalreceiver. If new markets do not develop as we anticipate, or if our products donot gain widespread acceptance in these markets, our business, financialcondition and results of operations could be materially and adversely affected.The emergence of new markets for our products is also dependent in part uponthird parties developing and marketing content in a format compatible withcommercial and consumer products that incorporate our products. If this contentis not available, manufacturers may not be able to sell products incorporatingour products, and our sales would suffer.

 

**We rely on independent foundries and contractors forthe manufacture, assembly and testing of our integrated circuits and otherhardware products, and the failure of any of these third parties to deliverproducts or otherwise perform as requested could damage our relationships withour customers and harm our sales and financial results.**

 

Wedo not operate any manufacturing facilities, and we rely on independentfoundries to manufacture substantially all of our products. These independentfoundries fabricate products for other companies and may also produce productsof their own design. From time to time, there are manufacturing capacityshortages in the semiconductor industry. We do not have long-term supplycontracts with any of our suppliers, including our principal supplier, TaiwanSemiconductor Manufacturing Company, or TSMC. Therefore, TSMC and our othersuppliers are not obligated to manufacture products for us for any specificperiod, in any specific quantity or at any specified price, except as may beprovided in a particular purchase order.

 

19

----

 

Ourreliance on independent foundries involves a number of risks, including:

 

•                  the inability to obtain adequatemanufacturing capacity;

 

•                  the unavailability of or interruption inaccess to certain process technologies necessary for manufacture of ourproducts;

 

•                  lack of control over delivery schedules;

 

•                  lack of control over quality assurance;

 

•                  lack of control over manufacturing yields andcost; and

 

•                  potential misappropriation of our intellectualproperty.

 

Inaddition, TSMC and some of our other foundries are located in areas of theworld that are subject to natural disasters such as earthquakes. While the 1999earthquake in Taiwan did not have a material impact on our independentfoundries, a similar event centered near TSMC’s facility could severely reduceTSMC’s ability to manufacture our integrated circuits. The loss of any of ourmanufacturers as a supplier, our inability to expand the supply of theirproducts in response to increased demand, or our inability to obtain timely andadequate deliveries from our current or future suppliers due to a naturaldisaster or any other reason could delay or reduce shipments of our products. Anyof these circumstances could damage our relationships with current andprospective customers and harm our sales and financial results.

 

Wealso rely on a limited number of independent contractors for the assembly andtesting of our products. Our reliance on independent assembly and testinghouses limits our control over delivery schedules, quality assurance andproduct cost. Disruptions in the services provided by our assembly or testinghouses or other circumstances that would require them to seek alternativesources of assembly or testing could lead to supply constraints or delays inthe delivery of our products. These constraints or delays could damage ourrelationships with current and prospective customers and harm our financialresults.

 

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

 

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

 

•                  option payments or other prepayments to afoundry;

 

•                  nonrefundable deposits with or loans tofoundries in exchange for capacity commitments;

 

•                  contracts that commit us to purchasespecified quantities of silicon wafers over extended periods;

 

•                  issuance of our equity securities to afoundry;

 

•                  investment in a foundry;

 

•                  joint ventures; or

 

•                  other partnership relationships withfoundries.

 

Wemay not be able to make any such arrangement in a timely fashion or at all, andsuch arrangements, if any, may not be on terms favorable to us. Moreover, if weare able to secure foundry capacity, we may be obligated to utilize all of thatcapacity or incur penalties. Such penalties may be expensive and could harm ourfinancial results.

 

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

 

Thefabrication of silicon wafers is a complex process. Minute levels ofcontaminants in the manufacturing environment, defects in photo masks used toprint circuits on a wafer, difficulties in the fabrication process or otherfactors can cause a substantial portion of the integrated circuits on a waferto be non-functional. Many of these problems are difficult to detect at anearly stage of the 

 

20

----

 

manufacturingprocess and may be time consuming and expensive to correct. As a result,foundries often experience problems achieving acceptable yields, which arerepresented by the number of good integrated circuits as a proportion of thenumber of total integrated circuits on any particular wafer. Poor yields fromour independent foundries would reduce our ability to deliver our products tocustomers, harm our relationships with our customers and harm our business.

 

**We face competition or potential competition fromcompanies with greater resources than ours, and if we are unable to competeeffectively with these companies, our market share may decline and our businesscould be harmed.**

 

Weface intense competition in the markets in which we compete. We expect that thelevel of competition will increase in the future from existing competitors andfrom other companies that may enter our existing or future markets withsolutions that may be less costly or provide higher performance or additionalfeatures.

 

Competitionin Zoran’s core compression technology market has historically been dominatedby large companies, such as ST Microelectronics, and companies thatdevelop and use their own integrated circuits, such as Sony and Matsushita. Asthis market continues to develop, we face competition from other largesemiconductor vendors.

 

TheDVD market continues to expand, and additional competitors are expected toenter the market for DVD players and software. Some of these potentialcompetitors may develop captive implementations for use only with their own PCand consumer electronics products. It is also possible that applicationsoftware vendors, such as Microsoft, may attempt to enter the DVD applicationmarket in the future. This increased competition may result in pricereductions, reduced profit margins and loss of market share.

 

Weface competition from several large semiconductor companies in the broadbanddigital television and set-top box markets. We expect competition to continueto increase in these markets as industry standards become well known and asother competitors enter these markets.

 

Wealso face significant competition in the digital office market. The futuregrowth of the digital office market is highly dependent on OEMs continuingto outsource an increasing portion of their product development work. While thetrend toward outsourcing on the part of our OEM customers in this market hasaccelerated in recent years, any reversal of this trend, or a change in the waythey outsource, could seriously harm our business.

 

Manyof our existing competitors, as well as OEM customers that are expected tocompete with us in the future, have substantially greater financial,manufacturing, technical, marketing, distribution and other resources, broaderproduct lines and longer standing relationships with customers than we have. Inaddition, much of our future success is dependent on the success of our OEMcustomers. If we or our OEM customers are unable to compete successfullyagainst current and future competitors, we could experience price reductions,order cancellations and reduced gross margins, any one of which could harm ourbusiness.

 

**Our products are characterized by average sellingprices that decline over relatively short time periods; if we are unable toreduce our costs or introduce new products with higher average selling prices,our financial results will suffer.**

 

Averageselling prices for our products decline over relatively short time periods,while many of our manufacturing costs are fixed. When our average sellingprices decline, our revenues decline unless we are able to sell more units andour gross margins decline unless we are able to reduce our manufacturing costsby a commensurate amount. Our operating results suffer when gross marginsdecline. We have experienced these problems, and we expect to continue toexperience them in the future, although we cannot predict when they may occuror how severe they will be.

 

**We derive most of our revenue from sales to a small number oflarge customers, and if we are not able to retain these customers, or they reschedule,reduce or cancel orders, our revenues would be reduced and our financialresults would suffer.**

 

Ourlargest customers have accounted for a substantial percentage of our revenues. In2005, no single customer accounted for more than 10% of our total revenues, andsales to our four largest customers accounted for 29% of our total revenues. In2004, one customer accounted for 11% of our total revenues while sales to ourfour largest customers accounted for 35% of our total revenues. Sales to theselarge customers have varied significantly from year to year and will continueto fluctuate in the future. These sales also may fluctuate significantly fromquarter to quarter. We may not be able to retain our key customers, or thesecustomers may cancel purchase orders or reschedule or decrease their level ofpurchases from us. Any substantial decrease or delay in sales to one or more ofour key customers could harm our sales and financial results. In addition, anydifficulty in collecting amounts due from one or more key customers could harmour financial results.

 

21

----

 

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

 

Ourproducts are technologically complex. Prospective customers generally must makea significant 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.

 

Longsales cycles also subject us to other risks, including customers’ budgetaryconstraints, internal acceptance reviews and cancellations. In addition, ordersexpected in one quarter could shift to another because of the timing ofcustomers’ purchase decisions. The time required for our customers toincorporate our products into their own can vary significantly with the needsof our customers and generally exceeds several months, which furthercomplicates our planning processes and reduces the predictability of ouroperating results.

 

**We are not protected by long-term contracts with ourcustomers.**

 

Wegenerally do not enter into long-term purchase contracts with our customers,and we cannot be certain as to future order levels from our customers. Customersgenerally purchase our products subject to cancelable short-term purchaseorders. We cannot predict whether our current customers will continue to placeorders, whether existing orders will be canceled, or whether customers who haveordered products will pay invoices for delivered products. When we do enterinto a long-term contract, the contract is generally terminable at theconvenience of the customer. In the event of an early termination by one of ourmajor customers, it is unlikely that we will be able to rapidly replace thatrevenue source, which would harm our financial results.

 

**Regulation of our customers’ products may slow the process ofintroducing new products and could impair our ability to compete.**

 

TheFederal Communications Commission, or FCC, has broad jurisdiction over ourtarget markets in the digital television business. 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 directgovernment regulation. For example, before they can be sold in the UnitedStates, advanced televisions and emerging interactive displays must be testedand certified by Underwriters Laboratories and meet FCC regulations. Accordingly,the effects of regulation on our customers or the industries in which ourcustomers operate may in turn harm our business. FCC regulatory policiesaffecting the ability of cable operators or telephone companies to offercertain services and other terms on which these companies conduct theirbusiness may impede sales of our products. In addition, our digital televisionbusiness may also be adversely affected by the imposition of tariffs, dutiesand other import restrictions on our suppliers or by the imposition of exportrestrictions on products that we sell internationally. Changes in current lawsor regulations or the imposition of new laws or regulations in the UnitedStates or elsewhere could harm our business. For example, any delays by the FCCin imposing its pending requirement that all new televisions have a digitalreceiver could have an adverse effect on our HDTV business.

 

**We are dependent upon our international sales and operations;economic, political or military events in a country where we make significantsales or have significant operations could interfere with our success oroperations there and harm our business.**

 

During2005, only 6% of our total revenues were derived from North America sales. Weanticipate that international sales will continue to account for a substantial majorityof our total revenues for the foreseeable future. In addition, substantiallyall of our semiconductor products are manufactured, assembled and testedoutside of the United States by independent foundries and subcontractors.

 

Weare subject to a variety of risks inherent in doing business internationally,including:

 

•                  unexpected changes in regulatoryrequirements;

 

•                  fluctuations in exchange rates;

 

•                  political and economic instability;

 

•                  imposition of tariffs and other barriers andrestrictions;

 

22

----

 

•                  the burdens of complying with a variety offoreign laws; and

 

•                  health risks in a particular region.

 

Amaterial amount of our research and development personnel and facilities and aportion of our sales and marketing personnel are located in Israel. Political,economic and military conditions in Israel directly affect our operations. Someof our employees in Israel are obligated to perform up to 39 days ofmilitary reserve duty annually. The absence of these employees for significantperiods during the work week may cause us to operate inefficiently during theseperiods.

 

Ouroperations in China are subject to the economic and political uncertaintiesaffecting that country. For example, the Chinese economy has experiencedsignificant growth in the past decade, but such growth has been uneven acrossgeographic and economic sectors. This growth may decrease and any slowdown mayhave a negative effect on our business. We also maintain offices in Taipei, Taiwan,Hong Kong and Seoul, Korea, and our operations are subject to the economic andpolitical uncertainties affecting these countries as well.

 

Thesignificant concentration of our manufacturing activities with third partyfoundries in Taiwan exposes us to the risk of political instability in Taiwan,including the potential for conflict between Taiwan and China. We have severalsignificant OEM customers in Japan, Korea and other parts of Asia. Adverseeconomic circumstances in Japan and elsewhere in Asia could affect thesecustomers’ willingness or ability to do business with us in the future or theirsuccess in developing and launching devices containing our products.

 

**Our business and future operating results could be harmed byterrorist activity or armed conflict.**

 

Ourbusiness and operating results are subject to uncertainties arising out ofpossible terrorist attacks on the United States and other regions of the worldincluding locations where we maintain operations and by armed conflict in theMiddle East and related economic instability. Our operations could be harmeddue to:

 

•                                                disruption in commercial activitiesassociated with heightened security concerns affecting international travel andcommerce;

 

•                                                reduced demand for consumer electronicproducts due to a potential economic slowdown;

 

•                                                tightened immigration controls that mayadversely affect the residence status of key non-U.S. managers and technicalemployees in our U.S. facilities or our ability to hire new non-U.S. employeesin such facilities; or

 

•                                                potential expansion of armed conflict in theMiddle East which could adversely affect our operations in Israel.

 

**The prices of our products may become less competitive due toforeign exchange fluctuations.**

 

Foreigncurrency fluctuations may affect the prices of our products. Prices for ourproducts are currently denominated in U.S. dollars for sales to our customersthroughout the world. If there is a significant devaluation of the currency ina specific country, the prices of our products will increase relative to thatcountry’s currency, our products may be less competitive in that country andour revenues may be adversely affected. Also, we cannot be sure that ourinternational 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.

 

**Our ability to compete could be jeopardized if we are unableto protect our intellectual property rights.**

 

Oursuccess and ability to compete depend in large part upon protection of ourproprietary technology. We rely on a combination of patent, trade secret,copyright and trademark laws, non-disclosure and other contractual agreementsand technical measures to protect our proprietary rights. These agreements andmeasures may not be sufficient to protect our technology from third-partyinfringement, or to protect us from the claims of others. Monitoringunauthorized use of our products is difficult, and we cannot be certain thatthe steps we have taken will prevent unauthorized use of our technology,particularly in foreign countries where the laws may not protect ourproprietary rights as fully as in the United States. The laws of certainforeign countries in which our products are or may be developed, manufacturedor sold, including various countries in Asia, may not protect our products orintellectual property rights to the same extent as do the laws of the UnitedStates and thus make the possibility of piracy of our technology and productsmore likely in these countries. If competitors are able to use our technology,our ability to compete effectively could be harmed.

 

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

 

23

----

 

intellectualproperty rights.

 

Wehave generally limited access to and distribution of the source and object codeof our software and other proprietary information. With respect to its pagedescription language software and drivers for the digital office market and inlimited circumstances with respect to firmware and platforms for its HDTVproducts, Oak has granted licenses that give its customers access to andrestricted use of the source code of Oak’s software. This access increases thelikelihood of misappropriation or misuse of our technology.

 

**Claims and litigation regarding intellectual property rightscould seriously harm our business and require us to incur significant costs.**

 

Inrecent years, there has been significant litigation in the United Statesinvolving patents and other intellectual property rights. In the past, Zoranand Oak have been subject to claims and litigation regarding allegedinfringement of other parties’ intellectual property rights, and both Oak andZoran have been parties to a number of patent-related lawsuits, both asplaintiff and defendant. We could become subject to additional litigation inthe future, either to protect our intellectual property or as a result ofallegations that we infringe others’ intellectual property rights. Claims thatour products infringe proprietary rights would force us to defend ourselves andpossibly our customers or manufacturers against the alleged infringement. Futurelitigation against us, if successful, could subject us to significant liabilityfor damages or invalidation of our proprietary rights. These lawsuits,regardless of their success, are time-consuming and expensive to resolve andrequire significant management time and attention. Future intellectual propertylitigation could force us to do one or more of the following:

 

•                  stop selling products that incorporate thechallenged intellectual property;

 

•                  obtain from the owner of the infringedintellectual property right a license to sell or use the relevant technology,which license may not be available on reasonable terms or at all;

 

•                  pay damages; or

 

•                  redesign those products that use suchtechnology.

 

Althoughpatent disputes in the semiconductor industry have often been settled throughcross-licensing arrangements, we may not be able in any or every instance tosettle an alleged patent infringement claim through a cross-licensingarrangement. We have a more limited patent portfolio than many of ourcompetitors. If a successful claim is made against us or any of our customersand a license is not made available to us on commercially reasonable terms orwe are required to pay substantial damages or awards, our business, financialcondition and results of operations would be materially adversely affected.

 

**If necessary licenses of third-party technology are notavailable to us or are very expensive, our products could become obsolete.**

 

Fromtime to time, we may be required to license technology from third parties todevelop new products or product enhancements. Third party licenses may not beavailable on commercially reasonable terms, if at all. If we are unable toobtain any third-party license required to develop new products and productenhancements, we may have to obtain substitute technology of lower quality orperformance standards or at greater cost, either of which could seriously harmthe competitiveness of our products.

 

Certaintechnology used in our products is licensed from third parties, and inconnection with these licenses, we are required to fulfill confidentialityobligations and, in some cases, pay royalties. Some of our products requirevarious types of copy protection software that we must license from thirdparties. If we are unable to obtain or maintain our right to use the necessarycopy protection software, we would be unable to sell and market these products.

 

**If we are not able to apply our net operating losses againsttaxable income in future periods, our financial results will be harmed.**

 

Ourfuture net income and cash flow will be affected by our ability to apply ournet operating losses, or NOLs, against taxable income in future periods. OurNOLs totaled approximately $268 million for federal and $85 millionfor state tax reporting purposes as of December 31, 2005. As a result ofthe change of control resulting from our initial public offering in 1995, theamount of NOLs that we can use to reduce future taxable income for federal taxpurposes is limited to approximately $3.0 million per year for NOLsincurred prior to the initial public offering. The Internal Revenue Codecontains a number of provisions that could limit the use of NOLs against incomeof the combined company as a result of the merger or as a result of thecombination of these transactions. Our utilization of Oak’s NOLs may be furtherlimited due to prior Oak transactions. No opinion or IRS ruling has been soughtregarding the potential application of any of these provisions. Changes in taxlaws in the United States may further limit our ability to utilize

 

24

----

 

these NOLs.  Any further limitation on our ability toutilize these respective NOLs could harm our financial condition.

 

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

 

We have made investments in, and acquisitionsof other complementary companies, products and technologies, and we may acquireadditional businesses, products or technologies in the future.  In the event of any future acquisitions, wecould:

 

•                  issue stock that would dilute its currentstockholders’ percentage ownership;

 

•                  incur debt;

 

•                  assume liabilities;

 

•                  incur expenses related to the futureimpairment of goodwill and the amortization of other intangible assets; or

 

•                  incur other large write-offs immediately orin the future.

 

Our operation of any other acquired businesswill also involve numerous risks, including:

 

•                  problems combining the purchased operations,technologies or products;

 

•                  unanticipated costs;

 

•                  diversion of management’s attention from ourcore business;

 

•                  adverse effects on existing businessrelationships with customers;

 

•                  risks associated with entering markets inwhich we have no or limited prior experience; and

 

•                  potential loss of key employees, particularlythose of the purchased organizations.

 

We may not be able to successfully completethe integration of the business, products or technologies or personnel that wemight acquire in the future, and any failure to do so could disrupt ourbusiness and seriously harm our financial condition.

 

In addition, we have made minority equityinvestments in early-stage companies, and we expect to continue to reviewopportunities to make additional investments in such companies where we believesuch investments will provide us with opportunities to gain access to importanttechnologies or otherwise enhance important commercial relationships.  We have little or no influence over theearly-stage companies in which we have made or may make strategic, minorityequity investments.  Each of theseinvestments involves a high degree of risk. We may not be successful in achieving the technological or commercialadvantage upon which any given investment is premised, and failure by theearly-stage company to achieve its own business objectives could result in aloss of all or part of our invested capital and require us to write off all ora 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 ourcustomers, errors may be found in existing or new products.  This could result in, among other things, adelay in recognition or loss of revenues, loss of market share or failure toachieve market acceptance.  These defectsmay cause us to incur significant warranty, support and repair costs, divertthe attention of our engineering personnel from our product development effortsand harm our relationships with customers. The occurrence of these problems could result in the delay or loss ofmarket acceptance of our products and would likely harm our business.  Defects, integration issues or otherperformance problems in our products could result in financial or other damagesto customers or could damage market acceptance of such products.  Our customers could also seek damages from usfor their losses.  A product liabilityclaim brought against us, even if unsuccessful, would likely be time consumingand costly to defend.

 

**If we donot maintain current development contracts or are unable to enter into newdevelopment contracts, our business could be harmed.**

 

We historically have generated a portion ofour total revenues from development contracts, primarily with keycustomers.  These development contractshave provided us with partial funding for the development of some of ourproducts.  Under these contracts, wereceive payments upon reaching certain development milestones.  If we fail to achieve the milestones specifiedin our existing

 

25

----

 

development contracts, if ourexisting contracts are terminated or if we are unable to secure futuredevelopment contracts, our ability to cost-effectively develop new productswould be reduced and our business would be harmed.

 

**We may needadditional funds to execute our business plan, and if we are unable to obtainsuch funds, we will not be able to expand our business as planned.**

 

We may require substantial additional capitalto finance our future growth, secure additional foundry capacity and fund our ongoingresearch and development activities beyond 2006.  Our capital requirements will depend on manyfactors, including:

 

•                                          acceptance of and demand for our products;

 

•                                          the types of arrangements that we may enterinto with our independent foundries;

 

•                                          the extent to which we invest in newtechnology and research and development projects; and

 

•                                          any additional acquisitions that we may make.

 

To the extent that our existing sources ofliquidity and cash flow from operations are insufficient to fund our activities,we may need to raise additional funds. If we raise additional funds through the issuance of equity securities,the percentage ownership of our existing stockholders would be reduced.  Further, such equity securities may haverights, preferences or privileges senior to those of our common stock.  Additional financing may not be available tous when needed or, if available, it may not be available on terms favorable tous.

 

**If we failto manage our future growth, if any, our business would be harmed.**

 

We anticipate that our future growth, if any,will require us to recruit and hire a substantial number of new engineering,managerial, sales and marketing personnel. Our ability to manage growth successfully will also require us to expandand improve administrative, operational, management and financial systems andcontrols.  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 andmarketing and certain of our research and development and administrativepersonnel, including our President and Chief Executive Officer and otherofficers, are based in the United States. The geographic separation of these operations places additional strainon our resources and our ability to manage growth effectively.  If we are unable to manage growtheffectively, our business will be harmed.

 

**We rely onthe services of our executive officers and other key personnel, whose knowledgeof our business and industry would be extremely difficult to replace.**

 

Our success depends to a significant degreeupon the continuing contributions of our senior management.  Management and other employees mayvoluntarily terminate their employment with us at any time upon shortnotice.  The loss of key personnel coulddelay product development cycles or otherwise harm our business.  We believe that our future success will alsodepend in large part on our ability to attract, integrate and retainhighly-skilled engineering, managerial, sales and marketing personnel, locatedin the United States, Israel and China. Competition for such personnel is intense, and we may not be successfulin attracting, integrating and retaining such personnel.  Failure to attract, integrate and retain keypersonnel could harm our ability to carry out our business strategy and competewith other companies.

 

**The Israelirate of inflation may negatively impact our costs if it exceeds the rate ofdevaluation of the new Israeli shekel against the United States dollar.**

 

A portion of the cost of our operations,relating mainly to our personnel and facilities in Israel, is incurred in newIsraeli shekels.  As a result, we bearthe risk that the rate of inflation in Israel or the decline in the value ofUnited States dollar compared to the Israeli shekel will increase our costs asexpressed in United States dollars.  Todate, we have not engaged in hedging transactions.  In the future, we may enter into currencyhedging transactions to decrease the risk of financial exposure fromfluctuations in the exchange rate of the United States dollar against the newIsraeli shekel.  These measures may notadequately protect us from the impact of inflation in Israel.

 

26

----

 

**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 financed a portion ofour research and development activities with grants for research anddevelopment from the Chief Scientist in Israel’s Ministry of Industry andTrade.  We earned proceeds from suchgrants in 2004. Although we did not earn proceeds from such grants in 2005, weplan to seek additional grants from the Chief Scientist in the future. To beeligible for these grants, our development projects must be approved by theChief Scientist on a case-by-case basis. 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 alsoreceive tax benefits, in particular exemptions and reductions as a result ofthe “Approved Enterprise” status of our 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. These tax benefits may not be continued in the future at their currentlevels 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 of incorporation and bylawsand Delaware law contain provisions that could make it more difficult for a thirdparty to acquire us, even if doing so would be beneficial to ourstockholders.  These include provisions:

 

•                  prohibiting a merger with a party that hasacquired control of 15% or more of our outstanding common stock, such as aparty that has completed a successful tender offer, until three years afterthat party acquired control of 15% of our outstanding common stock;

 

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

 

•                  eliminating stockholders’ rights to call a specialmeeting of stockholders; and

 

•                  requiring advance notice of any stockholdernominations of candidates for election to our board of directors.

 

**Our stockprice has fluctuated and may continue to fluctuate widely.**

 

The market price of our common stock hasfluctuated significantly since our initial public offering in 1995.  Between January 1, 2005 andDecember 31, 2005, the closing sale price of our common stock, as reportedon The Nasdaq National Market, ranged from a low of $8.97 to a high of $17.38.  The market price of our common stock issubject to significant fluctuations in the future in response to a variety offactors, including:

 

•                  announcements concerning our business or thatof our competitors or customers;

 

•                  annual and quarterly variations in our operatingresults;

 

•                  changes in analysts’ earnings estimates;

 

•                  announcements of technological innovations;

 

•                  the introduction of new products or changesin product pricing policies by Zoran or its competitors;

 

•                  loss of key personnel;

 

•                  proprietary rights or other litigation;

 

•                  general conditions in the semiconductorindustry; and

 

•                  developments in the financial markets.

 

In addition, the stock market has, from timeto time, experienced extreme price and volume fluctuations that have particularlyaffected the market prices for semiconductor companies or technology companiesgenerally and which have been unrelated to the operating

 

27

----

 

performance of the affected companies.  Broad market fluctuations of this type mayreduce the future market price of our common stock.

 

**Item 1B—Unresolved Staff Comments**

 

We have not received any written comments from the staff of theSecurities and Exchange Commission regarding any of our periodic or currentreports under the Securities Exchange Act which remain unresolved.

