**SECURITIES AND EXCHANGE COMMISSION**

 

**Washington, D.C. 20549**

 

**FORM 10-K**

 
| **(Mark One)**                                                                                                                                                                                                                                                                        |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                                                  |
| **ý**                                                                                                                                                                                                                                                                            |   | **Annual  report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934** |
|                                                                                                                                                                                                                                                                                  |   |   |
| **for the fiscal year ended December 31,  2002**                                                                                                                                                                                                                                 |
|                                                                                                                                                                                                                                                                                  |   |   |
| **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**

 

**ZORAN CORPORATION**

(Exact Name ofregistrant as specified in its charter)

 

| **DELAWARE**                                                    |   | **94-2794449**                        |
|-----------------------------------------------------------------|--------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |   | (I.R.S. Employer  Identification No.) |
|                                                            |   |                                  |
| **3112 Scott Boulevard, Santa Clara, California 95054**         |
| (Address of principal executive offices)  (Zip code)            |
|                                                            |
| **(408) 919-4111**                                              |
| (Registrant’s telephone number, including  area code)      |
| Securities registered pursuant to Section  12(b) of the Act:    |

 

| **Title of each class** |   | **Name of Exchange on which registered** |
|-------------------------|--------|------------------------------------------|
| None                    |   | None                                     |

 

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

 

**Common Stock, $.001 par value**

(Title ofClass)

 

Indicate by check mark whether registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the Securities Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.   YES ý    NO o

 

Indicate by check mark if disclosure of delinquent filers pursuant toItem 405 of Regulation S-K is not contained herein, and will not be contained,to the best of registrant’s knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K. o

 

Indicate by check mark whether registrant is an accelerated filer (asdefined by Rule 12b-2 of the Act). YES ýNO o

 

The aggregate market value of registrant’s voting stock held bynon-affiliates of registrant based upon the closing sale price of the CommonStock on June 28, 2002, as reported on the Nasdaq National Market, wasapproximately $618,000,000.  Shares ofCommon Stock held by each officer, director and holder of 10% or more of theoutstanding Common Stock have been excluded in that such persons may be deemedto be affiliates.  This determination ofaffiliate status is not necessarily a conclusive determination for otherpurposes.

 

Outstanding shares of registrant’s Common Stock, $0.001 par value, asof March 17, 2003: 27,399,578

 

DOCUMENTS INCORPORATED BYREFERENCE

 

Parts of the definitive proxy statement for registrant’s 2003 AnnualMeeting of Stockholders to be filed with the Commission pursuant to Regulation14A not later than 120 days after the end of the fiscal year covered by thisReport are incorporated by reference into Part III of this Report.

 

 

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**PART I**

 

***This report includesa number of forward-looking statements which reflect the Company’s currentviews with respect to future events and financial performance.  These forward-looking statements are subjectto certain risks and uncertainties, including those discussed in “Item 7Management’s Discussion and Analysis of Financial Condition and Results ofOperations - Future Performance and Risk Factors” and elsewhere in this report,that could cause actual results to differ materially from historical results orthose currently anticipated.  In thisreport, the words “anticipates,” “believes,” “expects,” “intends,” “future” andsimilar expressions identify forward-looking statements.  Readers are cautioned not to place unduereliance on these forward-looking statements, which speak only as of the datehereof.***

 

**Item 1.****                Business.**

 

**Introduction**

 

We develop and market integrated circuits, integrated circuit cores andembedded software used by original equipment manufacturers, or OEMs, in digitalvideo and audio products for commercial and consumer markets. We also providecomplete, copy-ready system reference designs based on our technology that helpour customers produce commercial and consumer products more quickly andcost-effectively. Our integrated circuits are used in a variety of products,including digital versatile disc, or DVD, players, filmless digital cameras,professional and consumer video editing systems and digital speakers and audiosystems.

 

We were incorporated in California in December 1981 and reincorporatedin Delaware in November 1996. Our corporate headquarters are located at 3112Scott Boulevard, Santa Clara California 95054, and our telephone number is(408) 919-4111. Our website can be found at www.zoran.com. Our annual reports onForm 10-K, quarterly reports on Form 10-Q, current reports on Forms 8-K, andany amendments to those reports, are available free of charge on our websiteunder “Investor Relations / SEC Documents” as soon as reasonably practicableafter they are filed with the Securities and Exchange Commission.

 

**IndustryBackground**

 

Until the mid-1990s, video images and audio soundtracks weretransmitted, edited and stored almost exclusively using analog formats. Morerecently, however, advances in technology have allowed audio and video to beprocessed and stored in digital form. Unlike analog formats, which areinherently unstable and difficult to edit and enhance, digital formats permitthe manipulation of audio and video signals through digital signal processingand offer a number of fundamental advantages over analog technologies. Throughcomplex digital signal processing operations, digital audio and video signalsmay be compressed, providing significant storage and transmission efficiencies.They also may be filtered, allowing for noise reduction, and they may betransmitted and reproduced without perceptible image or sound degradation.Digital formats provide users with additional benefits, including random accessto data, superior editing capabilities and enhanced security features such asprotection against 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 standard personalcomputer, thereby permitting the data to be accessed and edited easily. Digitalaudio compression 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.

 

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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:

 

•                                          TheJoint Photographic Experts Group, or JPEG, standard for the high qualitycompression of still images and the real-time, low-cost compression anddecompression of moving images;

 

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

 

•                                          TheMPEG 2 standard, subsequently adopted by the Motion Pictures Expert Group, forthe compression of both audio and video data, designed to provide improvedquality in broadcast and video playback applications;

 

•                                          TheMPEG 4 standard 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, module multimedia and videogame applications; and

 

•                                          DolbyAC-3, also known as Dolby Digital, developed by Dolby Laboratories, an industrystandard for the compression of audio for use in multi-channel digital surroundsound systems.

 

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

 

•                                          *DVD Playersand Recorders*. DVD players and recorders use MPEG 2 videocompression and Dolby Digital audio technology to provide significantly higherquality playback or recording than is possible with VCR or video CD technology.According to Cahners In-Stat Group, Sales of DVD players are expected to growfrom approximately 53 million units in 2002 to almost 84 million units by2006.  Sales of DVD recorders areexpected to grow from approximately 1. million units in 2002 to approximately31 million in 2006.

 

*•**                                          FilmlessDigital Cameras*. Filmless digital cameras use JPEG compression technologyto capture high resolution images that can be viewed, edited and stored on acomputer system and transmitted over telephone lines and computer networks.According to Cahners In-Stat and other marketing research firms, sales ofmegapixel digital cameras are expected to grow from approximately 24 millionunits in 2002 to just under 47 million units in 2006.

 

Additional products and markets are developing based on theseestablished compression standards as well as compression technologies such asMeridian Lossless PCM, or MLP, a new standard for DVD audio, Microsoft WindowsMedia Audio, or WMA, and MP3, a compression standard for the download of audiorecordings 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 format. These standardsdo not specify the compression methodologies to be employed or additionalfunctionality which may be used to enhance or manipulate digital signals. Thesestandards, therefore, do not determine image or sound quality or compressionefficiency.  For example, datacompression may comply with relevant standards despite being poorly processedand containing artifacts which result in image degradation in videoapplications or poor sound quality in audio applications. As a result, therecan be significant differences in overall image or sound quality between twosolutions based on the same standard. Therefore, integrated circuitmanufacturers can differentiate their products on the basis of the quality oftheir compression solution.

 

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 high volume consumerapplications. In addition, product manufacturers are facing competitivepressure to introduce their products more rapidly. To address these issues,OEMs seek to integrate multiple functions on individual chips in order toreduce their costs, speed time-to-market and produce smaller products withreduced power consumption. They also seek solutions that can be easilyintegrated into their commercial and consumer products. The current challengeto manufacturers of compression integrated circuits is, therefore, to provideproduct manufacturers with high-quality, cost-effective, standards-basedsolutions that deliver flexible control, image enhancement, audio effects andother functions in addition to high quality compression solutions.