** **

**Item 2—Properties**

 

Our executive offices and principal marketing, sales and productdevelopment operations are located in approximately 89,000 square feet ofleased space in Sunnyvale, California, under a lease that expires inNovember 2006. We are currently in the process of identifying andnegotiating a lease on a new space as well as considering options to negotiatean extension for our current space.  Asignificant portion of our research and development and engineering facilitiesand our administration, marketing and sales operations are currently located inapproximately 61,350 square feet of leased space in an industrial park inHaifa, Israel under a lease expiring in August 2006. We have entered into anagreement for the lease of a new facility in Haifa, with a 10-year term andexpect to move into the new facility during 2006.  We also lease facilities, primarily forsales, product development, and technical support, in Woburn, Massachusetts;Manchester, England; Dortmund, Germany; Tokyo, Japan; Seoul, Korea; Taipei,Taiwan and Shenzhen, Shanghai and Hong Kong, China.  Except as noted above, we believe that ourcurrent facilities are adequate for our needs for the foreseeable future andthat, should it be needed, suitable additional space in each of the locationsin which we operate will be available to accommodate expansion of ouroperations on commercially reasonable terms.

 

**Item 3—Legal Proceedings**

 

Zoran and its subsidiary, Oak Technology, Inc.,have been involved in five separate legal actions against MediaTek, Inc.and customers of MediaTek based on claims of patent infringement.

 

On March 11, 2004, Zoran and Oak filed acomplaint with****the United StatesInternational Trade Commission (“ITC”) alleging that certain MediaTek DVDplayer and optical disk controller chips and chipsets, and products in whichthey are used, infringe Zoran’s and Oak’s patents.  In addition to MediaTek, the complaint nameda number of other proposed respondents that sell products, including DVDplayers and PC optical storage devices that use MediaTek’s chips andchipsets.  On September 28, 2005,the ITC issued its final ruling finding one of Zoran’s patents to be valid andinfringed by optical disk controller chips and chipsets sold by MediaTek and byproducts using the infringing chips and chipsets sold by a number of MediaTekcustomers.  The ITC also issued anexclusion order prohibiting MediaTek and specified MediaTek customers fromimporting into the United States any optical disk controller chip or chipsetthat infringes the Zoran patent, or any optical disk storage product containingsuch a chip or chipset and cease and desist orders to the affected companieslocated in the United States prohibiting them from importing or sellinginfringing products in the United States. In November 2005, both parties filed notices of appeal with the UnitedStates Court of Appeals for the Federal Circuit.  On January 19, 2006, the court issued anorder temporarily staying enforcement of the ITC’s orders.

 

On March 15, 2004, Zoran and Oak filed acomplaint against MediaTek and one of its customers in the United StatesDistrict Court, Central District of California alleging similar facts regardinginfringement by MediaTek’s chips and chipsets and products in which they areused.  The lawsuit sought both monetarydamages and an injunction to stop the importation and sale of infringingproducts.  The complaint was subsequentlyamended to name additional MediaTek customers as defendants.  Trial of this case was set to beginMay 15, 2006.

 

On July 23, 2004, MediaTek filed a complaint withthe ITC alleging that certain Zoran and Oak DVD player and optical diskcontroller chips and chipsets infringe two MediaTek patents.  The complaint requested that the ITCinstitute an investigation into the accused products and issue exclusion andcease and desist orders prohibiting importation into the United States ofallegedly infringing chips and products that contain them.  On September 30, 2005, the ITCAdministrative Law Judge issued his initial determination finding that none ofZoran’s optical disk controller chips infringe any claim of the two patentsasserted against Zoran; that one of the two patents is invalid; that Oak’sdevices do not infringe one of the two patents asserted against Oak and thatthe other patent is invalid; and that MediaTek has failed to establish that ithas a domestic industry in the United States related to the patents atissue – a basic requirement for obtaining relief from the ITC.  The initial determination was subject toreview by the full ITC.  The target datefor completion of the investigation was March 1, 2006.

 

28

----

 

On July 23, 2004, MediaTek filed a complaintagainst Zoran and Oak in the United States District Court, District of Delawarealleging infringement of the same two patents asserted in MediaTek’s ITCcomplaint and seeking monetary damages and injunctive relief.  This action was stayed by order of the courton October 4, 2004.

 

On February 2, 2005, MediaTek filed a complaintagainst Zoran and Zoran Digital Technologies (Shenzhen) Ltd. (Zoran’s localChinese operations) in the Shenzhen People’s Republic of China court alleginginfringement of the Chinese counterpart patent of one of the two patentsasserted in MediaTek’s ITC complaint and seeking monetary damages.  Because Zoran had not been served with thecomplaint, the initiation of the proceeding has been stayed.

 

On January 25, 2006, Zoran and Oak entered intoan agreement with MediaTek to settle the litigation.  Under the agreement, each party agreed todismiss its respective claims and counterclaims under all of the pendinglawsuits.  The parties also agreed todismiss all proceedings pending against each other before the ITC, includingall appeals and enforcement proceedings pending before the ITC, United StatesCustoms and Border Protection and the United States Court of Appeals for theFederal Circuit related to the ITC’s September 28, 2005 order excludingthe importation into the United States of certain MediaTek chips and productsincorporating those chips.

 

In connection with the settlement, Zoran, Oak andMediaTek entered into agreements granting each other non-exclusive licensesunder the patents that were the subject of the litigation, and additionalpatents used in the design and manufacture of optical storage devices forpersonal computer products.  Inconsideration for licenses granted by Zoran, MediaTek agreed to make a cashpayment of $55 million to Zoran, $44 million of which was paid in February2006 and $11 million of which is payable in April 2006. In addition,MediaTek will be required to make royalty payments of up to $30 millionover the 30-month period commencing on the date of the agreement based onfuture sales of covered MediaTek products. Net of amounts payable by Zoran to a holder of rights under the Oakpatents involved in the litigation, and amounts payable as legal fees, Zoranwill realize approximately $27.5 million of the cash payment and up toapproximately $15 million of the future royalty payments.

** **

**Item4—Submission of Matters to a Vote of Security Holders**

 

We did notsubmit any matters to a vote of our security holders during the fourth quarterof the year ended December 31, 2005.

 

**Executive Officers**

 

The names of our executive officers and their ages as ofDecember 31, 2005 are as follows:

 
| **NAME**             | ** ** | **AGE** | ** ** | **POSITION**                                               |
|----------------------|------------|---------|------------|------------------------------------------------------------|
| Levy Gerzberg, Ph.D  |       | 60      |       | President, Chief Executive Officer and Director            |
| Karl Schneider       |       | 51      |       | Senior Vice President, Finance and Chief Financial Officer |
| Isaac Shenberg, Ph.D |       | 55      |       | Senior Vice President, Business and Strategic Development  |

 

*Levy Gerzberg* was a co-founder of Zoran in 1981 and has servedas our President and Chief Executive Officer since December 1988 and as adirector since 1981.  Dr.  Gerzberg also served as our President from1981 to 1984 and as our Executive Vice President and Chief Technical Officerfrom 1985 to 1988.  Prior to co-foundingZoran, Dr. Gerzberg was Associate Director of Stanford University’s ElectronicsLaboratory.  Dr.  Gerzberg holds a Ph.D. in ElectricalEngineering from Stanford University and an M.S. in Medical Electronics and aB.S. in Electrical Engineering from the Technion-Israel Institute ofTechnology in Haifa, Israel.

 

*Karl Schneider* joined Zoran as Corporate Controller inJanuary 1998 and was elected Vice President, Finance and Chief FinancialOfficer in July 1998 and Senior Vice President, Finance and ChiefFinancial Officer in July 2003. From September 1996 through 1997, Mr. Schneider served asController for the Film Measurement and Robotics and Integrated Technologiesdivisions of KLA-Tencor, a semiconductor equipment company.  Mr. Schneider served as the CorporateController for SCM Microsystems, Inc. from October 1995 toSeptember 1996, Controller for Reply Corporation from January 1994 toSeptember 1995, Director of Finance for Digital F/X from October 1992to January 1994 and Controller for Flextronics from September 1987through June 1991.  Mr. Schneiderholds a B.S. in Business Administration from San Diego State University.

 

*Isaac Shenberg* has served as Senior Vice President, Business andStrategic Development since October 1998 and previously as Vice President,Sales and Marketing from January 1995 through October 1998.  From August 1990 to January 1995,Dr. Shenberg served as our Product Line Business Manager.  Prior to joining Zoran, Dr. Shenberg wasImages Processing Group manager and Electro Optics Department manager atRafael, a leading Aerospace provider in Israel. Dr.  Shenberg holds a Ph.D. inElectrical Engineering from Stanford University and a B.S. and M.S. inElectrical Engineering from the Technion.

 

29

----

 

**PART II**

 

**Item 5—Market forRegistrant’s Common Equity, Related Stockholder Matters and Issuer Purchases ofEquity Securities**

 

We effected our initial public offering of our common stock onDecember 15, 1995.  Since that date,our common stock has been quoted on the Nasdaq National Market under the symbol“ZRAN.” The following table sets forth the high and low closing sales price ofour common stock as reported on The Nasdaq National Market for the periodsindicated:

 

| ** **     | ** ** | **High**   | ** ** | **Low**    | ** ** |
|----------------|------------|------------|------------|------------|------------|
| **2004**       | ** ** | ** ** | ** ** | ** ** | ** ** |
| First Quarter  |       | $          | 22.20      |       | $          | 15.70 |   |
| Second Quarter |       | $          | 18.89      |       | $          | 16.44 |   |
| Third Quarter  |       | $          | 18.50      |       | $          | 13.95 |   |
| Fourth Quarter |       | $          | 16.35      |       | $          | 9.85 |   |
| **2005**       |       |       |       |       |       |
| First Quarter  |       | $          | 11.21      |       | $          | 9.63 |   |
| Second Quarter |       | $          | 13.95      |       | $          | 8.97 |   |
| Third Quarter  |       | $          | 17.19      |       | $          | 13.31 |   |
| Fourth Quarter |       | $          | 17.38      |       | $          | 12.51 |   |

 

As of December 31, 2005, there were 314 holders of record of ourcommon stock.

 

We have never paid cash dividends on our capital stock.  It is our present policy to retain earningsto finance the growth and development of our business and, therefore, we do notanticipate paying any cash dividends in the foreseeable future.

 

**Item 6—SelectedFinancial Data**

 

The following selected consolidated financial data should be read inconjunction with the consolidated financial statements and the notes theretoincluded elsewhere herein.

 
| ** **                                         | ** ** | **Year Ended December 31,**                         | ** ** |
|----------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                         | ** ** | **2005**                                                           | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                         | ** ** | **(in thousands, except per share data)** | ** ** |
| **STATEMENT OF OPERATIONS DATA:**                  |       |                                                               |       |   |   |   |   |   |   |   |   |
| Total revenues                                     |       | $                                                                  | 395,758    |   | $ | 378,864 |   | $ | 216,528 |   | $ | 149,117 |   | $ | 107,709 |   |
| Gross profit                                       |       | 210,209                                                            |       | 152,629 |   | 85,477 |   | 62,213 |   | 42,969 |   |
| Operating income (loss)                            |       | (27,100                                                            | )          | (46,857 | ) | (72,004 | ) | 6,831 |   | (44,804 | ) |
| Net income (loss)                                  |       | (26,971                                                            | )          | (47,354 | ) | (67,978 | ) | 5,698 |   | (36,065 | ) |
| Diluted net income (loss) per share (1)            |       | $                                                                  | (0.61      | ) | $ | (1.11 | ) | $ | (2.05 | ) | $ | 0.20 |   | $ | (1.38 | ) |
| Shares used in diluted per share  calculations (1) |       | 44,267                                                             |       | 42,788 |   | 33,231 |   | 28,629 |   | 26,190 |   |

 
| ** **                                         | ** ** | **As of December 31,** | ** ** |
|----------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                         | ** ** | **2005**                              | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                         | ** ** | **(in thousands)**               | ** ** |
| **BALANCE SHEET DATA:**                            |       |                                  |       |   |   |   |   |   |   |   |   |
| Cash, cash equivalents and short-term  investments |       | $                                     | 149,346    |   | $ | 70,413 |   | $ | 126,366 |   | $ | 137,075 |   | $ | 110,105 |   |
| Working capital                                    |       | 170,946                               |       | 109,320 |   | 146,810 |   | 159,732 |   | 130,777 |   |
| Total assets                                       |       | 604,223                               |       | 599,281 |   | 622,237 |   | 345,848 |   | 331,344 |   |
| Accumulated deficit                                |       | (230,795                              | )          | (203,824 | ) | (156,470 | ) | (88,492 | ) | (94,190 | ) |
| Total stockholders’ equity                    |       | $                                     | 499,348    |   | $ | 500,627 |   | $ | 534,279 |   | $ | 311,012 |   | $ | 297,838 |   |

 

----

(1)                                  See Note 2 of Notes to Consolidated FinancialStatements for a description of the computation of the number of shares and netincome (loss) per share.

 

30

----

 

**Item7—Management’s Discussion and Analysis of Financial Condition and Results ofOperations**

 

**Overview**

 

Our products consist of integrated circuitsand related products used in digital versatile disc players, or DVDs, movie andhome theater systems, digital cameras and video editing systems.  We also provide integrated circuits, softwareand platforms for digital television applications that enable the delivery anddisplay of digital video content through a set-top box or television as well asdigital imaging products consisting of semiconductor hardware and software thatenable users to print, scan, process and transmit documents to computerperipherals that perform printing functions. Subsequent to our acquisition of Emblaze Semiconductor Ltd. onJuly 8, 2004, we also provide highperformance, low-power application processors, technology and products for themultimedia mobile telephone market. Through the acquisition of Oren Semiconductor, Inc. onJune 10, 2005, Zoran obtained Oren’s demodulator ICtechnology for the global high definition television market.

 

We derive most of our revenues from the saleof our integrated circuit products. Historically, average selling prices in the semiconductor industry ingeneral, and for our products in particular, have decreased over the life of aparticular product.  Average sellingprices for our hardware products have fluctuated substantially from period to period,primarily as a result of changes in our customer mix of original equipmentmanufacturer, or OEM, sales versus sales to resellers and the transition fromlow-volume to high-volume production.  Inthe past, we have periodically reduced the prices of some of our products inorder to better penetrate the consumer market. We believe that, as our product lines continue to mature and competitivemarkets evolve, we are likely to experience further declines in the averageselling prices of our products, although we cannot predict the timing and amountof such future changes with any certainty.

 

Our cost of hardware product revenuesconsists primarily of fabrication costs, assembly and test costs, and the costof materials and overhead from operations. If we are unable to reduce our cost of hardware product revenues tooffset anticipated decreases in average selling prices, our product grossmargins will decrease.  Our 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 marketingpartners purchase our products at lower prices but absorb most of theassociated marketing and sales support expenses, maintain inventories and providecustomer 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.  We expect both product and customer mix tocontinue to fluctuate in future periods, causing further fluctuations inmargins.

 

We also derive revenue from licensing oursoftware and other intellectual property. Licensing revenue includes one-time license fees and royalties based onthe number of units distributed by the licensee.  Annual licensing revenue can be significantlyaffected by the timing of a small number of licensing transactions, eachaccounting for substantial revenues. Accordingly, licensing revenues have fluctuated, and will continue tofluctuate, on an annual basis.  Inaddition, we have historically generated a portion of our total revenues fromdevelopment contracts, primarily with key customers, although developmentrevenue has declined substantially as a percentage of total revenues over thepast several years.  These developmentcontracts have provided us with partial funding for the development of some ofour products.  These developmentcontracts provide for license and milestone payments which are recorded asdevelopment revenue.  We classify alldevelopment costs, including costs related to these development contracts, asresearch and development expenses.  Weretain ownership of the intellectual property developed by us under thesedevelopment contracts.  While we intendto continue to enter into development contracts with certain strategic partners,we expect development revenue to continue to decline as a percentage of totalrevenues.

 

We recognize software license revenues inaccordance with the provisions of Statement of Position (SOP) 97-2, *Software Revenue Recognition,*as amendedby SOP 98-9, *Modification of*SOP 97-2,*Software Revenue Recognition, With Respectto Certain Transactions.* Our software license agreements typicallyinclude obligations to provide maintenance and other support over a fixed termand allow for renewal of maintenance services on an annual basis. We determinethe fair value of our maintenance obligations with reference to substantiverenewal rates within the agreement or objective evidence of fair value asrequired under SOP 97-2. Maintenance and support revenue is recognized ratablyover the term of the arrangement.  Wealso receive royalty revenues based on per unit shipments of products embeddingour software which we recognize upon receipt of a royalty report from thecustomer, typically one quarter in arrears.

 

Our research and development expenses consistof salaries and related costs of employees engaged in ongoing research, designand development activities and costs of engineering materials andsupplies.  We are a party to research anddevelopment agreements with the Chief Scientist in Israel’s Ministry ofIndustry and Trade and the Israel-United States Binational Industrial Researchand Development Foundation, which fund up to 50% of incurred project costs forapproved products up to specified 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.

 

31

----

 

Reported research and development expensesare net of these grants, which fluctuate from period to period.  From time to time, we enter intonon-refundable joint development projects in which our customers reimburse usfor a portion of our development costs. We classify such reimbursement of development costs as an offset toresearch and development expenses as we retain ownership of the intellectual propertydeveloped by us under these development arrangements.  During 2005, we received approximately $1.2million in such reimbursements.  We didnot receive any reimbursements in 2004 or 2003. We believe that significant investments in research and development arerequired for us to remain competitive, and we expect to continue to devotesignificant resources to product development, although such expenses as apercentage of total revenues may fluctuate.

 

Our selling, general and administrativeexpenses consist primarily of employee-related expenses, sales commissions,product promotion and other professional services.  We expect that selling, general andadministrative expenses will continue to increase to support our anticipatedgrowth.

 

We conduct a material amount of our researchand development and certain sales and marketing and administrative operationsin our foreign subsidiary offices.  As aresult, some of our expenses are incurred in foreign currency.  To date, substantially all of our hardwareproduct revenues and our software and other revenues have been denominated inU.S. dollars and most costs of hardware product revenues have been incurred inU.S. dollars.  We expect that most of ourrevenues and costs of revenue will continue to be denominated and incurred inU.S. dollars for the foreseeable future. We have not experienced material losses or gains as a result of currencyexchange rate fluctuations and have not engaged in hedging transactions toreduce our exposure to such fluctuations. We may in the future elect to take action to reduce our foreign exchangerisk.

 

Our effective income tax rate has benefitedfrom the availability of net operating losses which we have utilized to reducetaxable income for U.S.  federal incometax purposes and by our Israel based subsidiary’s status as an “ApprovedEnterprise” under Israeli law, which provides a ten-year tax holiday for incomeattributable to a portion of our operations in Israel.  Our U.S. federal net operating losses expireat various times between 2006 and 2025, and the benefits from our subsidiary’sApproved Enterprise status expire at various times beginning in 2006.

 

**Acquisitions**

 

*OrenSemiconductor, Inc.*

 

On June 10, 2005, we completed ouracquisition of Oren Semiconductor, Inc. (“Oren”), a privately-heldprovider of demodulator ICs for the global high definition televisionmarket.  Prior to this acquisition, wehad made investments in Oren that represented a 17% ownership interest. Underthe terms of the acquisition agreement, we acquired the remaining 83% of Oren’soutstanding stock by means of a merger of Oren with a wholly-owned subsidiaryof Zoran, in consideration for which we paid an aggregate of $28.4 millionin cash and issued 1,188,061 shares of Zoran common stock valued at$12.9 million, for total consideration of $41.3 million, to the otherstockholders of Oren and to employees holding Oren options.  The acquisition was accounted for under thepurchase method of accounting.

 

Following the completion of the acquisition,the results of operations of Oren have been included in our consolidatedfinancial statements.  Accordingly, ourresults of operations for the year ended December 31, 2005 include Oren’soperations between June 10, 2005 and December 31, 2005, and such operations arenot reflected in our results of operations for the years ended December 31,2004 and 2003.

 

*EmblazeSemiconductor Ltd.*

 

On July 8, 2004, we completed our acquisitionof Emblaze Semiconductor Ltd. (“Emblaze”), a wholly-owned subsidiary of Emblaze Ltd. for $54.2 millionin cash.  The acquisition was accountedfor under the purchase method of accounting.

 

Following the completion of the acquisition,the results of operations of Emblaze have been included in our consolidatedfinancial statements.  Accordingly, ourresults of operations for the year ended December 31, 2005 includeEmblaze’s operations for the full year while the results of operations for theyear ended December 31, 2004 only reflect Emblaze’s operations between July 8,2004 and December 31, 2004, and such operations are not reflected in ourresults of operations for the year ended December 31, 2003.

 

*OakTechnology, Inc.*

 

On August 11, 2003, we completed ouracquisition of Oak through the merger of Oak with a wholly-owned subsidiary ofZoran.  The acquisition was accounted forunder the purchase method of accounting.

 

32

----

 

Following the completion of the acquisition,the results of operations of Oak have been included in our consolidatedfinancial statements.  Accordingly, ourresults of operations for the years ended December 31, 2005 and 2004includes Oak’s operations for the full period, while our results of operationsfor the year ended December 31, 2003 only reflect Oak’s results of operationsbetween August 12, 2003 and December 31, 2003.

 

**Segments**

 

Prior to July 2004, we had fourreportable segments: Digital Versatile Disc (DVD), Imaging, Digital Camera (DC)and Digital Television (DTV).  Subsequentto the Emblaze acquisition in July 2004, the operations of Emblaze werecombined with the Digital Camera group and the group was renamed the Mobilesegment.  Each segment’s primary productsare based on highly integrated application-specific integrated circuits, orASICs, and system-on-a-chip, or SOC, solutions. The DVD, Imaging and DTV segments also license certain software andother intellectual property.  The DVDgroup provides products for use in DVD players and recordable DVD players.  The Imaging group provides products used indigital copiers, laser and inkjet printers as well as multifunctionperipherals.  The Mobile group focuses onsolutions for multimedia mobile phone products and digital cameraproducts.  The DTV group providesproducts for standard and high definition digital television products includingtelevisions, set top boxes and personal video recorders.

 

**Critical AccountingPolicies and Estimates**

 

This discussion and analysis of our financial condition and results ofoperations are based upon our consolidated financial statements, which havebeen prepared in accordance with accounting principles generally accepted inthe United States of America.  Thepreparation of these financial statements requires us to make estimates andjudgments that affect the reported amounts of assets, liabilities, revenues andexpenses, and related disclosure of contingent assets and liabilities.  On an on-going basis, we evaluate ourestimates, including bad debt, inventories, investments, intangible assets andincome taxes.  We base these estimates onhistorical experience and on various other assumptions that we believe to bereasonable under the circumstances.  Theresults of these estimates form the basis for making judgments about thecarrying values of assets and liabilities that are not readily apparent fromother sources.  Actual results may differfrom these estimates under different assumptions or conditions.

 

We believe the following critical accounting policies affect our moresignificant judgments and estimates used in the preparation of our consolidatedfinancial statements:

 

•                  We generally recognize product sales todistributors at the time of delivery. However, in some cases we grant rights of return or provide priceprotection arrangements.  When we are ableto estimate the effect of such an arrangement, we establish a reserve for theestimated adjustment and recognize the balance of the product revenueassociated with that arrangement upon shipment. When we cannot reasonably estimate the effect of such an arrangement, wedefer all revenue subject to the arrangement until the return right has lapsedor the price has become fixed.

 

•                  Revenue from development contracts is generallyrecognized as the services are performed based on the specific deliverablesoutlined in each contract.  Amountsreceived in advance of performance under contracts are recorded as deferredrevenue and are generally recognized within one year from receipt.  Costs associated with development revenuesare included primarily in research and development expenses.

 

•                  Inventories are recorded at the lower of standardcost, which approximates actual cost on a first-in-first-out basis, or marketvalue.  We write down inventories to netrealizable value based on forecasted demand and market conditions.  Actual demand and market conditions may bedifferent from those projected by our management.  This could have a material effect on ouroperating results and financial position. Inventory write-downs are not reversed and permanently reduce the costbasis of the affected inventory until such inventory is sold or scrapped.

 

•                  We maintain allowances for doubtful accounts forestimated losses resulting from the delays or inability of certain customers tomake required payments.  These allowancesare estimated based on both specific identification of facts and circumstanceswith respect to each doubtful account. If the financial condition of ourcustomers were to deteriorate, resulting in an impairment of their ability tomake payments, additional allowances may be required.

 

•                  We hold minority interests in private companieshaving operations or technology in areas within our strategic focus.  At December 31, 2005, these investmentstotaled $5.2 million.  Theinvestments are in start up companies engaged in development and are expectedto incur losses.  We record an investmentimpairment charge when we believe an investment has experienced a decline invalue.  We assess the value of thisinvestment principally by using information acquired from the investee,including historical and projected financial performance and recent fundingevents.  Future adverse changes in marketconditions or

 

33

----

 

unexpected operating losses of underlyinginvestments could result in losses or an inability to recover the carryingvalue of the investments that may not be reflected in an investment’s currentcarrying value thereby possibly requiring an impairment charge in the future.

 

•                  We assess the impairment of goodwill annually, ormore frequently if events or changes in circumstances indicate that the carryingvalue of such assets exceeds their fair value. We assess the carrying value of our long lived assets if events orcircumstances indicate the carrying value of the assets exceeds the futureundiscounted cash flows attributable to such assets.  With respect to both goodwill and long livedassets, factors which could trigger an impairment review include significantnegative industry or economic trends, exiting an activity in conjunction with arestructuring of operations, current, historical or projected losses thatdemonstrate continuing losses associated with an asset or a significant declinein our market capitalization for an extended period of time, relative to netbook value.  Impairment evaluationsinvolve management estimates of asset useful lives and future cash flows.  These estimates include assumptions aboutfuture conditions such as future revenues, gross margins, operating expenses,the fair values of certain assets based on appraisals, and industry trends.  Actual useful lives and cash flows could bedifferent from those estimated by our management.  This could have a material effect on ouroperating results and financial position.

 

•                  We follow the liability method of accounting forincome taxes which requires recognition of deferred tax liabilities and assetsfor the expected future tax consequence of temporary differences between thefinancial statement carrying amounts and the tax bases of assets andliabilities.  In the event actual resultsdiffer from these expectations, then the resulting impact to income would beassessed in the period such determination was made.  If it becomes likely that some portion or allof a deferred tax asset will not be realized, a valuation allowance isestablished.  This determination includesa process for providing estimates for future taxable income, and requires theuse of significant judgment.  Any futurerelease or adjustment to the valuation allowance is only made based upon achange in circumstances that triggers a change in judgment, about the realizability,with reasonable assurance, of the related deferred tax asset in future years.