 

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**ZoranSolutions**

 

We provide feature-rich, cost-effective, standards-based solutions fora broad range of digital video and audio applications. We were a pioneer in thedevelopment of high performance digital signal processor products, and havedeveloped expertise in digital signal processing, integrated circuit design,mathematical algorithms and software development, as well as proprietarydigital signal processing and video and audio compression technologies. Weapply our multi-disciplinary expertise and proprietary technologies to thedevelopment of fully-integrated solutions for high-growth multimedia markets.The key elements of our solution are:

 

*Standards-PlusMethodology*. We have leveraged our broad multi-disciplinaryexpertise and proprietary digital signal processing and compressiontechnologies to develop what we refer to as “standards-plus” solutions. We haveenabled OEMs to improve image and sound quality and deliver superior productsto end users by adding more features around compression standards, such as moreefficient use of memory, processing and communication resources, as well asaudio and image enhancement algorithms. We have also provided OEMs the abilityto include OEM-programmable effects, as well as variable compression ratios forvideo. These “standards-plus” features allow our customers to differentiatetheir products from those of their competitors.

 

*Expandable andProgrammable Architecture*. We design our integratedcircuits to enable easy adaptation for a broad range of specific applications.We can vary the architecture of our chips by adding or deleting modules, and wecan also modify the software embedded in the chips themselves to addressspecific 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 SystemSolutions*. We help our customers meet their totalsystem requirements by providing integrated products that combine hardware andsoftware to address required system functions and features on a singleintegrated circuit or chip set, reducing the number of integrated circuits, andin some cases providing a complete solution on a single chip. As a result, ourcustomers’ total system cost can be reduced and they can concentrate ondifferentiating their products from those of their competitors. For example, weintroduced the Camera On A CHip, or COACH, which includes most of theelectronics of a filmless digital camera.

 

*Cost-EffectiveProducts*. We focus on reducing the feature size, powerrequirements and number of integrated circuits necessary to perform requiredsystem functions, including compression functions. This reduces our customers’manufacturing costs for their products which incorporate our integratedcircuits, and also reduces the operating costs for these products, enabling theuse of our products in a broader range of high volume applications. The modularnature of our architecture reduces our new product development costs, andenables our design engineers to meet our customers’ new product specificationand cost parameters.

 

*Copy-Ready SystemReference Designs*. We provide our customers with abroad range of engineering reference boards and products complete with devicedriver software, embedded software and detailed schematics. These productssubstantially shorten our customers’ product design time.

 

**Strategy**

 

We provide cost-effective, high-performance digital audio and videosolutions addressing selected high-growth applications enabled by compressionin evolving multimedia markets. Key elements of our strategy include:

 

*Focus On High-GrowthApplications*. Our strategy is to focus on providingdigital video and audio solutions for emerging high-growth consumerelectronics, PC and communications applications. Our current focus marketsinclude DVD players and recorders, filmless digital cameras, digitaltelevision, or DTV, professional and consumer video editing systems and digitalspeakers and audio systems.

 

*Leverage ExistingTechnology and Expertise*. We intend to continue toidentify those markets that we believe have the highest growth potential forour products and to actively pursue those markets. Our proprietary digitalsignal processing 

 

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and compression technologies can be used to serve emerging markets fordigital video and audio. Potential markets include home network audio and videoappliances, as well as personal digital video and audio devices.

 

*Further PenetrateKey International Markets*. In 1998, we opened anoffice in Shenzhen, China. During 2000, we opened offices in Taiwan and Japan.In 2001, we opened offices in Korea and Hong Kong. We believe that by openingthese offices we are better able to provide sales, marketing, and applicationssupport for these growing consumer electronics markets.

 

*Extend TechnologicalLeadership*. Our years of experience in the fields ofdigital signal processing, integrated circuit design, algorithms and softwaredevelopment have enabled us to become a leader in the development of digitalaudio and video solutions enabled by compression. Using our multi-disciplinaryexpertise, we have developed new technologies for compression of digital audioand video. For example, our proprietary bit rate control technology has helpedus provide reliable and inexpensive JPEG-based video compression, and ourproprietary Virtual Multi-Channel Digital, or VMD, technology enableshigh-quality surround-sound effects from two low-cost audio speakers, ratherthan the four or five speakers required by other technologies. During 2000, weacquired PixelCam Inc., which enabled us to combine our Camera On A Chip, orCOACH, processor with PixelCam’s CMOS sensor, providing a more integrated system.Furthermore, during 2000 we acquired Nogatech Inc., which provided us with lowcost PC connectivity and MPEG-4 technologies. We intend to continue to invest in our own research and development, andto evaluate opportunities to acquire additional technologies in order tomaintain and extend our technological leadership.

 

*Expand StrategicPartnerships*. We work closely in the productdevelopment process with leading manufacturers of products that incorporate ourintegrated circuits. We also work closely with key customers and provide themearly access to our technologies. Potential products are designed to meetcustomer-driven product requirements defined jointly by us and our partnerswith the partner providing technological input and, in selected cases, a portionof the development funding. This strategy has enabled us to develop productswith substantial financial and other assistance while retaining ownership ofthe technology and ensuring an established customer for the product oncedevelopment is completed. In some cases, our strategic partners also providesales and marketing support. We have also established long-term relationshipswith strategic partners that provide manufacturing capacity and will seek todevelop additional strategic relationships with manufacturers.

 

**Marketsand Applications**

 

Our products are currently used in a variety of consumer multimedia andPC applications.

 

  *Video Playback Systems*

 

Currently, three types of digital video playback systems are availablefor consumer video applications: video CD players, Super Video CD players andDVD players.

 

Video CD players are essentially CD audio players with MPEG 1 decodersand a video output. Video CD players offer video playback of near-VCR qualityand two-channel stereo audio playback. Compression enables 60 to 70 minutes ofvideo to be stored on a single CD. Video CD players can also play karaoketitles and were particularly popular in China, although we believe that thevolume for these players has declined due to the growth of the DVD playermarket. We formerly sold MPEG 1-based products to manufacturers of stand-alonevideo CD players but are no longer selling these products for this market.

 

In 1998, the Chinese government adopted the Super Video CD standard. Byutilizing MPEG 2 compression technology as well as graphics, Super Video CDoffers substantially higher audio and video quality than is possible with avideo CD player. The Super Video CD standard is also being replaced by DVDplayers.

 

DVD players, the latest generation of video playback systems, use MPEG2 video compression and Dolby Digital or similar audio technology to providesignificantly higher quality playback than is possible with VCRs, Video CD orSuper Video CD players. DVD players are sold as stand-alone products and arealso bundled with other functions including DVD+VCR combinations, DVD-Receiversand DVD+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. DVDplayers are also included in place of CD-ROM drives in some PCs, where they 

 

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are referred to as DVD-ROMs. DVD-ROMs are also sold as upgrade products.The growth in the DVD market is demonstrated by the rapidly growing sales ofDVD players, the increasing number of models and manufacturers, and theincreasing number of DVD titles available for purchase and rent.

 

*  Filmless Digital Cameras*

 

Filmless digital cameras allow the capture of high resolution images,the viewing, 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. In addition, digital camerascan be connected directly to a PC for downloading of pictures and to atelevision for displaying pictures. The original digital cameras were developedfor the professional market and currently sell at prices of $1,000 to $3,000.As technology has advanced and manufacturing costs have decreased, digitalcameras for the consumer market have been introduced in the $69 to $600 pricerange. Compression technology has also enabled the development of digital videosecurity cameras and low cost digital video cameras for use with PCs.

 

  *Digital Video Recording Systems*

 

Digital video recording systems are aimed at replacing the analog VCR.Digital video recording systems will not only store home made movies and TVprograms but will allow them to be easily edited. In addition, digital videorecording systems will enable high quality time shifting of TV program viewingby recording the program so that it can be watched simultaneously or on adelayed basis. The recording media includes DVD recordable media and harddisks. Digital video recording systems use MPEG 2 as the video compressionformat and Dolby Digital or MPEG audio as the audio format.

 

*  PC Video Systems*

 

Historically, professional video editing systems were comprised ofexpensive pieces of analog audio and video equipment. Compression technologyallows digital video images to be stored in a computer’s memory in sufficientvolume to enable capture and “cut and paste” editing to be performed throughrandom access to stored images. As the cost of compression technology hasdeclined, a number of manufacturers have designed low cost digital videocapture and editing systems that run on PCs, creating a new category of usersin the corporate, education and government markets.

 

The availability of universal serial bus, or USB, connectors on mostPCs currently being manufactured creates an opportunity for the development oflow-cost external video capture and editing accessories that can be easilyinstalled by consumers. We believe that enhanced support of video in consumerPCs, and the growing popularity of wideband Internet services will open newopportunities for video capture and sharing applications on the PC and willincrease the popularity of such products.