 

•                  With respect to mergers and acquisitions, weassess the technological feasibility of in process research and developmentprojects and determine the number of alternative future uses for the technologybeing developed.  To the extent there areno alternative future uses we allocate a portion of the purchase price toin-process research and development expense. This expense is generally estimated based upon the projected fair valueof the technology, as determined by a discounted future cash flow reduced bythe cost to complete.  This analysisincludes certain estimates and assumptions made by management.  For larger acquisitions, we have historicallyengaged an external appraiser to assist with the assumptions and models used inthis analysis.

 

34

----

 

**Results of Operations**

 

The following table sets forth certain consolidated statement ofoperations data as a percentage of total revenues for the periods indicated andpercentage changes from period to period:

 
| ** **                          | ** ** | **Years ended December 31,** | ** ** | **Percentage change** | ** ** |
|-------------------------------------|------------|---------------------------------------------|------------|----------------------------|------------|
| ** **                          | ** ** | **2005**                                    | ** ** | **2004**                   | ** ** | **2003** | ** ** | **2005 to  2004** | ** ** | **2004 to  2003** | ** ** |
|                                |       |                                        |       |                       |       |   |   |   |   |   |   |
| Revenues:                           |       |                                        |       |                       |       |   |   |   |   |   |   |
| DVD hardware products               |       | 37.7                                        | %          | 58.5                       | %          | 69.2 | % | (32.8 | )% | 48.1 | % |
| DTV hardware products               |       | 11.6                                        | %          | 7.5                        | %          | 5.9 | % | 61.4 | % |   | * |
| Mobile hardware products            |       | 27.1                                        | %          | 8.3                        | %          | 13.4 | % | 241.2 | % | 8.5 | % |
| Imaging hardware products           |       | 9.4                                         | %          | 9.0                        | %          | 4.0 | % |   | * |   | * |
| Total hardware product revenues     |       | 85.8                                        | %          | 83.3                       | %          | 92.5 | % | 7.6 | % | 57.7 | % |
|                                |       |                                        |       |                       |       |   |   |   |   |   |   |
| Software and other revenues         |       | 14.2                                        | %          | 16.7                       | %          | 7.5 | % | (11.0 | )% | 287.8 | % |
| Total revenues                      |       | 100.0                                       | %          | 100.0                      | %          | 100.0 | % | 4.5 | % | 75.0 | % |
|                                |       |                                        |       |                       |       |   |   |   |   |   |   |
| Cost and expenses:                  |       |                                        |       |                       |       |   |   |   |   |   |   |
| Cost of hardware product revenues   |       | 46.9                                        | %          | 59.7                       | %          | 60.5 | % | (18.0 | )% | 72.6 | % |
| Research and development            |       | 22.5                                        | %          | 21.7                       | %          | 18.7 | % | 8.2 | % | 103.6 | % |
| Selling, general and administrative |       | 23.7                                        | %          | 17.7                       | %          | 19.3 | % | 39.9 | % | 60.7 | % |
| Amortization of intangible assets   |       | 12.7                                        | %          | 12.0                       | %          | 8.8 | % | 10.8 | % | 139.4 | % |
| Deferred stock compensation         |       | 0.4                                         | %          | 1.1                        | %          | 2.9 | % | (61.8 | )% | (35.5 | )% |
| Restructuring expense               |       | —                                      |       | 0.2                        | %          | — |   |   | * | — |   |
| In-process research and development |       | 0.7                                         | %          | —                     |       | 23.1 | % |   | * | — |   |
| Total costs and expenses            |       | 106.9                                       | %          | 112.4                      | %          | 133.3 | % | (0.7 | )% | 47.5 | % |
| Operating loss                      |       | (6.9                                        | )%         | (12.4                      | )%         | (33.3 | )% | (42.2 | )% | (34.9 | )% |
| Interest income                     |       | 0.6                                         | %          | 0.3                        | %          | 2.5 | % | 107.0 | % | (75.7 | )% |
| Other income (loss), net            |       | —                                      |       | —                     |       | — |   |   | * |   | * |
| Loss before income taxes            |       | (6.3                                        | )%         | (12.1                      | )%         | (30.8 | )% | (45.9 | )% | (31.2 | )% |
| Provision for income taxes          |       | 0.5                                         | %          | 0.4                        | %          | 0.6 | % | 40.5 | % | 13.0 | % |
| Net loss                            |       | (6.8                                        | )%         | (12.5                      | )%         | (31.4 | )% | (43.0 | )% | (30.3 | )% |
|                                |       |                                        |       |                       |       |   |   |   |   |   |   |
| Supplemental Operating Data:        |       |                                        |       |                       |       |   |   |   |   |   |   |
| Product gross margin                |       | 45.4                                        | %          | 28.3                       | %          | 34.6 | % | 72.1 | % | 29.3 | % |

 

----

(*)  not meaningful

 

*Year EndedDecember 31, 2005 Compared to Year Ended December 31, 2004*

 

*Revenues. *Total revenues increased by $16.9 million, or4.5%, to $395.8 million in 2005 from $378.9 million in 2004.  The increase in total revenues resultedprimarily from increases in Mobile segment revenues of $73.5 million, or 203.5%and DTV segment revenues of $21.8 million, or 74.6%, due to increased unitsales.  These increases were partiallyoffset by a decrease of $79.0 million, or 34.5%, in DVD segment revenuesresulting from decreases in DVD product sales and by decreases in software andother revenues.

 

Hardware product revenues increased by $23.8 million, or 7.6%, to$339.5 million in 2005 from $315.7 million in 2004.  The increase in hardware product revenues wasdue to revenue increases of $75.8 million in the Mobile segment, $17.5 millionin the DTV segment and $3.3 million in the Imaging segment resulting fromincreases in unit shipments in each of these segments. These increases werepartially offset by a decrease of $72.8 million in the DVD segment hardwareproduct revenues due to reduced unit shipments.

 

Software and other revenues decreased by $6.9 million, or 11.0%, to$56.2 million in 2005 from $63.2 million in 2004.  The decrease in software and other revenuesprimarily resulted from decreases of $6.3 million in the DVD segment, $2.6 millionin the Imaging segment and $2.3 million in the Mobile segment, partially offsetby an increase of $4.3 million in the DTV segment. The decreases in revenuesfrom the DVD, Imaging and Mobile segments were primarily due to reductions inIP licensing revenue. The increase in DTV segment revenues resulted from anincrease in IP licensing agreements.

 

35

----

 

*Cost of hardware product revenues*. Cost of hardware product revenues was$185.5 million in 2005 compared to $226.2 million in 2004. This decrease in thecost of hardware product revenues was mainly due to lower unit costs primarilydue to changes in product mix. In addition, part of the unit cost reduction wasdue to charges recorded in 2004 for inventory write-downs of $14.7 millioncoupled with the reduction in our inventory allowances of $9.4 million in 2005as a result of the sale or disposal of inventory that had been fully writtendown in 2004. Most of the inventory write-downs in 2004, as well as the sale ofpreviously written down inventory in 2005, primarily related to our DVD Vaddis6 product and a companion chip.  Therevenue recorded in 2005 associated with the sale of these previously writtendown products was approximately $18.5 million. Partially offsetting these reductions in unit costs was an increaseassociated with increased unit shipments, primarily in the Mobile segment. As apercentage of product revenues, hardware product costs were 54.6% in 2005compared to 71.7% in 2004. The decrease in hardware product costs as apercentage of hardware product revenues was primarily due to a change inproduct mix to a lower percentage of DVD segment products which generally havehigher product costs as a percentage of hardware product revenues than productsin the other segments. The inventory write down charges in 2004 coupled withthe reduction in inventory allowances also contributed to the reduction inhardware product costs as a percentage of hardware product revenues.

 

*Research andDevelopment. *Research and development (“R&D”) expensesincreased to $89.0 million in 2005 from $82.2 million in 2004, an increaseof 8.2%.  This increase was drivenprimarily by the acquisition of Oren Semiconductor, Inc. in June 2005 andinclusion of Emblaze operations acquired in July 2004 for the full year in2005.  Actual R&D expenses in 2004were offset in part by $1.5 million of research grants received from the ChiefScientist in Israel. We did not receive any such grants in 2005.  These grants are provided by the Israeligovernment to fund specific R&D projects. We are not obligated to repay the grants; however, future royalties maybe owed to the government if the R&D activities result in commercialproduct sales.  We remain committed toinvesting in research and development to enhance our technology and developmentcapabilities.

 

*Selling, General andAdministrative. *Selling, general andadministrative (“SG&A”) expenses increased to $93.8 million in 2005 from$67.1 million in 2004, representing a 39.9% increase.  Thisincrease was primarily due to increase in legal fees by $8.4 million related toour patent litigation with Mediatek, Inc., continued increases in marketing andfield application support expenses to support revenue growth in our AsiaPacific markets, an increase in the allowance for doubtful accounts receivableby $4.8 million to cover slow paying accounts and potential risk withincreasing business in certain regions of the world and the inclusion of theOren and Emblaze operations in 2005.

 

*Amortization of Intangible Assets. *Amortization of intangible assets increased to$50.3 million in 2005 from $45.4 million in 2004, an increase of10.8%.  This increase was the result ofamortization of approximately$24.2 million of intangible assets acquired in the Emblaze acquisition in July2004 for the full year in 2005 and amortization of $9.1 million of intangibleassets acquired in the Oren acquisition in June 2005.  At December 31, 2005, we had approximately$119.2 million in net intangible assets acquired through the Oak, Emblaze andOren acquisitions which we will continue to amortize on a straight line basisfor various periods extending through 2010.

 

*Deferred Stock Compensation. *Deferred stock compensation was recorded primarily as a result of stockoptions granted in connection with the Oak acquisition.  Forthe year ended December 31, 2005, these charges were $1.5 million compared to$4.1 million during the prior year.  The61.8 % decrease for fiscal 2005 was due to the cancellation of options held byemployees who terminated their employment during the year and the loweramortization associated with the graded vesting under the FIN 28 model.

 

*RestructuringExpense.*There were nocharges recorded for restructuring expenses during 2005.**During the year ended December 31, 2004, werecorded restructuring charges of $746,000 due to the discontinuation of theSensor product line of the Mobile group. This charge included $523,000 related to the reduction in force of 15employees for severance and other termination expenses, $173,000 for leaselosses on abandoned office space and other miscellaneous legal and consultingfees of approximately $50,000.  Theremaining accrual balance at December 31, 2005 of $73,000 relating to facilities will be paid over the lease termthrough June 2007.

 

*In-Process Researchand Development*. In 2005*,*approximately$2.7 million of the purchase price of Oren Semiconductor, Inc. was allocated toin-process research and development for projects which had not reachedtechnical feasibility and had no alternative future use. Accordingly, this amount was immediately expensedupon the acquisition date.  This amountwas determined using management’s estimates including consultation with anindependent appraiser.  The value ofin-process research and development was determined using the multi-periodexcess earnings method by estimating the expected net cash flows from theprojects once commercially viable and discounting the net cash flows back totheir present value using a discount rate of 21%.  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 identifiedprojects were based on estimates of revenue, cost of revenue, research anddevelopment expenses, selling general and administrative expenses, andapplicable income taxes.  These estimatesdid not take into account any potential synergies that could be realized as aresult of the acquisition.   At December31, 2005, there have been no material variations from the underlyingassumptions that were used in the original computation of the value of theacquired in-process research and

 

36

----

 

development. * *Therewere no charges recorded for in-process research and development during 2004.

 

*Operating Loss. *The operating loss of $27.1 million in 2005 wasprimarily driven by the amortization of intangible assets of $50.3 million,in-process research and development expense of $2.7 million and deferred stockcompensation expense of $1.5 million. Excluding these charges, the Companywould have recorded operating income of $27.4 million for fiscal 2005. Forfiscal 2004, the operating loss of $46.9 million was primarily driven by theamortization of intangible assets of $45.4 million and deferred stockcompensation expense of $4.1 million. Excluding these charges, the Company would have recorded operatingincome of $2.6 million for fiscal 2004.

 

*InterestIncome. *Interest income increased by $1.4 million to $2.7million in 2005 compared to $1.3 million in 2004.  The increase was a result of the higherinterest rates during 2005.

 

*Provision for IncomeTaxes. *Excluding charges related to the amortization ofintangible assets and write-off of acquired in-process research and developmentour estimated effective tax rate was approximately 8% for fiscal 2005 comparedto the 9% recorded in 2004 based on net income excluding the amortization ofintangible assets and the one time write down of inventory of $14.5 million.

 

*Year EndedDecember 31, 2004 Compared to Year Ended December 31, 2003*

 

*Revenues. *Total revenues increased by $162.4 million, or75%, to $378.9 million in 2004 from $216.5 million in 2003.  The increase in total revenues resultedprimarily from an increase in DVD segment revenues of $70.5 million, or 44%,and Imaging segment revenues of $69.7 million, or 473.5%.  DTV and Mobile segment revenues also grew in2004 by $15.3 million, or 109.8%, and $6.9 million, or 23.8%,respectively.  The increase in DVDsegment revenues was due to an increase in hardware product revenues of $72.0million due to increased unit sales of DVD products, partially offset by adecrease in software and other revenues of $1.4 million.  The increase in revenues for both the Imagingand DTV segments were primarily due to the inclusion of revenues from theformer Oak operations for the entire year in 2004, compared to approximatelyfour and one half months for 2003, subsequent to the Oak acquisition in August2003.  The increase in Mobile segmentrevenues was due to an increase in software and other revenues of $4.4 millionand increases in hardware product revenues of $2.5 million.  The increase in Mobile segment software andother revenues was primarily due to the Emblaze Semiconductor acquisition inJuly 2004.  The increase in Mobilesegment hardware product revenues was due to increased sales of Mobileproducts.

 

Hardware product revenues increased by $115.4 million, or 57.7%, to$315.7 million in 2004 from $200.3 million in 2003.  The increase in hardware product revenuesresulted from increases in the DVD segment of $72.0 million, Imaging segment of$25.3 million, DTV segment of $15.7 million and the Mobile segment of $2.5million.  Both the DVD and Mobilesegments’ hardware product revenue increases were due to increased unitshipments.  The increase in hardwareproduct revenues for both Imaging and DTV segments were primarily due to theinclusion of revenues from the former Oak operations for the entire year,compared to approximately four and a half months for 2003.

 

Software and other revenues increased by $46.9 million, or 287.8%, to$63.2 million in 2004 from $16.3 million in 2003.  The increase in software and other revenuesresulted from an increase in the Imaging segment of $44.3 million, and theMobile segment of $4.4 million, partially offset by decreases in the DVDsegment of $1.4 million and the DTV segment of $400,000.  The increase in Imaging segment software andother revenues was primarily due to the inclusion of Imaging revenues for theentire fiscal 2004 period as compared to approximately four and one half monthsfor 2003 subsequent to the Oak acquisition in August of 2003.  The increase in Mobile segment revenuesresulted from IP licensing agreements due to the Emblaze Semiconductoracquisition in July 2004.  The decreasefor the DVD segment was due to a reduction in IP licensing revenue.

 

*Cost of Hardware Product Revenues. *Cost of hardware product revenues was $226.2million in 2004 compared to $131.1 million in 2003.  The increased costs were primarily due toincreased unit shipments.  As a percentof hardware product revenues, hardware product costs were 71.7% in 2004compared with 65.4% for 2003.  Theincrease was primarily due to charges of $14.7 million for inventorywrite-downs of which $14.0 million was attributable to excess inventory of DVDproducts, $508,000 was attributable to products from our discontinued CMOSimage sensor product line and $200,000 related to other products.

 

*Research andDevelopment*.R&D expenses increased to $82.2 million in 2004 from$40.4 million in 2003, an increase of 103.6%.  This increase was driven primarily by themerger with Oak as well as the acquisition of Emblaze during July 2004.  Actual R&D expenses were offset in partby $1.5 million of research grants received from the Chief Scientist inIsrael.

 

*Selling, General andAdministrative. *SG&A expensesincreased to $67.1 million in 2004 from $41.8 million in 2003representing a 60.7% increase.  This increase was primarily a result of theinclusion of the Oak and Emblaze operations, increased legal fees related toour pending patent litigation with Mediatek, Inc., costs of compliance withprovisions of the Sarbanes-Oxley Act of 2002 and continued

 

37

----

 

increases in marketing andfield application support expenses to support revenue growth in our AsiaPacific markets.

 

*Amortization of Intangible Assets. *Amortization of intangible assets increased to$45.4 million in 2004 from $19.0 million in 2003, an increase of139.4%.  This increase was due to the addition of approximately $198 million ofamortizable intangible assets acquired in the Oak acquisition in August 2003,and $24.2 million of amortizable intangible assets acquired in the Emblazeacquisition in July 2004.

 

*Deferred Stock Compensation. *Deferred stock compensation was recorded primarily as a result of stockoptions granted in connection with the Oak acquisition.  Forthe year ended December 31, 2004, these charges were $4.1 million compared to$6.3 million during the prior year.  The35.5% decrease for 2004 was due to the cancellation of options held byemployees who terminated their employment during the year and the loweramortization associated with the graded vesting under the FIN 28 model.

 

*RestructuringExpense. *During the year ended December 31, 2004, werecorded restructuring charges of $746,000 due to the discontinuation of theSensor product line of the Mobile group. These charges included $523,000 related to the reduction in force of 15employees for severance and other termination expenses, $173,000 for leaselosses on abandoned office space and other miscellaneous legal and consultingfees of approximately $50,000.  Therewere no payments made prior to December 31, 2004 related to these charges.

 

*In-Process Researchand Development. *There were no charges recorded for in-processresearch and development during 2004.  In 2003, approximately $50.1 million of the purchase price of Oakwas allocated to in-process research and development for five R&D projectsin various product divisions which had not yet reached technologicalfeasibility and had no alternative future use. Accordingly, this amount was immediately expensed upon the acquisitiondate.  This amount was determined usingmanagement’s estimates including consultation with an independentappraiser.  The value of in-processresearch and development was determined using the multi-period excessearnings method by estimating the expected net cash flows from the projectsonce commercially viable and discounting the net cash flows back to theirpresent value using a discount rate of 22%. This rate was based on the industry segment for the technology, natureof the products to be developed, length of time to complete the project andoverall maturity and history of the development team.  The net cash flows from the identifiedprojects were based on estimates of revenue, cost of revenue, research anddevelopment expenses, selling general and administrative expenses, andapplicable income taxes.  These estimatesdid not take into account any potential synergies that could be realized as aresult of the acquisition.  Revenues forthe incremental core technologies developed commenced, and are expected toextend through 2011.  Revenue projectionswere based on estimates of market size and growth, expected trends intechnology and the expected timing of new product introductions.  At December 31, 2005, there have been nomaterial variations from the underlying assumptions that were used in theoriginal computation of the value of the acquired in-process research anddevelopment.

 

*Operating Loss. *The significant operating loss of $46.9 million in2004 was primarily driven by the amortization of intangible assets of $45.4million, deferred stock compensation expense of $4.1 million, and the $14.7 million chargetaken in the fourth quarter forinventory write downs of which $508,000 was attributable to products from thediscontinued CMOS image sensor product line and $14.2 million attributable toexcess inventory primarily related to DVD products.  Absentthese charges, the Company would have recorded operating income of $17.3million for fiscal 2004.  For fiscal2003, the operating loss of $72.0 million was primarily the result of a$50.1 million charge for in-process research and development expense,amortization of intangible assets of $19.0 million, deferred stockcompensation of $6.3 million and other non recurring acquisition relatedexpenses of $1.3 million (see SG&A discussion).  Excluding these items, our operating incomewould have been $4.7 million for fiscal 2003.

 

*InterestIncome. *Interest income decreased by $4.1 million to$1.3 million in 2004 compared to $5.4 million in 2003.  The reduction was a result of the loweraverage cash balances during 2004 due to the use of cash in the Oak acquisitionin August 2003 and in the Emblaze acquisition in July 2004.

 

*Provision for IncomeTaxes. *Excluding charges related to the amortization ofintangible assets and the one time write down of inventory of $14.5 million,our estimated effective tax rate was approximately 9% for fiscal 2004 comparedto the 10% recorded in 2003 based on net income excluding the amortization ofintangible assets and write-off of acquired in-process research anddevelopment.

 

38

----

 

**Liquidity and CapitalResources**

 

At December 31, 2005, we had $78.9 million of cash and cashequivalents and $70.5 million of short-term investments.  At December 31, 2005, we had $170.9million of working capital.

 

Our operating activities generated cash of $53.4 million during2005, primarily due to non-cash items such as amortization of intangibles assetsof $50.3 million, depreciation, amortization and other of $13.2 million, inprocess research and development expense of $2.7 million, and stock basedcompensation of $1.8 million which offset our net loss of $27.0 million.  Cash provided by operations also increaseddue to decreases of $17.6 million in net inventory primarily associated withour DVD segment due to reduction in supply chain inventory, $1.1 million inprepaid expenses and other assets and increases in accounts payable, accruedexpenses and other liabilities, goodwill and other long term liabilitiestotaling $3.6 million which were partially offset by a $9.9 million increase innet accounts receivable due to higher revenues recorded in the fourth quarterof 2005 compared to the same period of 2004.

 

Cash used in investing activities was $21.5 million during 2005,principally reflecting the use of $27.6 million in the acquisition of OrenSemiconductor, Inc, partially offset by $16.8 million of net proceeds fromsales and maturities of investments.  Inaddition we spent $10.7 million for property and equipment.

 

Cash provided by financing activities was $9.5 million during 2005and consisted of proceeds received from issuances of common stock throughexercises of employee stock options and employee stock purchase programs.

 

Our operating activities used cash of $15.0 million during 2004,primarily due to an increase in net inventory of $32.3 million which waspartially offset by $11.8 million of net income before non-cash relatedexpenses including amortization of intangibles, deferred stock compensation anddepreciation.  The cash used inoperations was also impacted by the increase in prepaid expenses and otherassets of $6.6 million which was offset by increases in accounts payable,accrued expenses and other liabilities totaling $6.7 million as well as thereduction of net accounts receivable by $5.4 million.

 

Cash used in investing activities was $3.5 million during 2004,principally reflecting the net proceeds from sales and maturities of investmentstotaling $58.0 million offset by the use of $54.2 million in theEmblaze acquisition.  In addition wespent $8.4 million for property and equipment which was offset by proceedsof approximately $978,000 from the sale of a building in Taiwan.

 

Cash provided by financing activities was $8.0 million during 2004and consisted of proceeds received from issuances of common stock throughexercises of employee stock options and employee stock purchase programs.

 

At December 31, 2005 and 2004, we did not have any relationshipswith unconsolidated entities or financial partnerships, such as entities oftenreferred to as structured finance or special purpose entities, established forthe purpose of facilitating off-balance sheet arrangements or other contractuallynarrow or limited purposes.  Accordingly,we are not exposed to the type of financing, liquidity, market or credit riskthat could arise if we had engaged in such relationships.

 

The following is a summary of fixed payments related to certaincontractual obligations (in thousands):

 

| **Contractual Obligation**          | ** ** | **Total** | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **Thereafter** | ** ** |
|------------------------------------------|------------|-----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------------|------------|
|                                     |       |      |       |     |       |     |       |     |       |     |       |     |       |           |       |
| Operating leases and license commitments |       | $         | 35,005     |     | $          | 13,376   |       | $        | 8,550      |     | $          | 2,110    |       | $              | 1,889      |   | $ | 1,600 |   | $ | 7,480 |   |
| Purchase commitments                     |       | 56,648    |       | 56,648   |       | —   |       | —   |       | —   |       | —   |       | —         |       |
| Total                                    |       | $         | 91,653     |     | $          | 70,024   |       | $        | 8,550      |     | $          | 2,110    |       | $              | 1,889      |   | $ | 1,600 |   | $ | 7,480 |   |

 

39

----

 

We believe that our current balances of cash,cash equivalents and short-term investments, and anticipated cash flow fromoperations, will satisfy our anticipated working capital and capitalexpenditure requirements at least through the next 12 months.  Nonetheless, our future capital requirementsmay vary materially from those now planned and will depend on many factorsincluding, but not limited to:

 

•                  the levels at which we maintain inventory andaccounts receivable;

 

•                  the market acceptance of our products;

 

•                  the levels of promotion and advertisingrequired to launch our new products or to enter markets and attain acompetitive position in the marketplace;

 

•                  our business, product, capital expenditureand research and development plans and technology roadmap;

 

•                  volume pricing concessions;

 

•                  capital improvements to new and existingfacilities;

 

•                  technological advances;

 

•                  the response of competitors to our products;and

 

•                  our relationships with our suppliers andcustomers.

 

In addition, we may requirean increase in the level of working capital to accommodate planned growth,hiring and infrastructure needs. Additional capital may also be required for additional acquisitions ofbusinesses, products or technologies.

 

To the extent that ourexisting resources and cash generated from operations are insufficient to fundour future activities, we may need to raise additional funds through public orprivate financings or borrowings.  Ifadditional funds are raised through the issuance of debt securities, thesesecurities could have rights, preferences and privileges senior to holders ofcommon stock, and the terms of this debt could impose restrictions on ouroperations.  The sale of additionalequity or convertible debt securities could result in additional dilution toour stockholders.  We cannot be certainthat additional financing will be available in amounts or on terms acceptableto us, if at all.  If we are unable toobtain this additional financing, we may be required to reduce the scope of ourplanned product development and sales and marketing efforts, which could harmour business, financial condition and operating results.

 

**Item 7A—Quantitative and Qualitative Disclosures about MarketRisks**

 

We areexposed to financial market risks including changes in interest rates andforeign currency exchange rates.

 

Thefair value of our investment portfolio or related income would not besignificantly impacted by either a 10% increase or decrease in interest ratesdue mainly to the short-term nature of the major portion of our investmentportfolio.

 

Amajority of our revenue and capital spending is transacted in U.S. dollars,although a portion of the cost of our operations, relating mainly to ourpersonnel and facilities in Israel, is incurred in New Israeli Shekels.  As a result, we bear the risk that the rate of inflation in Israel orthe decline in the value of United States dollar compared to the Israeli shekelwill increase our costs as expressed in United States dollars.  We havenot engaged in hedging transactions to reduce our exposure to fluctuations thatmay arise from changes in foreign exchange rates.  Based on our overall currency rate exposureat December 31, 2005, a near-term 10% appreciation or depreciation of theNew Israeli Shekel would have an immaterial affect on our financial condition.