 

  *Digital Audio Systems*

 

Digital audio facilitates enhanced audio playback with features such asmulti-channel surround sound and virtual surround sound utilizing two channeltechnology. Many standards have emerged for the digital compression of audio.  Current digital audio compression standardsin use include Dolby Digital, DTS, MLP and MP3. Dolby Digital and DTS arecompeting standards of audio compression for use in multi-channel digitalsurround sound systems in movie theaters and at home. MLP was developed foraudio compression in DVD audio. MP3 is one of the compression standardsrecognized for the download of audio recordings over the Internet. Our audiointegrated circuits support all of these standards. The principal productsusing compressed digital audio in the consumer market are DVD players andrecorders, PCs incorporating DVD-ROMs, digital speakers and portable MP3players.

 

  *Other Applications*

 

Other existing and potential applications for our audio and videocompression technologies include Internet audio and video appliances, digitaltelevision and television set-top boxes, as well as personal digital audio andvideo devices.

 

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**Technology**

 

  *Image and Video Technology*

 

*The JPEG Standard*.In 1991, 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 yieldsbroadcast image quality while 20-to-1 compression is similar to VHS quality.

 

*Zoran JPEGTechnology*. Our JPEG technology incorporates aproprietary bit rate control algorithm that enables our JPEG-based products tocompress any image to a predetermined size while optimizing video quality usingpre-selected parameters. Without this feature, the JPEG compression processresults in compressed data files of various sizes based on the actual contentof the original image given a constant degree of compression. An image withlarge amounts of visual detail will generate a larger data file than thatgenerated from an image with less detail. Performance of many videoapplications is hampered by variability in the size of the compressed images ina video sequence, which can result in inefficient use of available memory, busspeed or communication channel capacity or even the loss of images. Our bitrate control is a “standards-plus” solution that uses real-time digital signalprocessing algorithms to optimize video quality based on pre-selectedparameters, which can be programmed by OEMs, without the loss of any image orvideo frame. Our bit rate control has been incorporated in our JPEG-baseddevices that are used in video editing systems, filmless and tapeless digitalcameras, color scanners, PC-based security systems, video conferencing andother applications. Other features of our JPEG-based products include theirability to handle a wide range of compression ratios, to perform a “lossless”compression algorithm in the same JPEG device, to rapidly scan or browse alarge number of images and utilize advanced image processing algorithms thatenable bit rate control of USB data, vertical blank interval detection,infrared remote control detection and scene analysis for computer controlapplications. We implement these functions in a single integrated circuit whilewe believe most other manufacturers either offer fewer functions or requiremultiple chips, resulting in higher manufacturing costs and greater powerconsumption.

 

*CMOS  Sensor Technology*.With the widespread availability of inexpensive complementary metal oxidesemiconductor, or CMOS, fabrication facilities, image sensor designers are nowable to offer a single chip solution to perform the “light-to-bytes” functionat a quality level that is competitive with the long established charge coupleddevice, or CCD, sensor technology, but with far greater operational flexibilityand at much lower power consumption. CMOS sensors can scan in a variety ofmodes and directions and perform analog-domain pre-processing of the signalwhich may be advantageous from a system perspective. Although the greater pixelcircuit complexity results in a larger imager today, progress is being made toboth reduce the geometry of the pixel and use more aggressive design rules. Theresult will be a sensor which provides both cost reduction and performanceenhancement benefits to the system designer over the traditional CCD-basedsolution.

 

*Zoran CMOS SensorTechnology*. The PixelCam ZR32112 and ZR32312 are highperformance 1.3 megapixel CMOS image sensors that are ideal for digital stilland video imaging products. Using our proprietary Distributed-Pixel Amplifierdesign, the pixel response is independent of its distance from each column’sCDS circuitry. This unique architecture results in an extremely uniform pixelarray with low fixed-pattern noise without the need for off-chip backgroundframe subtraction circuitry. The bank of analog front-end circuits quantizeseach pixel to 10 bit resolution. This highly parallel approach eases speedrequirements on individual analog circuits and reduces overall powerconsumption. Separate programmable red, green and blue PGA circuits enableanalog-domain color balance. The flexibility of these sensors’ output imageformat permits the tradeoff between resolution and frame rate. The image outputmay also be horizontally “mirrored” and vertically “flipped”.