 

40

----

 

**Item 8—FinancialStatements and Supplemental Data**

 

**Index to ConsolidatedFinancial Statements**

 
| ** **                                                                                             | **Page** |
|--------------------------------------------------------------------------------------------------------|----------|
|                                                                                                   |     |
| Report of Independent Registered Public  Accounting Firm                                               | 42       |
| Consolidated Balance Sheets as of December  31, 2005 and 2004                                          | 43       |
| Consolidated Statements of Operations for  each of the three years ended December 31, 2005        | 44       |
| Consolidated Statements of Stockholders’  Equity for the three years ended December 31, 2005 | 45       |
| Consolidated Statements of Cash Flows for  each of the three years ended December 31, 2005        | 46       |
| Notes to Consolidated Financial Statements                                                             | 47       |

 

41

----

 

### **Reportof Independent Registered Public Accounting Firm**

 

To the Board of Directors and Stockholders ofZoran Corporation:

 

We have completed integrated audits of ZoranCorporation’s 2005 and 2004 consolidated financial statements and of itsinternal control over financial reporting as of December 31, 2005, and an auditof its 2003 consolidated financial statements in accordance with the standardsof the Public Company Accounting Oversight Board (United States).  Ouropinions, based on our audits, are presented below.

 

Consolidated financial statements

In our opinion, the consolidated financial statements listed in the accompanying index present fairly, inall material respects, the financial position of Zoran Corporation and itssubsidiaries at December 31, 2005 and December 31, 2004, and the results oftheir operations and their cash flows for each of the three years in the periodended December 31, 2005 in conformity with accounting principles generallyaccepted in the United States of America. These financial statements are the responsibility of the Company’smanagement.  Our responsibility is toexpress an opinion on these financial statements based on our audits.  We conducted our audits of these statementsin accordance with the standards of the Public Company Accounting OversightBoard (United States).  Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement.  An audit of financial statements includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements, assessing the accounting principles used andsignificant estimates made by management, and evaluating the overall financialstatement presentation.  We believe thatour audits provide a reasonable basis for our opinion.

 

Internal control over financial reporting

Also, in our opinion, management’s assessment, included in Management’sReport on Internal Control Over Financial Reporting appearing under Item 9A,that the Company maintained effective internal control over financial reportingas of December 31, 2005 based on criteria established in *InternalControl - Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO), is fairly stated, in allmaterial respects, based on those criteria. Furthermore, in our opinion, theCompany maintained, in all material respects, effective internal control overfinancial reporting as of December 31, 2005, based on criteria established in *Internal Control - Integrated Framework* issued by theCOSO.  The Company’s management isresponsible for maintaining effective internal control over financial reportingand for its assessment of the effectiveness of internal control over financialreporting.  Our responsibility is toexpress opinions on management’s assessment and on the effectiveness ofthe Company’s internal control over financial reporting based on our audit. Weconducted our audit of internal control over financial reporting in accordancewith the standards of the Public Company Accounting Oversight Board (UnitedStates).  Those standards require that weplan and perform the audit to obtain reasonable assurance about whethereffective internal control over financial reporting was maintained in allmaterial respects.  An audit of internalcontrol over financial reporting includes obtaining an understanding of internalcontrol over financial reporting, evaluating management’s assessment, testingand evaluating the design and operating effectiveness of internal control, andperforming such other procedures as we consider necessary in thecircumstances.  We believe that our auditprovides a reasonable basis for our opinions.

 

A company’s internal control over financialreporting is a process designed to provide reasonable assurance regarding thereliability of financial reporting and the preparation of financial statementsfor external purposes in accordance with generally accepted accountingprinciples.  A company’s internal controlover financial reporting includes those policies and procedures that(i) pertain to the maintenance of records that, in reasonable detail,accurately and fairly reflect the transactions and dispositions of the assetsof the company; (ii) provide reasonable assurance that transactions arerecorded as necessary to permit preparation of financial statements inaccordance with generally accepted accounting principles, and that receipts andexpenditures of the company are being made only in accordance withauthorizations of management and directors of the company; and(iii) provide reasonable assurance regarding prevention or timelydetection of unauthorized acquisition, use, or disposition of the company’sassets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internalcontrol over financial reporting may not prevent or detect misstatements.  Also, projections of any evaluation of effectivenessto future periods are subject to the risk that controls may become inadequatebecause of changes in conditions, or that the degree of compliance with thepolicies or procedures may deteriorate.

 

PricewaterhouseCoopers LLP

San Jose, California

March 14, 2006

 

42

----

 

**ZORANCORPORATION**

**CONSOLIDATEDBALANCE SHEETS**

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

 
| ** **                                                                                                                                                                                                                                                              | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ASSETS                                                                                                                                                                                                                                                                  |       |                        |       |                        |       |
| Current assets:                                                                                                                                                                                                                                                         |       |                        |       |                        |       |
| Cash and cash equivalents                                                                                                                                                                                                                                               |       | $                           | 78,856     |                        | $          | 37,435 |   |
| Short-term investments                                                                                                                                                                                                                                                  |       | 70,490                      |       | 32,978                      |       |
| Accounts receivable, net of allowance for  doubtful accounts of $6,180 and $1,409, respectively                                                                                                                                                                         |       | 70,174                      |       | 59,863                      |       |
| Inventory                                                                                                                                                                                                                                                               |       | 32,616                      |       | 50,033                      |       |
| Prepaid expenses and other current assets                                                                                                                                                                                                                               |       | 11,746                      |       | 14,130                      |       |
| Total current assets                                                                                                                                                                                                                                                    |       | 263,882                     |       | 194,439                     |       |
| Property and equipment, net                                                                                                                                                                                                                                             |       | 16,057                      |       | 17,190                      |       |
| Other assets and investments                                                                                                                                                                                                                                            |       | 12,943                      |       | 68,619                      |       |
| Goodwill                                                                                                                                                                                                                                                                |       | 184,254                     |       | 150,151                     |       |
| Intangible assets, net                                                                                                                                                                                                                                                  |       | 127,087                     |       | 168,882                     |       |
|                                                                                                                                                                                                                                                                    |       | $                           | 604,223    |                        | $          | 599,281 |   |
|                                                                                                                                                                                                                                                                    |       |                        |       |                        |       |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                                                                                               |       |                        |       |                        |       |
| Current liabilities:                                                                                                                                                                                                                                                    |       |                        |       |                        |       |
| Accounts payable                                                                                                                                                                                                                                                        |       | $                           | 38,999     |                        | $          | 34,017 |   |
| Accrued expenses and other liabilities                                                                                                                                                                                                                                  |       | 53,937                      |       | 51,102                      |       |
| Total current liabilities                                                                                                                                                                                                                                               |       | 92,936                      |       | 85,119                      |       |
| Other long-term liabilities                                                                                                                                                                                                                                             |       | 11,939                      |       | 13,535                      |       |
| Stockholders’ equity:                                                                                                                                                                                                                                              |       |                        |       |                        |       |
| Common stock, $0.001 par value; 105,000,000  shares authorized at December 31, 2005 and December 31, 2004;  45,426,912 shares issued and outstanding as of December 31, 2005; and  43,195,432 shares issued and outstanding as of December 31, 2004 |       | 45                          |       | 43                          |       |
| Additional paid-in capital                                                                                                                                                                                                                                              |       | 727,597                     |       | 705,661                     |       |
| Deferred stock-based compensation                                                                                                                                                                                                                                       |       | (593                        | )          | (2,791                      | )          |
| Accumulated other comprehensive income                                                                                                                                                                                                                                  |       | 3,094                       |       | 1,538                       |       |
| Accumulated deficit                                                                                                                                                                                                                                                     |       | (230,795                    | )          | (203,824                    | )          |
| Total stockholders’ equity                                                                                                                                                                                                                                         |       | 499,348                     |       | 500,627                     |       |
|                                                                                                                                                                                                                                                                    |       | $                           | 604,223    |                        | $          | 599,281 |   |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

43

----

 

**ZORANCORPORATION**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

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

 
| ** **                                         | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                         | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                               |       |                                       |       |   |   |   |   |
| Revenues:                                          |       |                                       |       |   |   |   |   |
| Hardware product revenues                          |       | $                                          | 339,539    |   | $ | 315,697 |   | $ | 200,239 |   |
| Software and other revenues                        |       | 56,219                                     |       | 63,167 |   | 16,289 |   |
| Total revenues                                     |       | 395,758                                    |       | 378,864 |   | 216,528 |   |
| Costs and expenses:                                |       |                                       |       |   |   |   |   |
| Cost of hardware product revenues                  |       | 185,549                                    |       | 226,235 |   | 131,051 |   |
| Research and development                           |       | 89,028                                     |       | 82,245 |   | 40,402 |   |
| Selling, general and administrative                |       | 93,831                                     |       | 67,086 |   | 41,748 |   |
| Amortization of intangible assets                  |       | 50,254                                     |       | 45,358 |   | 18,950 |   |
| Deferred stock compensation                        |       | 1,546                                      |       | 4,051 |   | 6,281 |   |
| Restructuring expense                              |       | —                                     |       | 746 |   | — |   |
| In-process research and development                |       | 2,650                                      |       | — |   | 50,100 |   |
| Total costs and expenses                           |       | 422,858                                    |       | 425,721 |   | 288,532 |   |
| Operating loss                                     |       | (27,100                                    | )          | (46,857 | ) | (72,004 | ) |
| Interest income                                    |       | 2,705                                      |       | 1,307 |   | 5,388 |   |
| Other income (loss), net                           |       | (412                                       | )          | (264 | ) | 1 |   |
| Loss before income taxes                           |       | (24,807                                    | )          | (45,814 | ) | (66,615 | ) |
| Provision for income taxes                         |       | 2,164                                      |       | 1,540 |   | 1,363 |   |
| Net loss                                           |       | $                                          | (26,971    | ) | $ | (47,354 | ) | $ | (67,978 | ) |
|                                               |       |                                       |       |   |   |   |   |
| Basic net loss per share                           |       | $                                          | (0.61      | ) | $ | (1.11 | ) | $ | (2.05 | ) |
|                                               |       |                                       |       |   |   |   |   |
| Diluted net loss per share                         |       | $                                          | (0.61      | ) | $ | (1.11 | ) | $ | (2.05 | ) |
|                                               |       |                                       |       |   |   |   |   |
| Shares used to compute basic net loss per  share   |       | 44,267                                     |       | 42,788 |   | 33,231 |   |
|                                               |       |                                       |       |   |   |   |   |
| Shares used to compute diluted net loss per  share |       | 44,267                                     |       | 42,788 |   | 33,231 |   |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

44

----

 

**ZORANCORPORATION**

**CONSOLIDATEDSTATEMENTS OF STOCKHOLDERS’ EQUITY**

**(in thousands)**

 
| ** **                                                                                                               | ** ** | ** **        | ** ** | ** **  | ** ** | ** **      | ** ** | ** **        | ** ** | **Accumulated**        | ** ** | ** **  | ** ** | ** ** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-------------|------------|-----------------|------------|-------------------|------------|------------------------|------------|-------------|------------|------------|------------|
| ** **                                                                                                               | ** ** | ** **        | ** ** | ** **  | ** ** | **Additional**  | ** ** | **Deferred**      | ** ** | **Other**              | ** ** | ** **  | ** ** | ** ** | ** ** |
| ** **                                                                                                               | ** ** | **Common  Stock** | ** ** | **Paid-In** | ** ** | **Stock-Based** | ** ** | **Comprehensive** | ** ** | **Accumulated**        | ** ** | ** **  | ** ** |
| ** **                                                                                                               | ** ** | **Shares**        | ** ** | **Amount**  | ** ** | **Capital**     | ** ** | **Compensation**  | ** ** | **Income (Loss)** | ** ** | **Deficit** | ** ** | **Total**  | ** ** |
| Balance at  December 31, 2002                                                                                            |       | 27,395            |       | $           | 27         |            | $          | 399,052           |       | $                      | (83        | )           | $          | 508        |       | $ | (88,492 | ) | $ | 311,012 |   |
| Issuance of  common stock                                                                                                |       | 1,773             |       | 2           |       | 19,865          |       | —            |       | —                 |       | —      |       | 19,867     |       |
| Issuance of  common stock in conjunction with the acquisition of Oak Technology, Inc.                                    |       | 13,180            |       | 13          |       | 227,449         |       | —            |       | —                 |       | —      |       | 227,462    |       |
| Issuance of stock  options in conjunction with the acquisition of Oak Technology, Inc.                                   |       | —            |       | —      |       | 57,446          |       | (19,212           | )          | —                 |       | —      |       | 38,234     |       |
| Amortization of  deferred stock-based compensation                                                                       |       | —            |       | —      |       | —          |       | 6,281             |       | —                 |       | —      |       | 6,281      |       |
| Change in  unrealized gain (loss) on securities available for sale                                                       |       | —            |       | —      |       | —          |       | —            |       | (599                   | )          | —      |       | (599       | )          |
| Net loss                                                                                                                 |       | —            |       | —      |       | —          |       | —            |       | —                 |       | (67,978     | )          | (67,978    | )          |
| Balance at  December 31, 2003                                                                                            |       | 42,348            |       | 42          |       | 703,812         |       | (13,014           | )          | (91                    | )          | (156,470    | )          | 534,279    |       |
| Issuance of  common stock                                                                                                |       | 847               |       | 1           |       | 8,021           |       | —            |       | —                 |       | —      |       | 8,022      |       |
| Amortization of  deferred stock-based compensation, net                                                                  |       | —            |       | —      |       | (6,172          | )          | 10,223            |       | —                 |       | —      |       | 4,051      |       |
| Change in  unrealized gain (loss) on securities available for sale                                                       |       | —            |       | —      |       | —          |       | —            |       | 1,629                  |       | —      |       | 1,629      |       |
| Net loss                                                                                                                 |       | —            |       | —      |       | —          |       | —            |       | —                 |       | (47,354     | )          | (47,354    | )          |
| Balance at  December 31, 2004                                                                                            |       | 43,195            |       | 43          |       | 705,661         |       | (2,791            | )          | 1,538                  |       | (203,824    | )          | 500,627    |       |
| Issuance of  common stock                                                                                                |       | 1,044             |       | 1           |       | 9,487           |       | —            |       | —                 |       | —      |       | 9,488      |       |
| Issuance of  common stock in conjunction with the acquisition of Oren Semiconductor, Inc.,  net of issuance costs of $89 |       | 1,188             |       | 1           |       | 12,815          |       | —            |       | —                 |       | —      |       | 12,816     |       |
| Amortization of  stock-based compensation, net                                                                           |       | —            |       | —      |       | (366            | )          | 2,198             |       | —                 |       | —      |       | 1,832      |       |
| Change in  unrealized gain (loss) on securities available for sale                                                       |       | —            |       | —      |       | —          |       | —            |       | 1,556                  |       | —      |       | 1,556      |       |
| Net loss                                                                                                                 |       | —            |       | —      |       | —          |       | —            |       | —                 |       | (26,971     | )          | (26,971    | )          |
| Balance at  December 31, 2005                                                                                            |       | 45,427            |       | $           | 45         |            | $          | 727,597           |       | $                      | (593       | )           | $          | 3,094      |       | $ | (230,795 | ) | $ | 499,348 |   |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

45

----

 

**ZORANCORPORATION**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(in thousands)**

 
| ** **                                                                        | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                        | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                              |       |                                       |       |   |   |   |   |
| Cash flows from operating activities:                                             |       |                                       |       |   |   |   |   |
| Net loss                                                                          |       | $                                          | (26,971    | ) | $ | (47,354 | ) | $ | (67,978 | ) |
| Adjustments to reconcile net loss to net  cash provided by (used in) operations:  |       |                                       |       |   |   |   |   |
| Depreciation, amortization and other                                              |       | 13,226                                     |       | 9,754 |   | 6,367 |   |
| Amortization of intangible assets                                                 |       | 50,254                                     |       | 45,358 |   | 18,950 |   |
| Amortization of stock based compensation                                          |       | 1,832                                      |       | 4,051 |   | 6,281 |   |
| In-process research and development                                               |       | 2,650                                      |       | — |   | 50,100 |   |
| Allowance for doubtful accounts                                                   |       | 4,771                                      |       | 175 |   | 640 |   |
| Write-down of inventory                                                           |       | —                                     |       | 14,680 |   | 1,653 |   |
| Changes in assets and liabilities, net of  effect of acquisitions:                |       |                                       |       |   |   |   |   |
| Accounts receivable                                                               |       | (14,706                                    | )          | 5,188 |   | (23,126 | ) |
| Inventory                                                                         |       | 17,630                                     |       | (47,022 | ) | (2,096 | ) |
| Prepaid expenses and other current assets  and other assets                       |       | 1,141                                      |       | (6,600 | ) | 11,416 |   |
| Accounts payable                                                                  |       | 4,437                                      |       | 4,595 |   | 11,942 |   |
| Accrued expenses and other liabilities,  goodwill and other long term liabilities |       | (857                                       | )          | 2,135 |   | (5,370 | ) |
| Net cash provided by (used in) operating  activities                              |       | 53,407                                     |       | (15,040 | ) | 8,779 |   |
| Cash flows from investing activities:                                             |       |                                       |       |   |   |   |   |
| Capital expenditures for property and  equipment                                  |       | (10,746                                    | )          | (8,401 | ) | (6,165 | ) |
| Proceeds from sale of property and  equipment                                     |       | —                                     |       | 978 |   | — |   |
| Purchases of investments                                                          |       | (43,576                                    | )          | (117,209 | ) | (161,028 | ) |
| Proceeds from sales and maturities of  investments                                |       | 60,415                                     |       | 175,252 |   | 205,192 |   |
| Purchases of intellectual property                                                |       | —                                     |       | — |   | (3,218 | ) |
| Purchases of long-term equity  investments                                        |       | —                                     |       | — |   | (3,500 | ) |
| Acquisition of Emblaze, net of cash acquired                                      |       | —                                     |       | (54,161 | ) | — |   |
| Acquisition of Oren Semiconductor, Inc.,  net of cash acquired.                   |       | (27,567                                    | )          | — |   | — |   |
| Acquisition of Oak Technology, Inc., net of  cash acquired                        |       | —                                     |       | — |   | (40,840 | ) |
| Net cash used in investing activities                                             |       | (21,474                                    | )          | (3,541 | ) | (9,559 | ) |
| Cash flows from financing activities:                                             |       |                                       |       |   |   |   |   |
| Proceeds from issuance of common stock                                            |       | 9,488                                      |       | 8,022 |   | 19,867 |   |
| Installment payment on purchased core  technology                                 |       | —                                     |       | — |   | (2,700 | ) |
| Net cash provided by financing activities                                         |       | 9,488                                      |       | 8,022 |   | 17,167 |   |
| Net increase (decrease) in cash and cash  equivalents                             |       | 41,421                                     |       | (10,559 | ) | 16,387 |   |
| Cash and cash equivalents at beginning of  period                                 |       | 37,435                                     |       | 47,994 |   | 31,607 |   |
| Cash and cash equivalents at end of period                                        |       | $                                          | 78,856     |   | $ | 37,435 |   | $ | 47,994 |   |
|                                                                              |       |                                       |       |   |   |   |   |
| **Supplemental information:**                                                     |       |                                       |       |   |   |   |   |
| Fair value of stock options assumed in Oak  acquisition                           |       | $                                          | —     |   | $ | — |   | $ | 57,446 |   |
|                                                                              |       |                                       |       |   |   |   |   |
| Fair value of stock issued in Oak  acquisition                                    |       | $                                          | —     |   | $ | — |   | $ | 227,462 |   |
|                                                                              |       |                                       |       |   |   |   |   |
| Fair value of stock issued in Oren  acquisition, net of issuance costs of $89     |       | $                                          | 12,816     |   | $ | — |   | $ | — |   |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

46

----

 

**ZORANCORPORATION**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE 1—THECOMPANY**

 

Zoran Corporation (“Zoran” or the “Company”) was incorporated inCalifornia in December 1981 and reincorporated in Delaware inNovember 1986.  Zoran develops andmarkets integrated circuits, integrated circuit cores and embedded softwareused by original equipment manufacturers, or OEMs, in digital audio and videoproducts for commercial and consumer markets, digital television applicationsas well as digital imaging products. Current applications incorporating Zoran’s products and IP include digitalversatile disc, or DVD, players and recorders, digital cameras, professionaland consumer video editing systems, digital speakers and audio systems,applications that enable the delivery and display of digital video contentthrough 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.  The Company operatesin four industry segments; DVD, Imaging, Mobile and Digital Television.

 

*Risk andUncertainties*

 

The Company performs research and development and generates asignificant portion of its sales from its operations located in the State ofIsrael.  A significant number of theCompany’s full-time employees are located in Israel, including a portion of theCompany’s research and development personnel. Therefore, the Company is directly affected by the political, economicand military conditions to which that country is subject.

 

The semiconductor business is highly cyclical and has been subject tosignificant downturns at various times that have been characterized bydiminished product demand, decreased production, overcapacity, and acceleratederosion of average selling prices.  Assuch, the selling price that the Company is able to command for its products ishighly dependent on industry-wide production capacity and demand.  Both of these factors could result in rapiddeviations in product pricing and, therefore, could adversely affect theCompany’s operating results.

 

The Company’s revenues may be impacted by its ability to obtainadequate wafer supplies from its foundries. The foundries with which the Company currently has arrangements,together with any additional foundry at which capacity might be obtained, maynot be willing or able to satisfy all of the Company’s manufacturingrequirements on a timely basis at favorable prices.  In addition, the Company could experiencedelays in qualifying new products and in ramping-up new productproduction.  The Company is also subjectto the risks of service disruptions, raw material shortages and price increasesby its foundries.

 

The Company depends on independent subcontractors to assemble and testits products.  The Company’s reliance onthese subcontractors involves the following significant risks:

 

•                  Reduced control over delivery schedules andquality;

 

•                  The potential lack of adequate capacity duringperiods of strong demand;

 

•                  Difficulties selecting and integrating new subcontracts;

 

•                  Potential increase in prices due to capacityshortages and other factors; and

 

•                  Potential misappropriation of the Company’sintellectual property.

 

*Principles ofconsolidation and basis of presentation*

 

The consolidated financial statements include the accounts of Zoran andall of its subsidiaries.  Intercompanytransactions and balances have been eliminated in consolidation.

 

47

----

 

**ZORANCORPORATION**

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS (Continued)**

 

**NOTE 2—SIGNIFICANTACCOUNTING POLICIES**

 

Zoran has adopted accounting policies which are generally accepted inthe industry in which it operates.  Thefollowing is a summary of the Company’s significant accounting policies.

 

*Use of estimates*

 

The preparation of these financial statements in conformity withgenerally accepted accounting principles in the Unites States of Americarequires management to make estimates and assumptions that affect the amountsreported in the financial statements and accompanying notes.  Actual results could differ from thoseestimates, although such differences are not expected to be material to theconsolidated financial statements.

 

*Translation offoreign currencies*

 

The majority of the Company’s purchasing and sales transactions aredenominated in US dollars, which is considered to be the functional currency ofthe Company and its subsidiaries.  TheCompany has not experienced material losses or gains as a result of currencyexchange rate fluctuations and has not engaged in hedging transactions toreduce its exposure to such fluctuations. The Company may take action in the future to reduce its foreign exchangerisk.  Monetary assets and liabilities ofthe Company’s foreign subsidiaries are remeasured into U.S. dollars from thelocal currency at rates in effect at period-end and non-monetary assets andliabilities are remeasured at historical rates. Revenues and expenses are remeasured at average rates during the period.  In accordance with Statement of FinancialAccounting Standards No. 52, gains and losses arising from the remeasurement oflocal currency financial statements are included in other income (loss), netand have not been significant for any of the periods presented.

 

*Revenue recognition*

 

The Company’s policy is to recognize revenue from product sales uponshipment, provided that persuasive evidence of an arrangement exists, the priceis fixed and determinable, collectibility is reasonably assured and legal titleand risk of ownership has transferred.  Aprovision for estimated future returns and potential warranty liability isrecorded at the time revenue is recognized. Warranty expenses in 2005, 2004 and 2003, were immaterial.  Development revenue under developmentcontracts is recognized as the services are performed based on the specificdeliverables outlined in each contract. Amounts received in advance of performance under contracts are recordedas deferred revenue and are recognized when our obligations have been met.  Costs associated with development revenuesare included primarily in research and development expenses.  Revenue resulting from the licensing of theCompany’s technology is recognized when significant contractual obligationshave been fulfilled and the customer has indicated acceptance.  Periodic service and maintenance fees whichprovide customers access to technical support and minor enhancements tolicensed releases are recognized ratably over the service or maintenanceperiod.  Royalty revenue is recognized inthe period licensed sales are reported to the Company which typically rangesbetween one month to one quarter in arrears.

 

*Research anddevelopment costs*

 

Research and development expenses are charged to operations asincurred.  Costs related to theconceptual formation and design of internally developed software are expensedas research and development as incurred. It is the Company’s policy that certain internal software developmentcosts incurred after technological feasibility has been demonstrated and whichmeet recoverability tests are capitalized and amortized over the estimatedeconomic life of the product.  To date,the Company has incurred no significant internal software development costswhich meet the criteria for capitalization.

 

*Cash equivalents andinvestments*

 

All highly liquid investments purchased with an original maturity of90 days or less are considered to be cash equivalents.

 

All of the Company’s investments in marketable securities areclassified as available-for-sale and, therefore, are reported at fair value withunrealized gains and losses, net of related tax, if any, included asaccumulated other comprehensive income (loss), a component of stockholders’equity.  Gains and losses realized uponsales of all such securities are reported in interest income.  See Note 3.

 

When the fair value of an investment declines below its amortized cost,we consider all available evidence to evaluate whether an other-than-temporarydecline in value has occurred.  Amongother things, we consider the duration and extent to which the market value hasdeclined relative to our cost basis, the economic factors influencing themarkets, the relative performance of the investee and its near-term prospects.