 

*The MPEG Standards*.In 1991, the Moving Pictures Expert Group, or MPEG, Committee of theInternational Standards Organization completed a technical specification for astandard to compress moving audio and video into a single data stream. LikeJPEG, MPEG 1 removes spatial redundancies from single frames of video data.MPEG 1 improves on JPEG by also removing redundancies that occur betweenconsecutive video frames. Because video represents movement, it is possible todetect and estimate the movement of similar picture elements between videoframes, a process called motion estimation. MPEG motion estimation uses thecontent of previous and future frames to predict the content of the currentframe without using its full content. MPEG 1 implements audio compression byexploiting psycho-acoustic masking, 

 

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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.It allows a new level of interaction with visual content, providing the abilityto view, access and manipulate objects rather than pixels. MPEG 4’s impact isespecially significant in video streaming, digital television, mobilemultimedia and game applications.

 

*Zoran MPEGTechnology*. Beginning in 1997, we establishedourselves as a leading provider of MPEG 2 technology for DVD and Super Video CDapplications. We introduced the first DVD decoder device integrating digitalvideo with multi-channel digital audio and programmable audio effects for usein DVD players. We also introduced new MPEG compression chip cores that can beintegrated into chips manufactured by OEM customers, enabling these customersto reduce the cost of custom chip design and accelerate the time-to-market oftheir products.

 

 *Audio Technology*

 

*The Dolby DigitalStandard*. 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 movie theaters comprising over 24,000 screens worldwide andis also used in home theater and computer multimedia applications. Digitalcompression of audio data allows the storage of full quality multi-channelaudio playback in the limited space allocated for audio in video-orientedformats. It also facilitates the seamless integration of sound with compressedvideo. The Dolby Digital audio compression standard is currently the principalaudio compression technique used in DVD players. Dolby Digital has also beenadopted as a standard for use in high-definition television and digital cablesystems.

 

*Other AudioStandards*. Other digital audio compression standardscurrently in use include DTS, an audio compression standard that competes withDolby Digital, MLP, a compression standard for DVD audio, and MP3, used for thedownload of audio recordings from the Internet.

 

*Zoran AudioTechnology*. Working closely with Dolby Laboratories,we have developed a programmable audio digital signal processing engine with anarchitecture optimized for Dolby Digital and other demanding audio applicationsand we were the first to develop a single-chip solution for Dolby Digitaldecoding. Our Vaddis DVD decoders and audio processors now incorporate thisengine to allow systems manufacturers to replace system components withsoftware modules, differentiate their products from their competition, use ourSiliconSoftware® library of advanced audio algorithms, and reduce system costsand time to market. In addition to Dolby Digital, our DVD decoders and audioprocessors support all principal audio compression standards, including DTS,MLP and MP3. Our integrated circuits also include additional functions such asVirtual Multi-Channel Digital, surround sound for headphones, High-DefinitionCD, karaoke processing and speaker equalization.

 

**Products**

 

Our multimedia product line consists of four principal productfamilies:

 

•                                          DVD—videoand audio compression and decompression products based on MPEG, Dolby Digitaland DTS;

 

•                                          FilmlessDigital Cameras—video compression and decompression products based on JPEGtechnology and CMOS sensors;

 

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•                                          PCVideo—video compression and decompression products based on JPEG technology andUSB multimedia controllers; and

 

•                                          DigitalAudio—audio decompression products for use in products using MPEG, DolbyDigital, DTS, MLP, MP3 and other audio technologies.