 

48

----

 

**ZORANCORPORATION**

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS (Continued)**

 

At December 31, 2005, the Company’s marketable securities includedcommercial paper and marketable equity securities.  Investments in marketable securities atDecember 31, 2004 also included bonds and medium term notes with maturitiesgreater than one year, which are included in other assets and investments, andamounted to $52.8 million.  SeeNote 3.

 

Other assets and investments also include investments in non-marketablesecurities which are accounted for on the cost basis and amounted to$5.2 million and $4.7 million at December 31, 2005 and 2004.  The Company records an investment impairmentcharge when the fair value of an investment declines below its cost basis.  In making this determination the Company considersall available evidence including the historical and projected financialperformance and recent funding events which are ascertained from aninvestee.  There were no such charges in2005 or 2004.

 

*Concentration ofcredit risk of financial instruments*

 

Financial instruments that potentially subject the Company tosignificant concentrations of credit risk consist principally of cash and cashequivalents, investments in marketable securities, non-marketable equitysecurities and trade accounts receivable. The Company places its cash in banks and cash equivalents consistprimarily of certificates of deposit and commercial paper.  The Company’s marketable securities portfolioconsists primarily of auction rate securities, stock, corporate bonds, shortand medium term notes, Euro dollar bonds and US Government securities.  The Company, by policy, limits the amount ofits credit exposure through diversification and restricting its investments tohighly rated securities. Individual securities are limited to comprising nomore than 10% of the portfolio value at the time of purchase.  Highly rated securities are defined as havinga minimum Moody or Standard & Poor’s rating of A2 or A respectively.  The average maturity of the portfolio shallnot exceed 24 months.  The Company hasnot experienced any significant losses on its cash equivalents or short-terminvestment.

 

The Company markets integrated circuits and technology to manufacturersand distributors of electronic equipment primarily in North America, Europe andthe Pacific Rim.  The Company performsongoing credit evaluations of its customers’ financial condition and limits theamount of credit extended when deemed necessary, but generally does not requirecollateral.  Management believes that anyrisk of loss is significantly reduced due to the diversity of its customers andgeographic sales areas.  As ofDecember 31, 2005, one customer accounted for approximately 14% of the netaccounts receivable balance.  As ofDecember 31, 2004, two customers accounted for approximately 27% and 13%of the net accounts receivable balance, respectively.

 

*Inventory*

 

Inventoriesare stated at the lower of standard cost (which approximates actual cost on afirst-in, first-out basis) or market. Market is based on estimated net realizable value.  The Company writes down inventories to netrealizable value based on forecasted demand and market conditions.  Inventory write-downs are not reversed andpermanently reduce the cost basis of the affected inventory until suchinventory is sold or scrapped.

 

*Property andequipment*

 

Property and equipment are recorded at cost.  Depreciation is computed using thestraight-line method over the estimated useful lives of three to fiveyears.  Leasehold improvements areamortized on a straight-line basis over the shorter of the estimated usefullives of the assets or the remaining term of the lease.

 

*Goodwill*

 

In accordance with Financial Accounting Standards Board (“FASB”)Statement No. 142 “Goodwill and Other Intangible Assets” (“SFAS 142”) goodwill is not amortized.  The Company monitors the recoverability ofgoodwill recorded in connection with acquisitions, by reporting unit, annually,or sooner if events or changes in circumstances indicate that the carryingamount may not be recoverable.  For each of the years ended December 31,2005, 2004 and 2003, the Company performed the annual analysis and concludedthat goodwill was not impaired, as the fair value of each reporting unitexceeded its carrying value, including goodwill.

 

49

----

 

**ZORANCORPORATION**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS (Continued)**

 

*Other Intangibles*

 

Acquired technology is amortized to expense on a straight-line basisover two to five years.  Other intangibleassets recorded in connection with the acquisitions of OakTechnology, Inc.,  EmblazeSemiconductor, Ltd and Oren Semiconductor, Inc. are amortized on astraight-line basis over the estimated periods of benefit, which range betweenthree and five years.

 

*Long-lived assets*

 

The Company evaluates the recoverability of its long-lived assets,other than goodwill, whenever events or changes in circumstance indicate thecarrying amounts of the assets may not be recoverable.  The Company evaluates these assets bycomparing expected undiscounted cash flows to the carrying value of the relatedassets.  If the expected undiscountedcash flows are less than the carrying value of the assets, the Companyrecognizes an impairment charge based on the fair value of the assets.  To date, the Company has not recorded anyimpairment charges against the value of its long-lived assets.

 

*Fair value offinancial instruments*

 

The fair value of a financial instrument is the amount at which theinstrument could be exchanged in a current transaction between willingparties.  The carrying amounts for cashand cash equivalents, short-term investments, accounts receivable, accountspayable and accrued liabilities approximate their respective fair valuesbecause of the short-term maturity of these items.

* *

*Income taxes*

 

The Company follows the liability method of accounting for income taxeswhich requires recognition of deferred tax liabilities and assets for theexpected future tax consequence of temporary differences between the financialstatement carrying amounts and the tax bases of assets and liabilities.

 

For the years ended December 31, 2005, 2004  and 2003, the provision for income taxesreflects the effective tax rate applied to earnings, excluding charges relatedto the amortization of goodwill and the write-off of acquired in-processresearch and development, for the periods. The effective tax rate differs from the U.S. statutory rate due toutilization of net operating losses and State of Israel tax benefits on foreignearnings.  The provision includesprimarily taxes on income in excess of net operating loss carryover limitationsand foreign withholding taxes.

 

*Earnings per share*

 

In accordance with Statement of Financial Accounting Standards No. 128,Zoran reports Earnings per Share (“EPS”), both basic and diluted, on theconsolidated statement of operations. Basic EPS is based upon the weighted average number of common sharesoutstanding.  Diluted EPS is computedusing the weighted average common shares outstanding plus any potential commonstock, except when their effect is anti-dilutive.  Potential common stock includes common stockissuable upon the exercise of stock options and restricted stock units.  See Note 12.

 

*Stock basedcompensation*

 

The Company accounts for stock-based compensation using theintrinsic value method prescribed in Accounting Principles Board OpinionNo.  25 (“APB 25”), “Accounting for StockIssued to Employees” and related interpretations.  Under APB 25, compensation expense isrecognized based on the difference, if any, on the date of grant between thefair value of the Company’s stock and the amount an employee must pay toacquire the stock.  The compensationexpense is recognized over the periods the employee performs the relatedservices, generally the vesting period of four years, consistent with themultiple option method described in FASB Interpretation No. 28 (“FIN 28”).Stock based compensation includes the amortization of restricted stock unitsand the amortization of certain stock options assumed as part of acquisitions.No other stock-based employee compensation cost is reflected in netincome as all other options granted under stock option plans had an exerciseprice equal to the market value of the underlying common stock on the date ofgrant.

 

50

----

 

**ZORANCORPORATION**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS (Continued)**

 

*Fair ValueDisclosures*

 

Had compensation cost for the Company’s option and stock purchase plansbeen determined based on the fair value at the grant dates, as prescribed inSFAS 123, the Company’s net loss and net loss per share for each of thethree years ended December 31, 2005, would have been as follows (inthousands, except per share data):

 

| ** **                                                                        | ** ** | **Year ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                        | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                              |       |                                       |       |   |   |   |   |
| Net loss as reported                                                              |       | $                                          | (26,971    | ) | $ | (47,354 | ) | $ | (67,978 | ) |
| Adjustments:                                                                      |       |                                       |       |   |   |   |   |
| Stock-based employee compensation  expense included in net loss                   |       | 1,832                                      | *          | 4,051 |   | 6,281 |   |
| Stock-based employee compensation  expense determined under the fair value method |       | (26,831                                    | )          | (39,693 | ) | (34,714 | ) |
| Pro forma net loss                                                                |       | $                                          | (51,970    | ) | $ | (82,996 | ) | $ | (96,411 | ) |
|                                                                              |       |                                       |       |   |   |   |   |
| Pro forma net loss per share:                                                     |       |                                       |       |   |   |   |   |
| Basic                                                                             |       | $                                          | (1.17      | ) | $ | (1.94 | ) | $ | (2.90 | ) |
|                                                                              |       |                                       |       |   |   |   |   |
| Diluted                                                                           |       | $                                          | (1.17      | ) | $ | (1.94 | ) | $ | (2.90 | ) |
|                                                                              |       |                                       |       |   |   |   |   |
| Net loss per share as reported:                                                   |       |                                       |       |   |   |   |   |
| Basic                                                                             |       | $                                          | (0.61      | ) | $ | (1.11 | ) | $ | (2.05 | ) |
|                                                                              |       |                                       |       |   |   |   |   |
| Diluted                                                                           |       | $                                          | (0.61      | ) | $ | (1.11 | ) | $ | (2.05 | ) |

 

(*) Amount includes a charge of $272,000 related to the issuance of 65,333restricted stock units to employees and $14,000 relating to 10,000 optionsissued to non-employees which are reported as part of selling, general andadministrative expenses.  The restrictedstock units and non-employee stock options vest over a 48 month period and wereoutstanding as of December 31, 2005.

 

The Company provides information regarding the methodology andassumptions used for the above pro forma disclosure in Note 10.

 

*Segment reporting*

 

Statement of Financial Accounting Standards No. 131 (“SFAS 131”),“Disclosures about Segments of an Enterprise and Related Information,”designates the internal organization that is used by management for makingoperating decisions and assessing performance as the source of the Company’sreportable segments.  SFAS 131 alsorequires disclosures about products and services, geographic areas, and majorcustomers.  The Company operates in fourreportable segments offering different product lines to each of its targetmarkets: Digital Versatile Disc (DVD), Digital Television (DTV), Imaging andMobile.

 

*Comprehensive loss*

 

Comprehensive loss is defined as the change in equity of a businessenterprise during a period from transactions and other events and circumstancesfrom non-owner sources.  Comprehensiveloss includes unrealized gains and losses on available-for-sale securities.

 

The following are the components of comprehensive loss (in thousands):

 

| ** **                                            | ** ** | **Year ended December 31,** | ** ** |
|-------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                            | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                  |       |                                       |       |   |   |   |   |
| Net loss                                              |       | $                                          | (26,971    | ) | $ | (47,354 | ) | $ | (67,978 | ) |
| Change in unrealized gain (loss) on  investments, net |       | 1,556                                      |       | 1,629 |   | (599 | ) |
| Total comprehensive loss                              |       | $                                          | (25,415    | ) | $ | (45,725 | ) | $ | (68,577 | ) |

 

51

----

 

**ZORAN CORPORATION**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)**

 

The components of accumulated other comprehensive loss as ofDecember 31, 2005, 2004 and 2003 consisted of the unrealized gain (loss)on marketable securities, net of related taxes.

 

*Recent accounting pronouncements*

 

In December 2004, the FinancialAccounting Standards Board (“FASB”), issued Statement of Financial AccountingStandards No. 123R, “Share-Based Payment, an Amendment of Statement ofFinancial Accounting Standards 123 (“SFAS 123R”).  On April 14, 2005, the SEC adopted a newrule extending the compliance dates for SFAS 123R.  In accordance with the new rule, theaccounting provisions of SFAS 123R will be effective for the Company in2006.  SFAS 123R requires companies torecognize in the statement of operations the grant-date fair value of stockoptions and other equity-based compensation issued to employees.  SFAS 123R requires the use of an optionpricing model for estimating fair value, which is amortized to expense over theservice periods.  SFAS 123R allowsfor either prospective recognition of compensation expense or retrospectiverecognition, which may be back to the original issuance ofSFAS No. 123, or only to interim periods in the year of adoption. OnMarch 29, 2005, the SEC issued Staff Accounting Bulletin No. 107 (“SAB107”).  This staff accounting bulletinexpresses views of the staff regarding the interaction between SFAS 123R andcertain SEC rules and regulations and the valuation of share-based paymentarrangements for public companies. Management is currently evaluating theimpact of adopting SFAS 123R; however, it believes the adoption ofSFAS 123R will have a significant impact on net loss and net loss pershare.  The impact on the Company’sfinancial statements will be dependent on the transition method, theoption-pricing model used to compute fair value and the inputs to that modelsuch as volatility and expected life. The pro-forma disclosures of the impact of SFAS 123 provided in Note 2to the Consolidated Financial Statements may not be representative of theimpact of adopting SFAS 123R.

 

In May 2005, the FASBissued Statement of Financial Accounting standards No. 154, “AccountingChanges and Error Corrections” (“SFAS 154”). SFAS 154 replaces APB Opinion No. 20, “Accounting Changes”, andSFAS No. 3, “Reporting Accounting Changes in Interim Financial Statements”.SFAS 154 requires retrospective application to prior periods’ financialstatements of changes in accounting principles, unless it is impracticable todetermine either the period-specific effects or the cumulative effect of thechange. SFAS 154 will be effective for all periods beginning afterDecember 15, 2005. The adoption of SFAS 154  is not expected to have a material effect onthe Company’s consolidated financial position, results of operations or cashflows.

 

In November 2005, theFASB issued FASB Staff Position (FSP) Nos. FAS 115-1 and FAS 124-1, “The Meaning of Other-Than-TemporaryImpairment and Its Application to Certain Investments.”  This FSP addresses the determination as towhen an investment is considered impaired, whether that impairment is otherthan temporary, and the measurement of an impairment loss. This FSP alsoincludes accounting considerations subsequent to the recognition ofother-than-temporary impairments. The guidance in this FSP will be applied toreporting periods beginning after December 15, 2005. The adoption of thisFSP is not expected to have a material effect on the Company’s consolidatedfinancial position, results of operations or cash flows.

 

52

----

** **

**ZORAN CORPORATION**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)**

** **

**NOTE3—MARKETABLE SECURITIES**

 

The Company’s portfolio ofmarketable securities at December 31, 2005 was as follows (in thousands):

 
| ** **                   | ** ** | **Cost** | ** ** | **Unrealized  Gains** | ** ** | **Unrealized  Losses** | ** ** | **Estimated  Fair  Value** | ** ** |
|------------------------------|------------|----------|------------|-----------------------|------------|------------------------|------------|----------------------------|------------|
| Corporate bonds              |       | $        | 23,677     |                  | $          | —                 |       | $                          | (96        | ) | $ | 23,581 |   |
| Short/medium term notes      |       | 1,501    |       | —                |       | (12                    | )          | 1,489                      |       |
| U.S. government securities   |       | 20,000   |       | —                |       | (151                   | )          | 19,849                     |       |
| Foreign bonds                |       | 4,474    |       | —                |       | (6                     | )          | 4,468                      |       |
| Auction rate securities      |       | 15,125   |       | —                |       | —                 |       | 15,125                     |       |
| Floating rate bonds          |       | 994      |       | —                |       | (4                     | )          | 990                        |       |
| Marketable equity securities |       | 1,623    |       | 3,365                 |       | —                 |       | 4,988                      |       |
| Total                        |       | $        | 67,394     |                  | $          | 3,365                  |       | $                          | (269       | ) | $ | 70,490 |   |

 

The Company’s portfolio ofmarketable securities at December 31, 2004 was as follows (in thousands):

 
| ** **                                  | ** ** | **Cost** | ** ** | **Unrealized  Gains** | ** ** | **Unrealized  Losses** | ** ** | **Estimated  Fair  Value** | ** ** |
|---------------------------------------------|------------|----------|------------|-----------------------|------------|------------------------|------------|----------------------------|------------|
| Corporate bonds                             |       | $        | 22,612     |                  | $          | —                 |       | $                          | (377       | ) | $ | 22,235 |   |
| Short/medium term notes                     |       | 8,630    |       | 1                     |       | (42                    | )          | 8,589                      |       |
| U.S. government securities                  |       | 38,690   |       | —                |       | (428                   | )          | 38,262                     |       |
| Foreign bonds                               |       | 9,709    |       | 9                     |       | (99                    | )          | 9,619                      |       |
| Auction rate securities                     |       | 2,700    |       | —                |       | —                 |       | 2,700                      |       |
| Marketable equity securities                |       | 1,624    |       | 2,744                 |       | —                 |       | 4,368                      |       |
| Total marketable securities                 |       | 83,965   |       | 2,754                 |       | (946                   | )          | 85,773                     |       |
| Less amounts classified as long term assets |       | (53,403  | )          | (10                   | )          | 618                    |       | (52,795                    | )          |
| Total                                       |       | $        | 30,562     |                  | $          | 2,744                  |       | $                          | (328       | ) | $ | 32,978 |   |

 

Gross realized gains on sales of marketable securities were $143,000,$94,000 and $43,000 in 2005, 2004 and 2003, respectively.  Gross realized losses on sales of marketablesecurities were $287,000, $104,000 and $20,000 in 2005, 2004 and 2003,respectively.

 

Interest income on cash and marketable securities was $ 2.7 million,$1.3 million and $5.4 million for the years ended December 31,2005, 2004 and 2003, respectively.

 

**NOTE4—BALANCE SHEET COMPONENTS (in thousands)**

 
| ** **                    | ** ** | **December 31,** | ** ** |
|-------------------------------|------------|-----------------------|------------|
| **Accounts receivable:** | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Trade                         |       | $                     | 76,354     |   | $ | 61,272 |   |
| Less: allowance               |       | (6,180                | )          | (1,409 | ) |
|                          |       | $                     | 70,174     |   | $ | 59,863 |   |

 
| ** **                          | ** ** | **December 31,** | ** ** |
|-------------------------------------|------------|-----------------------|------------|
| **Inventory:**                      | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Purchased parts and work in process |       | $                     | 14,904     |   | $ | 23,959 |   |
| Finished goods                      |       | 17,712                |       | 26,074 |   |
|                                |       | $                     | 32,616     |   | $ | 50,033 |   |

 

53

----

 

**ZORAN CORPORATION**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)**

 

 
| ** **                                       | ** ** | **December 31,** | ** ** |
|--------------------------------------------------|------------|-----------------------|------------|
| **Property and equipment:**            | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Computer equipment                               |       | $                     | 15,749     |   | $ | 17,492 |   |
| Office equipment and furniture                   |       | 2,512                 |       | 2,102 |   |
| Machinery and equipment                          |       | 5,762                 |       | 3,293 |   |
| Software                                         |       | 24,196                |       | 19,307 |   |
| Building and leasehold improvements              |       | 4,465                 |       | 3,301 |   |
|                                             |       | 52,684                |       | 45,495 |   |
| Less: accumulated depreciation and  amortization |       | (36,627               | )          | (28,305 | ) |
|                                             |       | $                     | 16,057     |   | $ | 17,190 |   |

 
| ** **                                                      | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------|------------|-----------------------|------------|
| **Accrued expenses and other liabilities:** | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Accrued payroll and related expenses                            |       | $                     | 18,981     |   | $ | 10,052 |   |
| Accrued royalties                                               |       | 5,355                 |       | 4,400 |   |
| Taxes payable                                                   |       | 12,180                |       | 13,220 |   |
| Deferred revenue                                                |       | 5,590                 |       | 7,334 |   |
| Other accrued liabilities                                       |       | 11,831                |       | 16,096 |   |
|                                                            |       | $                     | 53,937     |   | $ | 51,102 |   |

 

**NOTE 5—GOODWILL AND OTHER INTANGIBLE ASSETS**

 

In accordance with SFAS 142, goodwill is notamortized.  The Company monitors therecoverability of goodwill recorded in connection with acquisitions, byreporting unit, annually, or sooner if events or changes in circumstances indicatethat the carrying amount may not be recoverable.  For each of the years endedDecember 31, 2005, 2004 and 2003, the Company performed the annualanalysis and concluded that goodwill was not impaired, as the fair value ofeach reporting unit exceeded its carrying value, including goodwill.

 

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

 
| ** **                   | ** ** | **December 31, 2005** | ** ** | **December 31, 2004** | ** ** |
|------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **                   | ** ** | **Life  (Years)**               | ** ** | **Gross  Carrying  Amount**     | ** ** | **Accumulated  Amortization** | ** ** | **Net  Balance** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net Balance** | ** ** |
| Amortized intangible assets: |       |                            |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Purchased technology         |       | 2-3                             |       | $                               | 195,505    |   | $ | (105,088 | ) | $ | 90,417 |   | $ | 188,505 |   | $ | (67,139 | ) | $ | 121,366 |   |
| Patents                      |       | 3-5                             |       | 40,265                          |       | (19,978 | ) | 20,287 |   | 40,265 |   | (10,457 | ) | 29,808 |   |
| Customer base                |       | 3-5                             |       | 13,860                          |       | (7,123 | ) | 6,737 |   | 13,010 |   | (4,739 | ) | 8,271 |   |
| Tradename and others         |       | 3-5                             |       | 3,350                           |       | (1,560 | ) | 1,790 |   | 2,100 |   | (1,161 | ) | 939 |   |
| Purchased core technology *  |       | 4-5                             |       | 14,969                          |       | (7,113 | ) | 7,856 |   | 12,679 |   | (4,181 | ) | 8,498 |   |
| Total                        |       |                            |       | $                               | 267,949    |   | $ | (140,862 | ) | $ | 127,087 |   | $ | 256,559 |   | $ | (87,677 | ) | $ | 168,882 |   |
|                              |            |                                 |            |                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(*)                                 The Company recordsthe amortization of purchased core technology as cost of product sales.

 

54

----

 

**ZORAN CORPORATION**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)**

 

Estimated future intangibleamortization expense, based on current balances, as of December 31, 2005is as follows (in thousands):

 
| **Year ending December 31,** | ** ** | **Amount** | ** ** |
|---------------------------------------------|------------|------------|------------|
| ** **                                  | ** ** | ** ** | ** ** |
| 2006                                        |       | $          | 52,914     |   |
| 2007                                        |       | 46,095     |       |
| 2008                                        |       | 24,918     |       |
| 2009                                        |       | 2,350      |       |
| 2010                                        |       | 810        |       |
| Total                                       |       | $          | 127,087    |   |

 

Changes in the carrying amount of goodwill for the year endedDecember 31, 2005 are as follows (in thousands):

 
| ** **                                            | ** ** | **Amount** | ** ** |
|-------------------------------------------------------|------------|------------|------------|
| Balance at December 31, 2003                          |       | $          | 119,091    |   |
| Adjustment to goodwill related to  acquisition of Oak |       | 181        |       |
| Acquisition of Emblaze Semiconductor.                 |       | 30,879     |       |
| Balance at December 31, 2004                          |       | 150,151    |       |
| Acquisition of Oren Semiconductor, Inc.               |       | 35,305     |       |
| Adjustment to goodwill related to  acquisition of Oak |       | (1,202     | )          |
| Balance at December 31, 2005.                         |       | $          | 184,254    |   |

 

The adjustment to goodwill in 2005 is related to the realization ofcertain pre-acquisition tax net operating losses. Realization of these netoperating losses is reported as an adjustment to goodwill in accordance withFAS 109.

 

Goodwill by reporting unit atDecember 31, 2005 and 2004 were as follows (in thousands):

 
| ** ** | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
|------------|------------|-----------------------|------------|-----------------------|------------|
| ** ** | ** ** | **2005**              | ** ** | **2004**              | ** ** |
| DVD        |       | $                     | 63,495     |                  | $          | 63,855 |   |
| Imaging    |       | 6,057                 |       | 6,177                 |       |
| Mobile     |       | 61,770                |       | 62,131                |       |
| DTV        |       | 52,932                |       | 17,988                |       |
|       |       | $                     | 184,254    |                  | $          | 150,151 |   |

** **

**NOTE 6—RESEARCHAND DEVELOPMENT ARRANGEMENTS**

 

The Company is a party tocertain research and development agreements with the Chief Scientist in Israel’sMinistry of Industry and Trade Department (the “Chief Scientist”) and theIsrael-United States Binational Industrial Research and DevelopmentFoundation (“BIRDF”), which fund up to 50% of incurred project costs forapproved products up to specified contract maximums.  The Company is not obligated to repay fundingregardless of the outcome of its development efforts; however, these agreementsrequire the Company to use its best efforts to achieve specified results andrequire the Company to pay royalties at rates of 3% to 5% of resulting productssales, and up to 30% of resulting license revenues, up to a maximum of 100% to150% of the total funding received. Reported research and development expenses incurred in Israel are net ofthese grants, which fluctuate from period to period.

 

Research and development expenses that qualify for the grants and therelated grants are as follows:

 
| ** **                        | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------|------------|--------------------------------------------|------------|
| ** **                        | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                        | ** ** | ** **                                 | ** ** | **(in thousands)** | ** ** | ** ** | ** ** |
| ** **                        | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Research and development expenses |       | $                                          | 48,377     |   | $ | 38,461 |   | $ | 22,271 |   |
| Less: grants earned               |       | —                                     |       | (1,460 | ) | (2,500 | ) |
|                              |       | $                                          | 48,377     |   | $ | 37,001 |   | $ | 19,771 |   |

 

55

----

 

**ZORAN CORPORATION**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)**

 

There were no grant receipts or royalty expense in 2005.  Royalty expenses related to these grants were$654,000 and $40,600 in 2004 and 2003, respectively.

 

**NOTE 7—DEVELOPMENT CONTRACTS**

 

The Company has generated a portion of its total revenues fromdevelopment contracts, primarily with key customers.  The Company classifies costs related to thesedevelopment contracts as research and development expenses.  The Company is not obligated to repay fundingregardless of the outcome of its development efforts; however, the agreementsrequire the Company to use its best efforts to achieve specified results as perthe agreements.  The Company retainsownership of the intellectual property developed under the contracts; however,some contracts limit the product markets in which the Company may directly sellthe developed product.  Revenuesgenerated under these contracts were $3.2 million in 2005, $1.6 million in 2004and $1.4 million in 2003.  Inaddition, from time to time, we enter into non-refundable jointdevelopment projects in which our customers reimburse us for a portion of ourdevelopment costs.  We classify suchreimbursement of development costs as an offset to research and developmentexpenses as we retain ownership of the intellectual property developed by usunder these development arrangements. During 2005, we received approximately $1.2 million in suchreimbursements.  We did not receive anyreimbursements in 2004 or 2003.