 

 

 

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**                                      |
|-------------------------|--------|---------------------------------------------------------------------------|--------|-----------------------------------|--------|------------------------------------------------------------------|
|                    |   | Vaddis IV Integrated DVD decoder (ZR36730)                                |   | June 1999                         |   |                                                             |
|                    |   | Vaddis IV-LC Integrated DVD decoder (ZR36732)                             |   | November 2000                     |   |                                                             |
| DVD                     |   | Vaddis V Integrated DVD decoder (ZR36750)                                 |   | May 2001                          |   |                                                             |
|                    |   | Vaddis 5E Integrated DVD decoder (ZR36742)                                |   | June 2002                         |   | DVD players and recorders                                        |
|                    |   | Vaddis 6 Integrated DVD integrated servo processor and decoder  (ZR36768) |   | December 2002                     |   |                                                             |
|                    |   |                                                                      |   |                              |   |                                                             |
|                    |   | Filmless digital camera processor—COACH-LC (ZR36420)                 |   | March 2000                        |   |                                                             |
| FilmlessDigital Cameras |   | Filmless digital camera processor—COACH-V (ZR36430)                  |   | June 2002                         |   | Filmless digital cameras, security                               |
|                    |   | CMOS sensor (ZR32112)                                                     |   | July 2000                         |   |                                                             |
|                    |   | CMOS sensor (ZR32312)                                                     |   | August 2002                       |   |                                                             |
|                    |   |                                                                      |   |                              |   |                                                             |
|                    |   | JPEG codec (ZR36060)                                                      |   | February 1997                     |   | PC video editing, security                                       |
|                    |   | JPEG PCI multimedia controller (ZR36067)                                  |   | September 1997                    |   | PC video editing                                                 |
| PC Video                |   | USB multimedia controller   (ZR36503)                                |   | June 1998                         |   | PC-TVs, PC digital cameras, video capture devices                |
|                    |   | USB multimedia controller (ZR36504)                                       |   | December 1999                     |   | PC-TVs, PC digital cameras, PC set-top boxes, cable modems       |
|                    |   |                                                                      |   |                              |   |                                                             |
| Digital Audio           |   | Programmable Digital audio processor (ZR38601)                            |   | December 1998                     |   | Digital speakers for home theater, computers and gaming consoles |
|                    |   | Multi-standard Programmable Digital audio processor (ZR38650)             |   | December 1998                     |   | Audio/video receivers, 3D headphones                             |

 

9

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*DVD*.Our Vaddis decoders perform all the audio and video decoding and displayrequirements of the DVD specification, including MPEG 2 audio and videodecoding, Dolby Digital, DTS and MLP audio decoding, on-screen display,decryption required for copyright protection and presentation of graphicinformation. The Vaddis has additional computation power that can be utilizedfor customer differentiation features. For example, it can incorporate virtualsurround sound algorithms without the addition of hardware. This allows theuser to enjoy the theater-like sound obtained from six speakers using a systemthat includes only two speakers and the Vaddis. The Vaddis IV-LC incorporates amore powerful audio digital signal processor that enables the support ofadvanced audio algorithms like MPEG 5.1, and DTS and audio DVD, which areneeded in today’s DVD player systems. The Vaddis 5E incorporates a hostcontroller and progressive scan output and is targeted for the entry tomid-range segment of the market. The Vaddis V integrates the host controllerand incorporates DVD-Audio capability and progressive scan output features thatare part of current high-end DVD player systems. The Vaddis 6 is a DVD systemon a chip which integrates the functionality of the Vaddis 5E with thefunctionality of the front-end servo and read channel, further reducing chipcount and system cost for DVD player manufacturers. Vaddis decoders are beingused in DVD players manufactured by Orion, Samsung, Sanyo, Sharp, Toshiba andothers. We provide full reference designs of DVD players, based on our Vaddischips, that help our customers accelerate their time to market for theirproducts.

 

*Filmless DigitalCamera Products*. Our JPEG technology is used infilmless digital cameras. In September 1999, we introduced the Camera On ACHip, or COACH—an integrated system on a chip solution that includes most ofthe electronics of a filmless digital camera. The COACH can be connecteddirectly to a high-resolution (up to 4 mega pixel) CCD or CMOS sensor, processthe video information in real time, compress the captured image in real time toa flash memory, interface an LCD or micro display and interface to all types offlash memory. Among the unique capabilities of the COACH is the ability totransfer in real-time, over a USB bus, high quality video to the PC and thusserve also as a PC video camera. The COACH also allows for direct connection toa printer, including color correction and special effects, for the non-PCconsumer environment. The COACH is supplemented by full filmless digital camerareference designs, “CamONTM”and “CamMiniTM,”shortening the time to market for COACH customers. Our PixelCam CMOS sensorproducts currently deliver CCD image quality with 1.3 megapixel resolution atone-half the power dissipation and twice 

 

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the integration level of CCD sensors. The sensor’s architecture isscalable, which will enable higher resolution product offerings as the digitalcamera OEM’s needs change. These products also offer the digital cameramanufacturer longer battery life and reduced “time to next shot”.