 

**NOTE 8—COMMITMENTS AND CONTINGENCIES**

 

From time to time, the Company may have certain contingent liabilitiesthat arise in the ordinary course of its business activities.  The Company accrues contingent liabilitieswhen it is probable that future expenditures will be made and such expenditurescan be reasonably estimated.  In theopinion of management, there are no pending claims of which the outcome isexpected to result in a material adverse effect in the financial position,results of operations or cash flows of the Company.

 

*Lease and license commitments*

 

The Company rents facilitiesand equipment under various lease and license agreements expiring through2016.  Rent expense for 2005, 2004 and2003 totaled approximately $5.6 million, $4.4 million and $3.1 million,respectively.  The Company also enteredinto a time based license agreement for the right to use certain intellectualproperty. Future minimum lease and license payments required undernon-cancelable agreements at December 31, 2005 are as follows: (inthousands)

 
| **Year ending December 31,** | ** ** | **Amount** | ** ** |
|---------------------------------------------|------------|------------|------------|
| 2006                                        |       | $          | 13,376     |   |
| 2007                                        |       | 8,550      |       |
| 2008                                        |       | 2,110      |       |
| 2009                                        |       | 1,889      |       |
| 2010                                        |       | 1,600      |       |
| Thereafter                                  |       | 7,480      |       |
| Total                                       |       | $          | 35,005     |   |

 

*Legal proceedings*

 

Zoran and its subsidiary,Oak Technology, Inc., have been involved in five separate legal actionsagainst MediaTek, Inc. and customers of MediaTek based on claims of patentinfringement.

 

On March 11, 2004,Zoran and Oak filed a complaint with****theUnited States International Trade Commission (“ITC”) alleging that certainMediaTek DVD player and optical disk controller chips and chipsets, andproducts in which they are used, infringe Zoran’s and Oak’s patents.  In addition to MediaTek, the complaint nameda number of other proposed respondents that sell products, including DVDplayers and PC optical storage devices that use MediaTek’s chips andchipsets.  On September 28, 2005,the ITC issued its final ruling finding one of Zoran’s patents to be valid andinfringed by optical disk controller chips and chipsets sold by MediaTek and byproducts using the infringing chips and chipsets sold by a number of MediaTekcustomers.  The ITC also issued anexclusion order prohibiting MediaTek and specified MediaTek customers fromimporting into the United States any optical disk controller chip or chipsetthat infringes the Zoran patent, or any optical disk storage product containingsuch a chip or chipset and cease and desist orders to the affected companieslocated in the United States prohibiting them from importing or sellinginfringing products in the United

 

56

----

 

**ZORAN CORPORATION**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)**

 

States.  In November 2005, both parties filed noticesof appeal with the United States Court of Appeals for the Federal Circuit.  On January 19, 2006, the court issued anorder temporarily staying enforcement of the ITC’s orders.

 

On March 15, 2004,Zoran and Oak filed a complaint against MediaTek and one of its customers inthe United States District Court, Central District of California allegingsimilar facts regarding infringement by MediaTek’s chips and chipsets andproducts in which they are used.  Thelawsuit sought both monetary damages and an injunction to stop the importationand sale of infringing products.  Thecomplaint was subsequently amended to name additional MediaTek customers asdefendants.  Trial of this case was set tobegin May 15, 2006.

 

On July 23, 2004,MediaTek filed a complaint with the ITC alleging that certain Zoran and Oak DVDplayer and optical disk controller chips and chipsets infringe two MediaTekpatents.  The complaint requested thatthe ITC institute an investigation into the accused products and issueexclusion and cease and desist orders prohibiting importation into the UnitedStates of allegedly infringing chips and products that contain them.  On September 30, 2005, the ITCAdministrative Law Judge issued his initial determination finding that none ofZoran’s optical disk controller chips infringe any claim of the two patentsasserted against Zoran; that one of the two patents is invalid; that Oak’sdevices do not infringe one of the two patents asserted against Oak and thatthe other patent is invalid; and that MediaTek has failed to establish that ithas a domestic industry in the United States related to the patents atissue – a basic requirement for obtaining relief from the ITC.  The initial determination was subject toreview by the full ITC.  The target datefor completion of the investigation was March 1, 2006.

 

On July 23, 2004,MediaTek filed a complaint against Zoran and Oak in the United States DistrictCourt, District of Delaware alleging infringement of the same two patentsasserted in MediaTek’s ITC complaint and seeking monetary damages andinjunctive relief.  This action wasstayed by order of the court on October 4, 2004.

 

On February 2, 2005,MediaTek filed a complaint against Zoran and Zoran Digital Technologies(Shenzhen) Ltd. (Zoran’s local Chinese operations) in the Shenzhen People’sRepublic of China court alleging infringement of the Chinese counterpart patentof one of the two patents asserted in MediaTek’s ITC complaint and seekingmonetary damages.  Because Zoran had notbeen served with the complaint, the initiation of the proceeding has beenstayed.

 

On January 25, 2006, Zoran and Oak entered intoan agreement with MediaTek to settle the litigation.  Under the agreement, each party agreed todismiss its respective claims and counterclaims under all of the pendinglawsuits.  The parties also agreed todismiss all proceedings pending against each other before the ITC, includingall appeals and enforcement proceedings pending before the ITC, United StatesCustoms and Border Protection and the United States Court of Appeals for theFederal Circuit related to the ITC’s September 28, 2005 order excludingthe importation into the United States of certain MediaTek chips and productsincorporating those chips.

 

In connection with the settlement, Zoran, Oak and MediaTekentered into agreements granting each other non-exclusive licenses under thepatents that were the subject of the litigation, and additional patents used inthe design and manufacture of optical storage devices for personal computerproducts.  In consideration for licensesgranted by Zoran, MediaTek agreed to make a cash payment of $55 million toZoran, $44 million of which was paid in February 2006 and $11 million ofwhich is payable in April 2006. In addition, MediaTek will be required to makeroyalty payments of up to $30 million over the 30-month period commencingon the date of the agreement based on future sales of covered MediaTekproducts.  Net of amounts payable byZoran to a holder of rights under the Oak patents involved in the litigation, andamounts payable as legal fees, Zoran will realize approximately$27.5 million of the cash payment and up to approximately $15 millionof the future royalty payments.

 

**NOTE 9—RESTRUCTURING**

 

During the year ended December 31, 2004, the Companyrecorded restructuring charges of $746,000 due to the discontinuation of theSensor product line of the Mobile group. These charges included $523,000 related to the reduction in force of 15employees for severance and other termination expenses, $173,000 for lease losseson abandoned office space and other miscellaneous legal and consulting fees ofapproximately $50,000.  The remainingbalance at December 31, 2005 of approximately $73,000 related to facilitieswill be paid over the lease term through June 2007.

 

57

----

 

**ZORAN CORPORATION**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)**

 

**NOTE 10—STOCKHOLDERS’EQUITY**

 

*1993 Stock Option Plan*

 

The Company’s 1993 Stock OptionPlan (the “1993 Option Plan”) was adopted by the Board of Directors of theCompany and approved by the stockholders of the Company in July 1993.  A total of 7,755,000 shares of common stockwere reserved for issuance under the 1993 Option Plan.  The 1993 Option Plan provided for grants ofoptions to employees, non-employee directors and consultants.  The 1993 Stock Option Plan expired during2003 and no future shares will be granted under this plan.  The option price for shares granted under the1993 Option Plan was typically equal to the fair market value of the commonstock at the date of grant.

 

Generally, options granted under the 1993 Option Plan are fullyexercisable on and after the date of grant, subject to the Company’s right torepurchase from an optionee, at the optionee’s original per share exerciseprice, any unvested shares which the optionee has purchased and holds in theevent of the termination of the optionee’s employment, with or withoutcause.  The Company’s right lapses asshares subject to the option become vested. Such shares generally vest in monthly installments over two or fouryears following the date of grant (as determined by the Compensation Committeeof the Board of Directors), subject to the optionee’s continuous service.  Options expire ten years from the date ofgrant and an option shall generally terminate three months after termination ofemployment.

 

*2000 Stock Option Plan*

 

The Company’s2000 Nonstatutory Stock Option Plan (the “2000 Option Plan”) was adopted by theBoard of Directors of the Company in October 2000.  A total of 450,000 shares of preferred stockwere initially reserved for issuance under the 2000 Option Plan.  The options to purchase preferred stockautomatically converted to options to purchase common stock upon the amendmentof the Company’s certificate of incorporation to effect an increase in thenumber of authorized shares of common stock to 55,000,000 inOctober 2000.  A total of 13,325,000shares of common stock were reserved for issuance under the 2000 OptionPlan.  The 2000 Option Plan provided forgrants of options to employees or consultants. The 2000 Option Plan wasmodified in 2001 to allow for exercisability of stock options ahead of vestingsubject to the Company’s right to repurchase the associated stock at the optionexercise price through the original vesting schedule.  The option price for shares granted under the2000 Option Plan was typically equal to the fair market value of the commonstock at the date of grant.  Optionsexpire ten years from the date of grant and an option generally terminate threemonths after termination of employment. The 2000 Stock Option Plan was terminated in 2005 and was replaced bythe 2005 Equity Incentive Plan.

 

*1995 Outside Directors Stock Option Plan*

 

The Company’s Outside DirectorsStock Option Plan (the “1995 Directors Plan”) was adopted by the Company’sBoard of Directors in October 1995, and was approved by its stockholdersin December 1995.  A total of525,000 shares of Common Stock were reserved for issuance under the 1995Directors Plan.  The 1995 Directors Planprovided for the grant of nonstatutory stock options to nonemployee directorsof the Company.  The 1995 Directors Planprovided that each new nonemployee director would automatically be granted anoption to purchase 30,000 shares on the date the optionee first became anonemployee director (the “Initial Grant”). Thereafter, on the date immediately following each annual stockholders’meeting, each nonemployee director who was reelected at the meeting to anadditional term was granted an additional option to purchase 15,000 shares ofCommon Stock if, on such date, he or she had served on the Company’s Board ofDirectors for at least six months (the “Annual Grant”).  Initial Grants were exercisable in four equalannual installments, and each Annual Grant became exercisable in full one yearafter the date of grant, subject to the director’s continuous service.  The exercise price of all stock optionsgranted under the 1995 Directors Plan was equal to the fair market value of theCompany’s Common Stock on the date of grant. Options granted under the 1995 DirectorsPlan have a term of ten years.  This planwas terminated in July 2005 and was replaced by the 2005 Outside Directors Equity Plan.

 

*2005Equity Incentive Plan*

 

The 2005 Equity Incentive Plan (the “2005Plan”) was adopted by the Board of Directors in May 2005 and replaced the 1993Stock Option Plan, which expired in 2003, and the 2000 Nonstatutory StockOption Plan, which was terminated by the Board of Directors upon stockholderapproval of the 2005 Plan in July 2005. A total of 1,800,000 shares of the Company’s common stock is authorizedfor issuance pursuant to awards granted under the 2005 Plan.  Such awards may include stock options, stockappreciation rights, restricted stock, restricted stock units, performanceshares, performance units, deferred stock units and other stock-based orcash-based awards.  Up to an additional1,250,000 shares may be issued in the form of restricted stock or uponsettlement of restricted stock units issued or other full value awards issued underthe 2005 Plan in replacement of stock options cancelled in an option exchangeprogram approved by the stockholders. The 2005 Plan is generally administered by the Compensation Committee ofthe Board of Directors and has a term of 10 years.  Participation in the 2005 Plan is limited toemployees and consultants of Zoran and its subsidiaries and other affiliates.

 

Options and stock appreciation rights grantedunder the 2005 Plan must have exercise prices per share not less than the fairmarket 

 

58

----

 

**ZORAN CORPORATION**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)**

 

value of Zoran common stock on the date ofgrant and may not be repriced without stockholder approval.  Such awards will vest and become exercisableupon conditions established by the Compensation Committee and may not have aterm exceeding 10 years.

 

Except with respect to 5% of the number ofshares authorized under the 2005 Plan, awards of restricted stock, restrictedstock units, performance shares, performance units and other full value awardsgranted under the 2005 Plan generally must have service-based vesting schedulesof at least three years or a performance period of at least 12 months.  However, restricted stock or restricted stockunits issued pursuant to a stockholder-approved option exchange program whichvest based on service must have a vesting schedule of at least two years.  Performance share and performance unit awardsvest to the extent that pre-established performance goals based on one or moremeasures of business and financial performance authorized by the 2005 Plan areattained during a performance period established by the CompensationCommittee.  The grant or vesting of othertypes of awards under the 2005 Plan may similarly be based on the attainment ofone or more such performance goals.  The2005 Plan provides that the number of shares remaining available for issuancewill be reduced by 1.3 shares for each one share of Zoran common stock subjectto a full value award granted under the 2005 Plan.

 

At December 31, 2005, 1,279,762 shares of the Company’s commonstock were available for the grant of the options and other awards under the2005 Plan, subject to the provisions described above that reduce the number ofshares available for full value awards.

 

*2005Outside Directors Equity Plan*

 

The 2005 Outside Directors Equity Plan (the “2005Directors Plan”) was adopted by the Board of Directors in May 2005 and replacedthe 1995 Outside Directors Stock Option Plan, which was terminated by the Boardof Directors upon stockholder approval of the Directors Plan in July 2005.  A total of 600,000 shares of the Company’scommon stock is authorized for issuance pursuant to awards granted under the2005 Directors Plan.  Such awards mayinclude stock options, stock appreciation rights, restricted stock units anddeferred stock units.  The 2005 DirectorsPlan is generally administered by the Board of Directors and has a term of 10years.  Participation in the 2005 DirectorsPlan is limited to non-employee members of the Zoran Board of Directors (“outsidedirectors”).  The 2005 Directors Planprovides that the number of shares remaining available for issuance will bereduced by 1.3 shares for each one share of Zoran common stock subject to afull value award granted under the 2005 Directors Plan.

 

Awards under the 2005 Directors Plan aregranted by the Board of Directors to all outside directors on a periodic,nondiscriminatory basis within limits prescribed by the 2005 DirectorsPlan.  Subject to appropriate adjustmentfor any change in the Company’s capital structure, awards granted to anyoutside director in any fiscal year may not exceed 20,000 shares, increased byone or more of the following: 40,000 shares upon an outside director’s initialelection, 10,000 shares for service as Chairman of the Board or Lead Director,5,000 shares for service on a Board committee as chairman and 2,500 shares forservice on a Board committee other than as chairman.  Stock options, stock appreciation rights,restricted stock units and deferred stock units granted under the DirectorsPlan are generally subject to terms substantially similar to those applicableto the same type of award granted under the 2005 Plan.

 

At December 31, 2005, 510,000 shares of the Company’s common stockwere available for the grant of the options and other awards under the 2005 DirectorsPlan, subject to the provisions described above that reduce the number ofshares available for full value awards.

 

59

----

 

**ZORAN CORPORATION**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)**

 

The following table summarizesthe Company’s stock option activity for the years ended December 31, 2005,2004 and 2003.  The weighted averageexercise price for each category presented is also shown in the table below:

 
| ** **                  | ** ** | **Options  Outstanding** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Restricted  Stock Units  Outstanding** | ** ** |
|-----------------------------|------------|--------------------------|------------|----------------------------------------|------------|-----------------------------------------------|------------|
| Balances, December 31, 2002 |       | 7,053,542                |       | $                                      | 15.45      |                                          | —     |   |
| Assumed                     |       | 4,528,965                |       | $                                      | 14.74      |                                          | —     |   |
| Granted                     |       | 4,697,685                |       | $                                      | 19.92      |                                          | —     |   |
| Exercised                   |       | (1,648,920               | )          | $                                      | 11.08      |                                          | —     |   |
| Canceled                    |       | (962,108                 | )          | $                                      | 21.41      |                                          | —     |   |
| Balances, December 31, 2003 |       | 13,669,164               |       | $                                      | 16.86      |                                          | —     |   |
| Granted                     |       | 1,091,733                |       | $                                      | 16.80      |                                          | —     |   |
| Exercised                   |       | (502,921                 | )          | $                                      | 8.57       |                                          | —     |   |
| Canceled                    |       | (1,412,219               | )          | $                                      | 17.95      |                                          | —     |   |
| Balances, December 31, 2004 |       | 12,845,757               |       | $                                      | 17.06      |                                          | —     |   |
| Granted                     |       | 2,296,315                |       | $                                      | 11.63      |                                          | 65,333     |   |
| Exercised                   |       | (555,106                 | )          | $                                      | 9.26       |                                          | —     |   |
| Canceled                    |       | (1,631,381               | )          | $                                      | 17.95      |                                          | —     |   |
| Balances, December 31, 2005 |       | 12,955,585               |       | $                                      | 16.32      |                                          | 65,333     |   |

 

In connection with the Company’s acquisition of OakTechnology, Inc. in August 2003, the Company assumed all outstandingoptions granted by Oak Technology, Inc. prior to the acquisition datewhich were converted into options to purchase an aggregate of approximately 4.5million shares of the Company’s common stock.

 

Significant option groupsoutstanding as of December 31, 2005 and the related weighted averageexercise price and contractual life information, are as follows:

 
| ** **               | ** ** | **Options Outstanding**                       | ** ** | ** **                                                  | ** ** | **Options Exercisable**           | ** ** |
|--------------------------|------------|----------------------------------------------------|------------|-------------------------------------------------------------|------------|----------------------------------------|------------|
| **Exercise Prices** | ** ** | **Options at   December 31,  2005** | ** ** | **Weighted  Average  Remaining  Contractual Life  (Years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Options at  December 31,  2005** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| $0.00 to $9.99           |       | 1,210,716                                          |       | 5.43                                                        |       | $                                      | 6.52       |   | 956,473 |   | $ | 6.67 |   |
| $10.00 to $11.99         |       | 2,140,594                                          |       | 7.84                                                        |       | $                                      | 10.70      |   | 2,140,594 |   | $ | 10.70 |   |
| $12.00 to $14.99         |       | 2,621,248                                          |       | 7.00                                                        |       | $                                      | 12.95      |   | 2,203,421 |   | $ | 12.82 |   |
| $15.00 to $19.99         |       | 3,558,882                                          |       | 7.84                                                        |       | $                                      | 17.09      |   | 2,907,845 |   | $ | 17.13 |   |
| $20.00 to $25.99         |       | 2,445,616                                          |       | 7.02                                                        |       | $                                      | 23.83      |   | 2,357,736 |   | $ | 23.83 |   |
| $26.00 to $46.53         |       | 978,529                                            |       | 4.71                                                        |       | $                                      | 28.19      |   | 978,513 |   | $ | 28.19 |   |
| Total                    |       | 12,955,585                                         |       | 7.05                                                        |       | $                                      | 16.32      |   | 11,544,582 |   | $ | 16.55 |   |

 

*1995 Employee Stock Purchase Plan*

 

The Company’s 1995 Employee Stock Purchase Plan (“ESPP”) was adopted bythe Company’s Board of Directors in October 1995, and approved by itsstockholders in December 1995.  TheESPP enables employees to purchase shares through payroll deductions atapproximately 85% of the lesser of the fair value of Common Stock at thebeginning of a 24-month offering period or the end of each six-month segmentwithin such offering period.  The ESPP isintended to qualify as an “employee stock purchase plan” under Section 423of the U.S. Internal Revenue Code. During the years ended December 31, 2005 and 2004, 488,313 and344,927 shares were purchased by employees under the terms of the planagreements at a weighted average price of $8.90 and $10.52 per share,respectively.  At December 31, 2005,1,574,596 shares were reserved and available for issuance under this plan.

 

The weighted average grant date fair value of options granted duringthe year ended December 31, 2005, 2004 and 2003 as defined bySFAS 123, was $6.62, $11.08, and $15.97 per share, respectively.

 

60

----

 

**ZORAN CORPORATION**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)**

 

For purposes of the disclosure in Note 2 and as required underStatement of Financial Accounting Standards No. 123 (“SFAS 123”), “Accountingfor Stock-Based Compensation,” the fair value of each option grant on thedate of grant is estimated using the Black-Scholes model with the followingassumptions used for options during the applicable period.

 
| ** **              | ** ** | **Stock Option Plans** | ** ** | **Stock Purchase Plan** | ** ** |
|-------------------------|------------|----------------------------------|------------|-----------------------------------|------------|
| ** **              | ** ** | **2005**                         | ** ** | **2004**                          | ** ** | **2003** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| Dividend rate           |       | —                           |       | —                            |       | — |   | — |   | — |   | — |   |
| Expected life (years)   |       | 3.9                              |       | 5.1                               |       | 5.0 |   | 0.5 |   | 0.5 |   | 0.5 |   |
| Expected volatility     |       | 68                               | %          | 75                                | %          | 90 | % | 46 | % | 59 | % | 90 | % |
| Risk-free interest rate |       | 3.8% to 4.4                      | %          | 3.0% to 3.7                       | %          | 2.9% to 3.2 | % | 2.9% to 4.3 | % | 1.0% to 2.3 | % | 1.0% to 2.9 | % |

 

 

On January 6, 2006, theCompany filed a Tender Offer Statement with the Securities and ExchangeCommission and commenced an offer to current employees to exchange outstandingoptions with exercise prices per share that were more than the greater of$20.00 and the closing sale price of Zoran common stock on the offer expirationdate of February 6, 2006. The exchange offer was approved by Zoran’sstockholders at their 2005 annual meeting. On February 6, 2006, the Companyaccepted for exchange options to purchase aggregate of 1,060,536 shares of Zorancommon stock. Subject to the terms and conditions of the exchange, the Companygranted 197,433 restricted shares of common stock or restricted stock units inexchange for the tendered options.  Theshares of restricted stock and restricted stock units granted will vest overperiods of two to four years, depending on the remaining vesting periods of theoptions exchanged. None of the directors or executive officers was eligible forparticipation in the exchange offer.

 

**NOTE 11—RETIREMENT PLAN**

 

We maintain a 401(k) Plan that covers substantially all of the Company’sUS employees.  Participants may elect tocontribute a percentage of their compensation to this plan, up to the statutorymaximum amount prescribed by the Internal Revenue Code.  The Company has the ability to make adiscretionary matching contribution to the 401(k) Plan based on a uniformpercentage of the employee’s eligible contribution up to a maximum employermatch of $2,000 per year per employee. Approximately $235,000, $384,000 and $434,000 in matching contributionswere recorded during 2005, 2004 and 2003, respectively.

 

**NOTE 12—EARNINGSPER SHARE**

 

The following is a reconciliationof the numerators and denominators of the basic and diluted net loss per sharecomputations for the periods presented (in thousands except per share amounts):

 
| ** **                       | ** ** | **Year ended December 31,** | ** ** |
|----------------------------------|------------|--------------------------------------------|------------|
| ** **                       | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net loss                         |       | $                                          | (26,971    | ) | $ | (47,354 | ) | $ | (67,978 | ) |
|                             |       |                                       |       |   |   |   |   |
| Shares:                          |       |                                       |       |   |   |   |   |
| Weighted average common shares   |       | 44,267                                     |       | 42,788 |   | 33,231 |   |
| Dilutive potential common shares |       | 44,267                                     |       | 42,788 |   | 33,231 |   |
|                             |       |                                       |       |   |   |   |   |
| Net loss per share:              |       |                                       |       |   |   |   |   |
| Basic                            |       | $                                          | (0.61      | ) | $ | (1.11 | ) | $ | (2.05 | ) |
| Diluted                          |       | $                                          | (0.61      | ) | $ | (1.11 | ) | $ | (2.05 | ) |

 

For the years ended December31, 2005, 2004 and 2003, all outstanding options and restricted stock unitstotaling 13.0 million, 12.8 million and 13.7 million shares, respectively, wereexcluded from the calculation of diluted net loss per share as the Company wasin a net loss position and their inclusion would have been anti-dilutive.

 

61

----

 

**ZORAN CORPORATION**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)**

 

**NOTE 13—INCOMETAXES**

 

The components of loss beforeincome taxes are as follows (in thousands) :

 
| ** ** | ** ** | **December 31,** | ** ** |
|------------|------------|-----------------------|------------|
| ** ** | ** ** | **2005**              | ** ** | **2004** | ** ** | **2003** | ** ** |
| Current:   |       |                  |       |   |   |   |   |
| Federal    |       | $                     | (46,685    | ) | $ | (35,106 | ) | $ | (73,779 | ) |
| Foreign    |       | 21,878                |       | (10,708 | ) | 7,164 |   |
|       |       | $                     | (24,807    | ) | $ | (45,814 | ) | $ | (66,615 | ) |

 

The components of the provision for income taxes are as follows:

 
| ** **               | ** ** | **December 31,** | ** ** |
|--------------------------|------------|-----------------------|------------|
| ** **               | ** ** | **2005**              | ** ** | **2004** | ** ** | **2003** | ** ** |
| Current:                 |       |                  |       |   |   |   |   |
| Federal                  |       | $                     | 709        |   | $ | (694 | ) | $ | 444 |   |
| State                    |       | (202                  | )          | — |   | 370 |   |
| Foreign                  |       | 1,657                 |       | 2,234 |   | 549 |   |
|                     |       | 2,164                 |       | 1,540 |   | 1,363 |   |
| Deferred                 |       | —                |       | — |   | — |   |
| Total income tax expense |       | $                     | 2,164      |   | $ | 1,540 |   | $ | 1,363 |   |

 

The tax provision differs from the amounts obtained by applying thestatutory U.S.  Federal Income Tax Rateto income taxes as shown below.

 

*Tax provision difference*

 
| ** **                          | ** ** | **December 31,** | ** ** |
|-------------------------------------|------------|-----------------------|------------|
| ** **                          | ** ** | **2005**              | ** ** | **2004** | ** ** | **2003** | ** ** |
| Tax benefit at U.S. statutory rate  |       | $                     | (8,434     | ) | $ | (15,577 | ) | $ | (22,656 | ) |
| Foreign earnings                    |       | (5,769                | )          | 3,240 |   | (1,887 | ) |
| State taxes net of federal benefit  |       | 91                    |       | — |   | 370 |   |
| Other differences not benefited     |       | 15,323                |       | 15,198 |   | 7,522 |   |
| Permanent differences               |       | 52                    |       | 59 |   | 33 |   |
| In-process research and development |       | 901                   |       | — |   | 17,034 |   |
| Research and development credits    |       | —                |       | (1,380 | ) | (831 | ) |
| Other                               |       | —                |       | — |   | 1,778 |   |
| Total income tax expense            |       | $                     | 2,164      |   | $ | 1,540 |   | $ | 1,363 |   |

 

Deferred income tax assets comprise the following:

 
| ** **                                          | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------|------------|-----------------------|------------|
| ** **                                          | ** ** | **2005**              | ** ** | **2004** | ** ** | **2003** | ** ** |
| Deferred tax assets:                                |       |                  |       |   |   |   |   |
| Federal and state net operating loss  carryforwards |       | $                     | 98,716     |   | $ | 100,443 |   | $ | 96,161 |   |
| Tax credits                                         |       | 30,896                |       | 33,570 |   | 30,208 |   |
| Nondeductible reserves and accruals                 |       | 12,005                |       | 9,212 |   | 12,180 |   |
| Total deferred tax assets                           |       | 141,617               |       | 143,225 |   | 138,549 |   |
| Deferred tax  liabilities:                          |       |                  |       |   |   |   |   |
| Intangible assets                                   |       | (38,727               | )          | (46,904 | ) | (61,971 | ) |
| Deferred tax assets                                 |       | 102,890               |       | 96,321 |   | 76,578 |   |
| Valuation allowance                                 |       | (102,890              | )          | (96,321 | ) | (76,578 | ) |
|                                                |       |                  |       |   |   |   |   |
| Net deferred tax assets                             |       | $                     | —     |   | $ | — |   | $ | — |   |

 

62

----

 

**ZORAN CORPORATION**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)**

 

A significant portion of the deferred tax asset above relates topre-acquisition loss carryforwards and other attributes along with stock optionbenefits that will result in an adjustment to goodwill and paid in capital whenrealized. During 2005, the Company realized $1.2 million related to certainpre-acquisition tax net operating losses. Realization of these net operatinglosses is reported as an adjustment to goodwill in accordance with FAS 109.

 

As of December 31, 2005, the Company had NOLs of approximately$268 million for federal and $85 million for state tax reporting purposes.  The federal NOLs expire on various datesbetween 2006 and 2025.  The state NOLsexpire between 2006 and 2015.  As ofDecember 31, 2005 the Company had tax credits of approximately $19 million forfederal and $11 million for state tax purposes, which will expire beginning in2006.  Management has recorded a fullvaluation allowance against all U.S. deferred tax assets on the basis thatsignificant uncertainty exists regarding the realizeability of the assets.  Approximately $18 million of NOLs relate tostock option deductions, for which a full valuation allowance has beenrecorded.

 

As of December 31, 2005, the Company had not accrued income taxes on$38.1 million of accumulated undistributed earnings of its foreign subsidiariesbecause the earnings are intended to be reinvested indefinitely.

 

The calculation of the Company’s tax liabilities involves dealing withuncertainties in the application of complex tax regulations.  The Company records liabilities foranticipated tax audit issues on its estimate of whether, and the extent towhich, additional taxes may be due. Actual tax liabilities may be differentthan the recorded estimates and could result in an additional charge or benefitto the tax provision in the period when the ultimate tax assessment isdetermined.

 

Pursuant to the Tax Reform Act of 1986, the amounts of and the benefitfrom NOLs that can be carried forward may be impaired or limited in certaincircumstances, including a cumulative stock ownership change of more than 50%over a three-year period.  Approximately$214 million of the federal NOL carryover and $75 million of state NOLcarryover relate to recent acquisitions and are subject to certain limitationsunder Internal Revenue Code Section 382.

 

The Company’s Israeli subsidiary has been granted the status of anApproved Enterprise pursuant to the Israeli law for the Encouragement ofCapital Investments, 1959, as amended. The Company has eight approved programs pursuant to this law.  The first program was approved in 1984 andexpired in 1998.  The second program wasapproved in 1991.  Income subject to thisprogram is exempt from tax for two years from the first year in which theCompany has taxable income (net of NOLs) and is taxed at a rate of 10% for theeight years thereafter.  Benefits underthe second program expired in 2004.  Thethird program was approved in 1995. Income subject to this program is exempt from tax for four years fromthe first year in which the Company has taxable income (net of NOLs) and is taxedat a rate of 10% during the remaining period of six years.  The fourth program was approved in 1997.  Income subject to this program is exempt fromtax for two years from the first year in which the Company has taxable income(net of NOLs) and is taxed at a rate of 10% during the remaining period ofeight years.  The fifth program wasapproved in 2000.  Income subject to thisprogram is exempt from tax for two years from the first year in which theCompany has taxable income (net of NOLs) and is taxed at a rate of 10% duringthe remaining period of six years.  Thesixth program was approved in 2001. Income subject to this program is exempt from tax for two years from thefirst year in which the Company has taxable income (net of NOLs) and is taxedat a rate of 10% during the remaining period of seven years.  The seventh program was approved in2002.  Income subject to the seventhprogram is exempt from tax for two years from the first year in which theCompany has taxable income (net of NOLs) and is taxed at a rate of 10% duringthe remaining period of eight years. The eighth program was approved in2004.  Income subject to the eighthprogram is exempt from tax for two years from the first year in which theCompany has taxable income (net of NOLs) and is taxed at a rate of 10% duringthe remaining period of eight years. Benefits under the programs are granted for a period of ten yearslimited to the early of fourteen years from application; twelve years fromcommencement of production.. Benefits for the eighth program will expire on2014.

 

The benefit of these Approved Enterprise programs to the Company’s netloss in 2005 was $5.7 million.  These taxholidays had no impact to the Company’s net loss in 2004 and resulted in abenefit of $1.8 million in 2003.

 

**NOTE 14—SEGMENT REPORTING**

 

SFAS No. 131 establishes standards for thereporting by public business enterprises of information about operatingsegments, products and services, geographic areas, and major customers.  The method for determining what informationto report is based on the way that management organizes the operating segmentswithin the Company for making operational decisions and assessments offinancial performance.  The Company’schief operating decision-maker is considered to be the Chief Executive Officer.

 

Subsequent to the acquisition of OakTechnology, Inc. in 2003, the Company determined it had four reportablesegments: Digital Versatile Disc (DVD), Imaging, Digital Camera (DC) andDigital Television (DTV).  Subsequent tothe Emblaze acquisition in July 2004, the Digital Camera segment was combinedwith the Emblaze Mobile business unit and was renamed the Mobile segment.  Each segment’s primary products are based onhighly integrated application-specific integrated circuits, or ASICs, and system-on-a-chip,or 

 

63

----

 

**ZORAN CORPORATION**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)**

 

SOC, solutions.  The DVD and Imaging segments also licensecertain software and other intellectual property.  The DVD group provides products for use inDVD players and recordable DVD players. The Imaging group provides products used in digital copiers, laser andinkjet printers as well as multifunction peripherals.  The Mobile group focuses on solutions for multimediamobile phone products and digital camera products.  The DTV group provides products for standardand high definition digital television products including televisions, set topboxes and personal video recorders.

 

The Company evaluates operating segmentperformance based on net revenues and operating expenses of thesesegments.  The accounting policies of theoperating segments are the same as those described in the summary of accountingpolicies.  No reportable segments havebeen aggregated.

 

Information about reportedsegment income or loss is as follows for the years ended December 31,2005, 2004 and 2003 (in thousands):

 
| ** **           | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------|------------|----------|------------|----------|------------|----------|------------|
| Net revenues:        |       |     |       |     |       |     |       |
| DVD                  |       | $        | 150,192    |     | $          | 229,227  |       | $ | 158,682 |   |
| Imaging              |       | 85,063   |       | 84,368   |       | 14,711   |       |
| Mobile               |       | 109,574  |       | 36,104   |       | 29,227   |       |
| DTV                  |       | 50,929   |       | 29,165   |       | 13,908   |       |
|                 |       | $        | 395,758    |     | $          | 378,864  |       | $ | 216,528 |   |
|                 |       |     |       |     |       |     |       |
| Operating expenses:  |       |     |       |     |       |     |       |
| DVD                  |       | $        | 156,763    |     | $          | 231,438  |       | $ | 142,671 |   |
| Imaging              |       | 57,983   |       | 51,242   |       | 17,746   |       |
| Mobile               |       | 84,399   |       | 42,039   |       | 27,622   |       |
| DTV                  |       | 69,263   |       | 50,847   |       | 23,793   |       |
|                 |       |     |       |     |       |     |       |
|                 |       | $        | 368,408    |     | $          | 375,566  |       | $ | 211,832 |   |
|                 |       |     |       |     |       |     |       |
| Contribution Margin: |       |     |       |     |       |     |       |
| DVD                  |       | $        | (6,571     | )        | $          | (2,211   | )          | $ | 16,011 |   |
| Imaging              |       | 27,080   |       | 33,126   |       | (3,035   | )          |
| Mobile               |       | 25,175   |       | (5,935   | )          | 1,605    |       |
| DTV                  |       | (18,334  | )          | (21,682  | )          | (9,885   | )          |
|                 |       | $        | 27,350     |     | $          | 3,298    |       | $ | 4,696 |   |

 

The following is a reconciliation of the totals reported for theoperating segments to the applicable line items in the consolidated financialstatements for the years ended December 31, 2005, 2004 and 2003 (inthousands):

 
| ** **                                    | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Contribution margin from operating segments   |       | $        | 27,350     |     | $          | 3,298    |       | $ | 4,696 |   |
| Amortization of intangibles                   |       | (50,254  | )          | (45,358  | )          | (18,950  | )          |
| Acquisition related expenses                  |       | —   |       | —   |       | (1,369   | )          |
| Deferred stock compensation                   |       | (1,546   | )          | (4,051   | )          | (6,281   | )          |
| Restructuring expense                         |       | —   |       | (746     | )          | —   |       |
| Acquired in-process research and  development |       | (2,650   | )          | —   |       | (50,100  | )          |
| Total operating loss                          |       | $        | (27,100    | )        | $          | (46,857  | )          | $ | (72,004 | ) |

 

Zoran maintains operations in the Canada, China, Germany, Israel,Japan, Korea, Taiwan, the United Kingdom and United States.  Activities in the Israel and United Statesconsist of corporate administration, product development, logistics andworldwide sales management.  Otherforeign operations consist of sales, product development and technical support.

 

64

----

 

**ZORAN CORPORATION**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)**

 

The distribution of netrevenues for the years ended December 31, 2005, 2004 and 2003 was asfollows (in thousands):

 
| ** **                                                                  | ** ** | **Year ended December 31,** | ** ** |
|-----------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                  | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Revenue from unaffiliated customers  originating from:**                  |       |                                       |       |   |   |   |   |
| China                                                                       |       | $                                          | 156,737    |   | $ | 150,562 |   | $ | 78,542 |   |
| Japan                                                                       |       | 111,370                                    |       | 101,792 |   | 48,872 |   |
| Korea                                                                       |       | 24,865                                     |       | 28,353 |   | 40,751 |   |
| Taiwan                                                                      |       | 51,900                                     |       | 36,631 |   | 24,577 |   |
| Other (Customers originating in the US is  less than 10% of total revenues) |       | 50,886                                     |       | 61,526 |   | 23,786 |   |
|                                                                        |       | $                                          | 395,758    |   | $ | 378,864 |   | $ | 216,528 |   |

 

The distribution ofidentifiable assets by geographic areas and property and equipment as ofDecember 31, 2005 and 2004 was as follows (in thousands):

 
| ** **                       | ** ** | **December 31,** | ** **    |
|----------------------------------|------------|-----------------------|---------------|
| ** **                       | ** ** | **2005**              | ** **    | **2004** | ** ** |
| **Identifiable assets:**         |       |                  |          |   |   |
| U.S.                             |       | $                     | 478,256       |   | $ | 465,192 |   |
| Israel                           |       | 117,736               |          | 125,506 |   |
| Japan                            |       | 2,722                 |          | 2,068 |   |
| China                            |       | 2,399                 |          | 1,057 |   |
| United Kingdom                   |       | 689                   |          | 1,220 |   |
| Taiwan                           |       | 318                   |          | 3,454 |   |
| Canada                           |       | 266                   |          | 233 |   |
| Korea                            |       | 186                   |          | 211 |   |
| Other                            |       | 1,651                 |          | 340 |   |
|                             |       | $                     |  604,223 |   | $ |  599,281 |   |
|                             |       |                  |          |   |   |   |   |
| **Property and equipment, net:** |       |                  |          |   |   |
| ** **                       |       |                  |          |   |   |
| U.S.                             |       | $                     | 7,569         |   | $ | 9,785 |   |
| Israel                           |       | 4,940                 |          | 5,486 |   |
| China                            |       | 1,388                 |          | 554 |   |
| Japan                            |       | 685                   |          | 529 |   |
| United Kingdom                   |       | 318                   |          | 415 |   |
| Taiwan                           |       | 229                   |          | 199 |   |
| Canada                           |       | 158                   |          | 37 |   |
| Korea                            |       | 73                    |          | 96 |   |
| Other                            |       | 697                   |          | 89 |   |
|                             |       | $                     |  16,057  |   | $ |  17,190 |   |
|                                  |            |                       |               |  |  |  |  |  |  |

 

The following table summarizesthe percentage contribution to net revenues by customers when sales to suchcustomers exceeded 10% of net revenues:

 
| ** **                      | ** ** | **Year ended December 31,** | ** ** |
|---------------------------------|------------|--------------------------------------------|------------|
| ** **                      | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Percentage of net revenues:** |       |                                       |       |   |   |   |   |
| A                               |       | —                                     |       | — |   | 14 | % |
| B                               |       | —                                     |       | 11 | % | 17 | % |

 

None of the above customers had accountsreceivable balances greater than 10% as of the end of 2005 and 2004.

 

65

----

 

**ZORAN CORPORATION**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)**

 

**NOTE15—ACQUISITIONS**

 

**Oren Semiconductor, Inc.**

 

OnJune 10, 2005, Zoran completed the acquisition of OrenSemiconductor, Inc. (“Oren”), a privately-held provider of demodulator ICsfor the global high definition television market.  Prior to this acquisition, Zoran had madeinvestments in Oren that represented a 17% ownership interest.  Under the terms of the acquisition agreement,Zoran acquired the remaining 83% of Oren’s outstanding stock by means of amerger of Oren with a wholly-owned subsidiary of Zoran, in consideration forwhich Zoran paid an aggregate of $28.4 million in cash and issued 1,188,061shares of Zoran common stock valued at $12.9 million, for totalconsideration of $41.3 million, to the other stockholders of Oren and toemployees holding Oren options.  TheCompany considered the requirements under

 

AccountingPrinciples Board Opinions 18 (“APB 18”), “The Equity Method of Accounting forInvestments in Common Stock,” to retroactively record the gains or losses oninvestment of the prior 17% ownership under the equity basis.  Based on the Company’s analysis, suchadjustments were considered to be immaterial to the prior financial results ofthe Company and, accordingly, such adjustments are not reflected in the Company’spreviously reported results of operations.

 

Theprimary purpose of the acquisition was to obtain Oren’s demodulator IC technology for the global highdefinition television market.  The Company intends to combine thistechnology with Zoran’s digital television technology to deliver a complete andcost-effective system solution for digital television makers.

 

Thetransaction was accounted for under SFAS No. 141, “Business Combinations,”using the purchase method of accounting. The Company incurred approximately $375,000 for acquisition-relatedexpenses consisting of financial advisory, legal and other consulting services.  The Company completed a valuation analysisand purchase price allocation. The results of operations of Oren have beenincluded in the consolidated financial statements from the date of acquisition.The acquisition resulted in goodwill of approximately $35.3 million. Inaccordance with SFAS 142, “Goodwill and Other Intangible Assets”, goodwillwill not be amortized and will be tested for impairment at least annually.  The Company does not expect goodwill to bedeductible for tax purposes.

 

Allocation of thepurchase price is as follows (in thousands):

 
| Net liabilities acquired            |   | $      | (941   | )      |
|-------------------------------------|--------|--------|--------|--------|
| In process research and development |   | 2,650  |   |
| Intangible assets                   |   | 9,100  |   |
| Goodwill                            |   | 35,305 |   |
|                                |   | $      | 46,114 |   |

 

Tangibleassets were valued at estimates of their current fair values.  The purchase price exceeded the net assetsacquired resulting in the recognition of goodwill and other intangibleassets.  The amounts allocated tointangible assets include purchased technology totaling $7.0 million, tradename and other intangible assets totaling $1.25 million and customer basetotaling $850,000 which are being amortized over their estimated useful livesof five years.

 

Approximately$2.7 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 upon the acquisition date.  This amount was determined using management’sestimates including consultation with an independent appraiser.  The value of the in-process research anddevelopment was determined using a discounted cash flow method and factorsincluding projected financial results, relative risk of successful development,time-value of money and level of completion.

 

**EmblazeSemiconductor Ltd.**

 

On July 8, 2004, Zoran acquired Emblaze SemiconductorLtd.  (“Emblaze”), a subsidiary ofEmblaze Ltd. and a provider of semiconductor-based solutions for high volumemanufacturers of multimedia mobile telephones. Under the terms of the agreement, Zoran’s wholly-owned Israel basedsubsidiary, Zoran Microelectronics Ltd., acquired all of the outstanding commonshares of Emblaze for approximately $54.2 million in cash.

 

Theprimary purpose of the acquisition was to gain high performance, low-powerapplication processors, technology and products for the fast growing multimediamobile phone market.  This technology wascombined with Zoran’s image processing technology to deliver reliable,cost-effective system solutions for mobile phone makers. As of December 31, 2005, there have been nomaterial variations from the underlying assumptions that were used in theoriginal computation of the value of the acquired entity.

 

66

----

 

**ZORAN CORPORATION**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)**

 

Thetransaction was accounted for under SFAS No. 141, “Business Combinations,”using the purchase method of accounting. The Company incurred approximately $180,000 for acquisition-relatedexpenses consisting of financial advisory, legal and other consultingservices.  The Company completed avaluation analysis and purchase price allocation with the assistance of a thirdparty appraiser.  The results ofoperations of Emblaze have been included in the consolidated financialstatements from the date of acquisition. The acquisition resulted in goodwill of approximately$30.9 million.  In accordance withSFAS 142, “Goodwill and Other Intangible Assets”, goodwill will not beamortized and will be tested for impairment at least annually.  The Company does not expect goodwill to bedeductible for tax purposes.

 

Allocation of the purchase price is as follows (inthousands):

 
| Net liabilities acquired |   | $      | (649   | )      |
|--------------------------|--------|--------|--------|--------|
| Intangible assets        |   | 24,150 |   |
| Goodwill                 |   | 30,879 |   |
|                     |   | $      | 54,380 |   |

 

Thepurchase price exceeded the net assets acquired resulting in the recognition ofgoodwill and other intangible assets. The amounts allocated to intangible assets include purchased technologytotaling $11.8 million and patents totaling $12.4 million which are beingamortized over their estimated useful lives of three years.

 

**Oak Technology, Inc.**

 

OnAugust 11, 2003, pursuant to an Agreement and Plan of Reorganization datedas of May 4, 2003 (the “Merger Agreement”) among Zoran, a wholly-ownedsubsidiary of Zoran (“Merger Sub”), and Oak Technology, Inc., Oak wasmerged with and into Merger Sub.

 

Thetransaction was accounted for under SFAS No. 141, “Business Combinations,” using the purchase method of accountingand accordingly the results of operations of Oak have been included in theCompany’s financial statements since the date of acquisition.

 

TheCompany’s primary objectives in acquiring Oak were based on the Company’sbelief that the combined company would benefit from the following:

 

•                  Oak’s complementary technologies andproducts, especially in the digital TV and digital imaging markets, and theability of the combined company to expand its existing customer base and marketshare in the digital consumer electronics market by integrating the productlines of each company;

 

•                  Oak’s intellectual property portfolio andrelated expertise, especially intellectual property relating to front-endoptical recording;

 

•                  access to Oak’s customer relationships,providing cross-selling opportunities to existing customers as well asopportunities to build new relationships;

 

•                  the opportunity to achieve synergies andrealize significant cost savings, including operational efficiencies, such asacceleration of various product development activities by leveraging Oak’sintellectual property, reduced overhead and, in geographic areas where the twocompanies overlap, increased efficiency in the combined company’s saleschannels;

 

•                  Oak’s existing market position as a leadingsupplier of HDTV integrated circuits, providing the combined company withaccess to this high-growth market segment; and

 

•                  Oak’s existing market position as a leadingsupplier of Digital Imaging related integrated circuit and software products.

 

Thepurchase price exceeded the net assets acquired resulting in the recognition ofgoodwill and other intangible assets.

 

67

----

 

**ZORAN CORPORATION**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)**

 

The financial statements reflect a purchaseprice of approximately $392.7 million, determined as follows (inthousands):

 
| 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 |   |

 

Thecash payment and fair value of common stock issued represents the conversion ofeach outstanding share of Oak common stock into $1.78 in cash and 0.2323 of ashare of Zoran common stock.  As a resultof the acquisition, 56,737,298 shares of Oak common stock were converted into$101.0 million in cash and 13,180,074 shares of Zoran common stock with afair value of $227.5 million based on the fair market value of Zorancommon stock for the period two days before and after the date on which theterms of agreement were finalized and announced, May 5, 2003.

 

Non-qualifiedoptions to purchase approximately 4.5 million shares of Zoran common stockwith a term of ten years were granted to Oak employees as part of theacquisition.  The corresponding fairvalue of these options of $57.4 million was estimated based on the fairvalue of the Zoran common stock as of the acquisition date using the Black-Scholesoption pricing model applying the following assumptions: expected life of50 months, risk-free interest rate of 3.65%, expected volatility of 93%and no expected dividend yield.  Theintrinsic value of the unvested options, totaling approximately$19.2 million, has been recorded as deferred stock compensation is beingamortized over the vesting period using the multiple option approach.

 

Acquisitioncosts included $3.3 million of investment banker fees, $1.7 millionof insurance costs, $1.1 million of legal and accounting fees and $700,000in other acquisition related expenses.

 

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

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

 

The following table summarizes the estimatedfair value of the tangible assets acquired and liabilities assumed at the dateof 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 |   |

 

Tangibleassets were valued at estimates of their current fair values.  The valuation of the acquired intangibleassets, which was based on management’s estimates and considered variousfactors including appraisals, resulted in a value of purchased technology ofapproximately $157.9 million, patents of $27.0 million, customer baseof $11.5 million and trademarks and tradenames of approximately$1.3 million.  Purchased technologyis being amortized over a weighted average estimated useful life of4.8 years, and patents, customer base, trademarks and tradenames are beingamortized over their estimated useful lives of five years with no residualvalues.

 

Duringthe period August 11, 2003 through March 31, 2004, management revised itsestimates related to certain assets and liabilities, and as a result, thepurchase price and goodwill were each decreased by $3.4 million. In 2005,goodwill was reduced by $1.2 million due to tax adjustments associated with theOak acquisition.

 

68

----

 

**ZORAN CORPORATION**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)**

 

Approximately$60.0 million of the purchase price was allocated to goodwill.  Goodwill represents the excess of thepurchase price over the fair value of the net tangible and identifiableintangible assets acquired.  Inaccordance with SFAS 142, “Goodwill and Other Intangible Assets”, goodwillwill not be amortized and will be tested for impairment at least annually.  The Company does not expect goodwill to bedeductible for tax purposes.

 

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

 

Atthe time of acquisition, Oak had five material development projects in processas follows:

 

•                  Quatro® 4100—a highly integrated, fully programmable system-on-a-chip (SOC)solution for the emerging class of appliance type printers.  The Quatro-4100 incorporates the RISC CPU coreand Quatro SIMD DSP core to provide an easy to program controller platform.

 

•                  Quatro® 4230—a programmable SOC solution that will complement the Quatro-4110and Quatro-4100 in the inkjet market. Quatro 4230 will provide a fully scalable solution platform to covermuch of the performance and feature range of an OEM’s laser offerings.

 

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

 

•                  Generation 9®—an integrated SOC that integrates a previous generation of HDTVdigital video technology with a new Audio-DSP Core as well as a MIPS 64 bitprocessor and certain other video processing features.

 

•                  A new lower cost highly integrated HDTVdecoder—the first in a family of highly integrated HDTV decoders specificallydesigned for the FCC mandated digital television chassis market.  This device includes all the requiredinterfacing to support digital cable applications and is applicable to existingCRT and flat panel display devices.

 

Thevalue of in-process research and development was determined using the multi-periodexcess earnings method by estimating the expected net cash flows from theprojects once commercially viable and discounting the net cash flows back totheir present value 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 developmentteam.  The net cash flows from theidentified projects were based on estimates of revenue, cost of revenue, researchand development expenses, selling general and administrative expenses, andapplicable income taxes.  These estimatesdid not take into account any potential synergies that could be realized as aresult of the acquisition.  Revenues forthe incremental core technologies commenced in 2005 and are expected to extendthrough 2011.  Revenue projections werebased on estimates of market size and growth, expected trends in technology andthe expected timing of new product introductions.  As of December 31, 2005, there have been nomaterial variations from the underlying assumptions that were used in theoriginal computation of the value of the acquired in-process research anddevelopment.

 

69

----

** **

**ZORAN CORPORATION**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)**

** **

**Pro FormaFinancial Information**

 

The following unaudited pro forma financialinformation presents the combined results of operations of Zoran, Oak, Emblazeand Oren as if the acquisitions had occurred as of the beginning of each periodpresented, after giving effect to certain adjustments, including amortizationof intangibles.  The in-process researchand development charge of $2.7 million related to the Oren acquisition and$50.1 million related to the Oak acquisition is not reflected in theunaudited pro forma combined condensed statement of operations.  The unaudited pro forma financial informationdoes not necessarily reflect the results of operations that would have occurredhad the combined companies constituted a single entity during such periods, andis not necessarily indicative of results which may be obtained in the future.

 
| ** **                                  | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                  | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                        |       |                                       |       |   |   |   |   |
| **In thousands except for per share data:** |       |                                       |       |   |   |   |   |
| Pro forma revenues                          |       | $                                          | 396,737    |   | $ | 383,131 |   | $ | 283,931 |   |
|                                        |       |                                       |       |   |   |   |   |
| Pro forma net loss                          |       | $                                          | (29,941    | ) | $ | (62,453 | ) | $ | (96,333 | ) |
|                                        |       |                                       |       |   |   |   |   |
| Pro forma net loss per share:               |       |                                       |       |   |   |   |   |
| Basic                                       |       | $                                          | (0.68      | ) | $ | (1.46 | ) | $ | (2.33 | ) |
|                                        |       |                                       |       |   |   |   |   |
| Diluted                                     |       | $                                          | (0.68      | ) | $ | (1.46 | ) | $ | (2.33 | ) |

 

70

----

** **

**ZORAN CORPORATION**

**SELECTED QUARTERLY FINANCIAL INFORMATION**

**(Unaudited)**

 

 
| ** **                                        | ** ** | **Three Months Ended**                                   | ** ** |
|---------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                        | ** ** | **Dec. 31,  2005**                                            | ** ** | **Sep 30,  2005** | ** ** | **Jun. 30,  2005** | ** ** | **Mar. 31,  2005** | ** ** | **Dec. 31,  2004** | ** ** | **Sep. 30,  2004  (restated)** | ** ** | **Jun. 30,  2004  (restated)** | ** ** | **Mar. 31,  2004  (restated)** | ** ** |
| ** **                                        | ** ** | **(In Thousands, Except Per Share Data)** | ** ** |
| Total revenues                                    |       | $                                                                  | 109,311    |   | $ | 117,484 |   | $ | 95,079 |   | $ | 73,884 |   | $ | 74,764 |   | $ | 119,747 |   | $ | 103,716 |   | $ | 80,637 |   |
| Gross profit                                      |       | $                                                                  | 59,622     |   | $ | 63,824 |   | $ | 49,843 |   | $ | 36,920 |   | $ | 19,252 |   | $ | 53,190 |   | $ | 44,878 |   | $ | 35,309 |   |
| Operating income (loss)                           |       | $                                                                  | (2,002     | ) | $ | 5,437 |   | $ | (11,334 | ) | $ | (19,201 | ) | $ | (32,374 | ) | $ | (501 | ) | $ | (3,658 | ) | $ | (10,324 | ) |
| Net income (loss)                                 |       | $                                                                  | (2,078     | ) | $ | 4,958 |   | $ | (11,055 | ) | $ | (18,796 | ) | $ | (30,130 | ) | $ | (2,639 | ) | $ | (4,600 | ) | $ | (9,985 | ) |
| Basic net income (loss) per share(1)              |       | $                                                                  | (0.05      | ) | $ | 0.11 |   | $ | (0.25 | ) | $ | (0.43 | ) | $ | (0.70 | ) | $ | (0.06 | ) | $ | (0.11 | ) | $ | (0.23 | ) |
| Diluted net income (loss) per share(1)            |       | $                                                                  | (0.05      | ) | $ | 0.11 |   | $ | (0.25 | ) | $ | (0.43 | ) | $ | (0.70 | ) | $ | (0.06 | ) | $ | (0.11 | ) | $ | (0.23 | ) |
| Shares used in basic per share  calculations(1)   |       | 45,249                                                             |       | 44,877 |   | 43,707 |   | 43,213 |   | 43,212 |   | 42,969 |   | 42,697 |   | 42,522 |   |
| Shares used in diluted per share  calculations(1) |       | 45,249                                                             |       | 46,622 |   | 43,707 |   | 43,213 |   | 43,212 |   | 42,969 |   | 42,697 |   | 42,522 |   |

 

----

(1)   Computed on the basis described inNote 2 of Notes to Consolidated Financial Statements.

 

**Restatementof Financial Results for Quarters Ended March 31, June 30 and September 30,2004**

 

The selected quarterlyfinancial information above reflects the restatement of the quarters endedMarch 31, 2004, June 30, 2004 and September 30, 2004 to correct an error in thecalculation of deferred stock compensation expense.  Following the acquisition of Oak, the Companyfailed to update its personnel and financial records to reflect the forfeitureof unvested options held by former Oak employees that occurred when theemployment of any such employee terminated prior to vesting.  As a result, the Company improperlyrecognized deferred stock compensation expenses relating to options that hadbeen held by former Oak employees after the vesting of such options had ceaseddue to termination of employment and did not reverse stock based compensationexpense previously recognized for unvested awards that were forfeited.  For the quarters ended March 31, 2004, June30, 2004 and September 30, 2004, the previously recorded deferred stockcompensation expense was reduced by $704,000, $1,545,000 and $880,000,respectively, as a result of the restatement. The financial information includedon Form 10-Q and Form 8-K reports previously filed or furnished by Zoran forthese periods should not be relied upon and are superceded by the followinginformation.

 

The following table showsthe effect of the restatement:

 
| ** **                          | ** ** | **Three Months Ended**                                   | ** ** |
|-------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                          | ** ** | **March 31, 2004**                                       | ** ** | **June 30, 2004** | ** ** | **September 30, 2004** | ** ** |
| ** **                          | ** ** | **As reported**                                               | ** ** | **As restated** | ** ** | **As reported** | ** ** | **As restated** | ** ** | **As reported** | ** ** | **As restated** | ** ** |
| ** **                          | ** ** | **(In Thousands, Except Per Share Data)** | ** ** |
| ** **                          | ** ** | ** **                                                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Deferred stock compensation expense |       | $                                                                  | 2,531      |   | $ | 1,827 |   | $ | 2,117 |   | $ | 572 |   | $ | 1,790 |   | $ | 910 |   |
| Operating loss                      |       | $                                                                  | (11,028    | ) | $ | (10,324 | ) | $ | (5,203 | ) | $ | (3,658 | ) | $ | (1,381 | ) | $ | (501 | ) |
| Net loss                            |       | $                                                                  | (10,689    | ) | $ | (9,985 | ) | $ | (6,145 | ) | $ | (4,600 | ) | $ | (3,519 | ) | $ | (2,639 | ) |
| Basic net loss per share            |       | $                                                                  | (0.25      | ) | $ | (0.23 | ) | $ | (0.14 | ) | $ | (0.11 | ) | $ | (0.08 | ) | $ | (0.06 | ) |
| Diluted net loss per share          |       | $                                                                  | (0.25      | ) | $ | (0.23 | ) | $ | (0.14 | ) | $ | (0.11 | ) | $ | (0.08 | ) | $ | (0.06 | ) |

 

71

----

 

**Item 9—Changes in and Disagreements withAccountants on Accounting and Financial Disclosure**

 

Not applicable.

 

**Item 9A—****Controls and Procedures**

 

**ConclusionRegarding the Effectiveness of Disclosure Controls and Procedures**

 

Under the supervision and with theparticipation of our management, including our principal executive officer andprincipal financial officer, we conducted an evaluation of our disclosurecontrols and procedures, as such term is defined under Rule 13a-15(e)promulgated under the Securities Exchange Act of 1934, as amended (the “ExchangeAct”).   Based on our evaluation, our principal executive officer and ourprincipal financial officer concluded that our disclosure controls andprocedures were effective as of the end of the period covered by this annualreport.

 

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

 

Our management is responsible forestablishing and maintaining adequate internal control over financialreporting. Internal control over financial reporting is a process designed by,or under the supervision of, our Chief Executive Officer and Chief FinancialOfficer, and effected by our board of directors, management and otherpersonnel, to provide reasonable assurance regarding the reliability offinancial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles (“GAAP”),and includes those policies and procedures that:

 

(1)                                  pertain to the maintenance of records that inreasonable detail accurately and fairly reflect the transactions anddispositions of the assets of Zoran;

 

(2)                                  provide reasonable assurance thattransactions are recorded as necessary to permit preparation of financialstatements in accordance with GAAP, and that our receipts and expenditures arebeing made only in accordance with authorizations of our management anddirectors; and

 

(3)                                  provide reasonable assurance regardingprevention or timely detection of unauthorized acquisition, use or dispositionof our assets that could have a material effect on our financial statements.

 

Because of its inherent limitations, internalcontrol over financial reporting may not prevent or detect misstatements.  Also, projections of any evaluation ofeffectiveness to future periods are subject to the risk that controls maybecome inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.

 

Under the supervision and with theparticipation of our management, including our principal executive officer andprincipal financial officer, we conducted an evaluation of the effectiveness ofour internal control over financial reporting based on the framework in *Internal Control - Integrated Framework*issuedby the Committee of Sponsoring Organizations of the Treadway Commission.  Based on our evaluation under the frameworkin *Internal Control — Integrated Framework*,our management concluded that our internal control over financial reporting waseffective as of December 31, 2005.

 

Our management’s assessment of theeffectiveness of our internal control over financial reporting as ofDecember 31, 2005 has been audited by PricewaterhouseCoopers LLP, anindependent registered public accounting firm, as stated in their report whichis included herein.

 

**Changes toInternal Control Over Financial Reporting**

 

Therewere no changes in our internal controls over financial reporting during thequarter ended December 31, 2005 that have materially affected****orare reasonably likely to materially affect our internal controls over financialreporting.

 

**Item 9B –Other Information**

 

Not applicable.

 

72

----

 

**PART III**

 

Certain information required by Part III is omitted from thisreport in that the Company intends to file its definitive proxy statementpursuant to Regulation 14A (the “Proxy Statement”) not later than120 days after the end of the fiscal year covered by this report andcertain information therein is incorporated herein by reference.

 

**Item 10—Directors and Executive Officers ofthe Registrant**

 

The information required by this Item is incorporated by reference toinformation set forth in the Proxy Statement under the heading “Proposal No.1—Election of Directors” and in Part I of this Report under the heading “ExecutiveOfficers of the Registrant.”

 

The information required by this Item with respect to compliance withSection 16(a) of the Securities Exchange Act of 1934 is incorporated byreference to information set forth in the Proxy Statement under the heading “Section 16(a)Beneficial Ownership Reporting Compliance.”

 

Theinformation required by this Item with respect to our code of ethics isincorporated by reference to information set forth in the Proxy Statement underthe heading “Proposal No. 1—Election of Directors – Committee Chartersand other Corporate Governance Materials.”

 

**Item 11—Executive Compensation**

 

The information required by this Item is incorporated by reference toinformation set forth in the Proxy Statement under the heading “ExecutiveCompensation and Other Matters”

 

**Item 12—Security Ownership of CertainBeneficial Owners and Management and Related Stockholder Matters**

 

The information required by this Item is incorporated by reference toinformation set forth in the Proxy Statement under the headings “PrincipalStockholders and Stock Ownership by Management” and “Equity Compensation PlanInformation.”

 

**Item 13—Certain Relationships and RelatedTransactions**

 

The information required by this Item is incorporated by reference toinformation set forth in the Proxy Statement under the heading “ExecutiveCompensation and other Matters.”

 

**Item 14—Principal Accounting Fees andServices**

 

The information required by this Item is incorporated by reference toinformation set forth in the proxy statement under the heading “Proposal No. 6– Ratification of Appointment of Independent Registered Public Accounting Firm.”

 

73

----

 

**PART IV**

 

**Item 15—Exhibits and Financial StatementSchedules**

 

The following documents are filed as a partof this report:

 
| (1)    |   | Financial Statements:                                                                                                                                                                                                                   |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   | See Index to Consolidated Financial Statements at page 41 of this  report.                                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                    |
| (2)    |   | Financial Statement Schedules:                                                                                                                                                                                                          |
|   |   | All financial statement schedules are omitted because they are not  applicable or not required, or because the required information is included  in the Consolidated Financial Statements and Notes thereto which are included  herein. |
| (3)    |   | Exhibits:                                                                                                                                                                                                                               |
|   |   | The exhibits listed on the accompanying Exhibit Index are filed as  part of, or are incorporated by reference into, this report.                                                                                                        |

 

74

----

 

**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) of theSecurities Exchange Act of 1934, the registrant has duly caused this report tobe signed on its behalf by the undersigned, thereunto duly authorized.

 
| Dated: March 14, 2006 | ZORAN CORPORATION |
|-----------------------|-------------------|
|                  |              |   |
|                  | By:               | /s/ Levy Gerzberg |
|                  |              | Levy Gerzberg,

President and Chief Executive Officer |

 

Pursuant to the requirements of the Securities Exchange Act of 1934,this report has been signed by the following persons on behalf of theregistrant and in the capacities and on the dates indicated.

 
| **Signature**          | ** ** | **Title**                                                  | ** ** | **Date**       |
|------------------------|------------|------------------------------------------------------------|------------|----------------|
| /s/ Levy Gerzberg      |       | President, Chief Executive Officer and Director (Principal |       | March 14, 2006 |
| Levy Gerzberg          |       | Executive Officer)                                         |       |           |
|                   |       |                                                       |       |           |
| /s/ Karl Schneider     |       | Senior Vice President, Finance and Chief Financial Officer |       | March 14, 2006 |
| Karl Schneider         |       | (Principal Financial and Accounting Officer)               |       |           |
|                   |       |                                                       |       |           |
| /s/ Uzia Galil    |       | Chairman of the Board of Directors                         |       | March 14, 2006 |
| Uzia Galil             |       |                                                       |       |           |
|                   |       |                                                       |       |           |
| /s/ Raymond A. Burgess |       | Director                                                   |       | March 14, 2006 |
| Raymond A. Burgess     |       |                                                       |       |           |
|                   |       |                                                       |       |           |
| /s/ James D. Meindl    |       | Director                                                   |       | March 14, 2006 |
| James D. Meindl        |       |                                                       |       |           |
|                   |       |                                                       |       |           |
| /s/ James B. Owens     |       | Director                                                   |       | March 14, 2006 |
| James B. Owens, Jr.    |       |                                                       |       |           |
|                   |       |                                                       |       |           |
| /s/ David Rynne   |       | Director                                                   |       | March 14, 2006 |
| David Rynne            |       |                                                       |       |           |
|                   |       |                                                       |       |           |
| /s/ Arthur B. Stabenow |       | Director                                                   |       | March 14, 2006 |
| Arthur B. Stabenow     |       |                                                       |       |           |
|                   |       |                                                       |       |           |
| /s/ Philip M. Young    |       | Director                                                   |       | March 14, 2006 |
| Philip M. Young        |       |                                                       |       |           |

 

75

----

** **

**EXHIBIT INDEX**

 
| **Exhibit  Number** | ** ** | **Exhibit Title**                                                                                                                                                                                                                                                                                                         |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1(1)              |       | Form of Restated Certificate of Incorporation of the Registrant.                                                                                                                                                                                                                                                               |
|                |       |                                                                                                                                                                                                                                                                                                                           |
| 3.2(2)              |       | Amended Bylaws of the Registrant.                                                                                                                                                                                                                                                                                              |
|                |       |                                                                                                                                                                                                                                                                                                                           |
| 4.1(3)              |       | Amended and Restated Stock Rights Agreement dated July 30, 1993 among  the Registrant and certain of its stockholders, as amended.                                                                                                                                                                                             |
|                |       |                                                                                                                                                                                                                                                                                                                           |
| *10.1(4)            |       | 1993 Stock Option Plan, as amended.                                                                                                                                                                                                                                                                                            |
|                |       |                                                                                                                                                                                                                                                                                                                           |
| *10.2(4)            |       | 1995 Outside Directors Stock Option Plan.                                                                                                                                                                                                                                                                                      |
|                |       |                                                                                                                                                                                                                                                                                                                           |
| *10.3(5)            |       | Amended and Restated 1995 Employee Stock Purchase Plan.                                                                                                                                                                                                                                                                        |
|                |       |                                                                                                                                                                                                                                                                                                                           |
| *10.4(3)            |       | Form of Indemnity Agreement for officers and directors.                                                                                                                                                                                                                                                                        |
|                |       |                                                                                                                                                                                                                                                                                                                           |
| 10.7(3)             |       | Letter Agreement dated December 16, 1991 between the Registrant and  Dolby Laboratories Licensing Corporation, as amended.                                                                                                                                                                                                     |
|                |       |                                                                                                                                                                                                                                                                                                                           |
| 10.11(3)            |       | Lease Agreement dated October 1, 1992 between the Registrant’s  subsidiary, Zoran Microelectronics Ltd. (“ZML”), and Matam-Haifa  Scientific Industries Center Ltd. (“Matam”).                                                                                                                        |
|                |       |                                                                                                                                                                                                                                                                                                                           |
| †10.12(3)      |       | License Agreement for ZR33891 Digital Filter Processor dated June 8,  1995 between the Registrant and Atmel Corporation (“Atmel”).                                                                                                                                                                                   |
|                |       |                                                                                                                                                                                                                                                                                                                           |
| †10.13(3)      |       | License Agreement for ZR34325 Vector Signal Processor dated June 8,  1995 between the Registrant and Atmel.                                                                                                                                                                                                                    |
|                |       |                                                                                                                                                                                                                                                                                                                           |
| †10.14(3)      |       | Cooperation and Project Funding Agreement dated June 16, 1991 between  ZML and the Israel-United States Binational Industrial Research and  Development Foundation (“BIRDF”).                                                                                                                                        |
|                |       |                                                                                                                                                                                                                                                                                                                           |
| †10.15(3)      |       | Cooperation and Project Funding Agreement dated June 9, 1992 between  ZML and BIRDF.                                                                                                                                                                                                                                           |
|                |       |                                                                                                                                                                                                                                                                                                                           |
| 10.16(3)            |       | Note of Approval No. 17391 dated September 5, 1994 issued to ZML by  the Office of Chief Scientist, Head of the Industrial Research and  Development Administration of the Israeli Ministry of Industry and Trade (the  “Chief Scientist”), together with ZML’s Letter of Undertaking dated September  4, 1994. |
|                |       |                                                                                                                                                                                                                                                                                                                           |
| 10.17(3)            |       | Note of Approval No. 17337 dated September 5, 1994 issued to ZML by  the Chief Scientist, together with ZML’s Letter of Undertaking dated  September 4, 1994.                                                                                                                                                             |
|                |       |                                                                                                                                                                                                                                                                                                                           |
| 10.18(3)            |       | Loan Agreements dated July 25, 1995, August 1, 1995, August 15, 1995,  August 31, 1995 and November 1, 1995 between ZML and the Israel Discount  Bank.                                                                                                                                                                         |
|                |       |                                                                                                                                                                                                                                                                                                                           |
| 10.29(6)            |       | Summary of Discussion dated April 23, 1996 between ZML and Matam  regarding Lease Agreement dated October 1, 1992 between ZML and Matam.                                                                                                                                                                                       |
|                |       |                                                                                                                                                                                                                                                                                                                           |
| 10.30(7)            |       | Memorandum of Understanding Dated April 23, 1996 between ZML and IBM  Israel Ltd. regarding Lease Agreement dated October 1, 1992 between ZML and  Matam.                                                                                                                                                                      |
|                |       |                                                                                                                                                                                                                                                                                                                           |
| 10.33(8)            |       | Sub-Sublease dated April 1, 1997 between the Registrant and  Integrated Silicon Solutions, Inc.                                                                                                                                                                                                                                |
|                |       |                                                                                                                                                                                                                                                                                                                           |
| 10.36(9)            |       | Unprotected Tenancy Agreement dated September 16, 1997 between ZML  and Matam, together with Appendix Addendum to Unprotected Tenancy Agreement  of 16.9.97.                                                                                                                                                                   |

 

76

----

 
| **Exhibit  Number** | ** ** | **Exhibit Title**                                                                                                                                                                                                      |
|---------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.37(1)            |       | Addendum to sub-sublease dated April 1, 1997 between the  Registrant Integrated Silicon Solution, Inc.                                                                                                                      |
|                |       |                                                                                                                                                                                                                        |
| *10.38(10)          |       | Form of Amendment of Nonstatutory Stock Option Agreement for Outside  Directors.                                                                                                                                            |
|                |       |                                                                                                                                                                                                                        |
| 10.39(11)           |       | 2000 Nonstatutory Stock Option Plan.                                                                                                                                                                                        |
|                |       |                                                                                                                                                                                                                        |
| *10.40(12)          |       | Executive Retention and Severance Plan, as amended.                                                                                                                                                                         |
|                |       |                                                                                                                                                                                                                        |
| 10.42(13)           |       | Sublease dated June 18, 2001 between Yahoo! Inc. and Oak  Technology, Inc.                                                                                                                                             |
|                |       |                                                                                                                                                                                                                        |
| 10.44(14)           |       | Oak Technology, Inc. 1994 Stock Option Plan (as amended and  restated).                                                                                                                                                     |
|                |       |                                                                                                                                                                                                                        |
| 10.45(15)           |       | Oak Technology, Inc. 1994 Outside Directors’ Stock Option Plan (as  Amended and Restated November 21, 2002).                                                                                                      |
|                |       |                                                                                                                                                                                                                        |
| *10.46(13)          |       | Form of Oak Technology, Inc. Outside Directors’ Non-Qualified  Stock Option Agreement for the 1994 Stock Option Plan and 1994 Outside  Director’s Stock Option Plan entered into by David Rynne and Peter Simone. |
|                |       |                                                                                                                                                                                                                        |
| 10.47(16)           |       | Asset purchase agreement between Oak Technology, Inc., and Sunplus  Technology, Co. LTC. dated April 3, 2003.                                                                                                          |
|                |       |                                                                                                                                                                                                                        |
| *10.48(17)          |       | Summary  of Compensation Arrangements with Named Executive Officers and Nonemployee  Directors.                                                                                                                             |
|                |       |                                                                                                                                                                                                                        |
| *10.49(18)          |       | Offer  Letter to Karl Schneider dated December 15, 1997, as amended July 15, 1998.                                                                                                                                          |
|                |       |                                                                                                                                                                                                                        |
| 10.50(19)           |       | Lease  Agreement dated May 2005 between ZML and Matam.                                                                                                                                                                      |
|                |       |                                                                                                                                                                                                                        |
| *10.51(18)          |       | Form  of Employee Proprietary Information and Invention Agreement.                                                                                                                                                          |
|                |       |                                                                                                                                                                                                                        |
| *10.52(20)          |       | Zoran  Corporation 2005 Equity Incentive Plan.                                                                                                                                                                              |
|                |       |                                                                                                                                                                                                                        |
| *10.53(21)          |       | Zoran  Corporation 2005 Directors Equity Plan.                                                                                                                                                                              |
|                |       |                                                                                                                                                                                                                        |
| 23.1                |       | Consent of PricewaterhouseCoopers LLP.                                                                                                                                                                                      |
|                |       |                                                                                                                                                                                                                        |
| 31.1                |       | Certification of Chief Executive Officer, pursuant to Rule 13a-14(a)  or 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                                  |
|                |       |                                                                                                                                                                                                                        |
| 31.2                |       | Certification of Chief Financial Officer, pursuant to Rule 13a-14(a)  or 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                                  |
|                |       |                                                                                                                                                                                                                        |
| 32.1                |       | Certification of Chief Executive Officer, pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002.                                                                                                                       |
|                |       |                                                                                                                                                                                                                        |
| 32.2                |       | Certification of Chief Financial Officer, pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002.                                                                                                                       |

 

----

*                                         Constitutes amanagement contact or compensatory plan required to be filed pursuant to Item15(b) of Form 10-K.

 

†                                          Confidentialtreatment has been granted as to a portion of this Exhibit.

 

(1)                                  Incorporated byreference to identically numbered exhibit to Registrant’s Form 10-KAnnual Report for the year ended December 31, 2000 and to Exhibit 3.3 toRegistrant’s Form 10-Q Quarterly report for the quarter ended September 30,2003.

 

(2)                                  Incorporated byreference to Exhibit 3.3 to Registrant’s Form 10-Q Quarterly Report forthe quarter ended September 30, 1998.

 

(3)                                  Incorporated byreference to identically numbered exhibit to Registrant’s Form SB-2Registration Statement (No. 33-98630-LA), which became effective onDecember 14, 1995.

 

77

----

 

(4)                                  Incorporated byreference to identically numbered exhibit to Registrant’s Form 10-QQuarterly Report for the quarter ended June 30, 2002.

 

(5)                                  Incorporated byreference to Exhibit 99.3 to Registrant’s Form 8-K Current Report filed onAugust 3, 2005.

 

(6)                                  Incorporated byreference to Exhibit 10.1 to the Registrant’s Form 10-Q Quarterly Reportfor the quarter ended June 30, 1996 (the “June 1996 Form 10-Q”).

 

(7)                                  Incorporated byreference to Exhibit 10.2 to the June 1996 Form 10-Q.

 

(8)                                  Incorporated byreference to identically numbered exhibit to Registrant’s Form 10-QQuarterly Report for the quarter ended March 31, 1997.

 

(9)                                  Incorporated byreference to identically numbered exhibit to Registrant’s Form 10-KAnnual Report for the year ended December 31, 1999.

 

(10)                            Incorporated by referenceto identically numbered exhibit to Registrant’s Form 10-Q QuarterlyReport for the quarter ended June 30, 2001.

 

(11)                            Incorporated by referenceto identically numbered exhibit to Registrant’s Form 10-K Annual Reportfor the year ended December 31, 2002.

 

(12)                            Incorporated by referenceto Exhibit 99.1 to Registrant’s Form 8-K Current Report filed on October 31,2005.

 

(13)                            Incorporated by referenceto identically numbered exhibit to Registrant’s Form 10-Q Quarterlyreport for the quarter ended September 30, 2003.

 

(14)                            Incorporated by referenceto Exhibit 99.1 of Form S-8 Registration Statement filed by OakTechnology, Inc.  (“Oak”) onApril 14, 2003.

 

(15)                            Incorporated by referenceto Exhibit 10.01 of Form 10Q/A Amended Quarterly Report filed by Oak onJune 27, 2003.

 

(16)                            Incorporated by referenceto Exhibit 2.2 of Form 8-K Current Report filed by Oak onApril 18, 2003.

 

(17)         Incorporatedby reference to Exhibit 99.1 to Registrant’s Form 8-K Current Report filed onNovember 30, 2005.

 

(18)                            Incorporated by reference to identicallynumbered exhibit to Registrant’s Form 10-K/A Amended Annual Report for the yearended December 31, 2004.

 

(19)                            Incorporated by reference to exhibit 10.11 toRegistrant’s Form S-1 Registration Statement which became effective on June 27,2005.

 

(20)         Incorporated by reference to exhibit99.1 to Registrant’s Form 8-K Current Report filed on August 3, 2005.

 

(21)         Incorporated by reference to exhibit99.2 Registrant’s Form 8-K Current Report filed on August 3, 2005.

 

78

----