 

*PC Video Products*.Our ZR36060 codec is a compression/decompression device used for real timeencoding and decoding of JPEG video for editing applications. It is fullycompliant with JPEG standards. The ZR36060 utilizes our proprietary bit ratecontrol technology for high quality video capture. The ZR36060 can be installedin a chipset that includes the ZR36067 motion controller for PCI boardimplementation or pre/post-processing devices such as an integrated colorspace/raster-to-block converter. The ZR36067 is a PCI motion JPEG controllertargeting consumer-priced but professional quality desktop PCI video editingsystems. The ZR36503 is a video chip for video communication across the USBchannel to the PC. The ZR36504 chip incorporates video, audio and datastreaming into a single chip for video, audio and data transfer across the USBchannel to the PC.

 

*Digital AudioProducts*. The ZR38601, a single-chip digital audioprocessor designed to support the PC and home theater digital speaker market,takes advantage of most of the advanced audio algorithms included in our

Silicon Software library. Its eight channel output architecturesupports the latest home theater applications, including Dolby Surround EX 6.1channel sound. The ZR38601’s ability to accept six individual channels of audioinput also makes it the ideal processor for today’s four channel Direct Soundcomputer games. The ZR38650, a true multi-standard digital audio processor,takes advantage of our complete SiliconSoftware library. It is designed tosupport the large mid and low range audio/video receiver market, whileproviding features previously available only on more expensive models.

 

*Integrated CircuitCores*. We offer multimedia integrated circuit, orintellectual property (“IP”), cores which can be incorporated into ourcustomers’ chips. For example, Zoran licenses a video decoder IP core forconversion of an NTSC, PAL, or SECAM TV signal into a format that allows theinformation in the TV signal to be displayed on a TV monitor. This IP coreenables the integration of TV functionality into integrated circuits for LCDpanels, LCD-TVs, Plasma Display TVs, set-top boxes, Digital TVs (“DTVs”),projector systems, PC video capture and other applications. Our video encoderIP cores perform the reverse function, converting component video data into anNTSC, PAL or SECAM TV signal. This IP core has applications in ICs for graphicsdisplay, set-top boxes, digital cameras, DTVs, DVD players, gaming systems andother applications.

 

 

 

**Customers**

 

The following table lists representative customers, as well as otherOEMs who purchase our products through our resellers. Each of these customersand OEMs purchased, directly or indirectly, at least $100,000 of our productsfrom January 1, 2002 through December 31, 2002:

 
| **PRODUCT FAMILY**       |   | **DIRECT  CUSTOMERS**           |   | **OTHER OEMs**                      |
|--------------------------|--------|---------------------------------|--------|-------------------------------------|
| DVD                      |   | Alco Electronics LTD.           |   | Samsung Electronics                 |   | Orion |
|                     |   | Alcom Electronics               |   | Sanyo Electric                      |   | Sanyo |
|                     |   | Amoisonic Electronics Co., LTD. |   | Shenzhen Bao Tong Electronic        |   | Sharp |
|                     |   | Beautiful Enterpirse Co. LTD.   |   | Shenzhen HPT Electronics Co. LTD    |   | Toshiba |
|                     |   | Daewoo Electronics Co., LTD.    |   | Shenzhen Paragon Ind.               |   |   |
|                     |   | Fly Ring Digital Technology     |   | Sichuan Changhong Electronic Co.    |   |   |
|                     |   | FM COM Corp.                    |   | Sky Wise Holdings LTD..             |   |   |
|                     |   | Fujifilm                        |   | Tomen Electronics Corp.             |   |   |
|                     |   | J&S Industrial Co.          |   | Universal Pacific Co. LTD.          |   |   |
|                     |   | Jiangsu Hongtu High Technology  |   | Up-Today Industrial Co., LTD        |   |   |
|                     |   | Marketa Semiconductor           |   | Zenitron Corporation                |   |   |
|                     |   | Mustek International, Inc.      |   | Zhongshan Kenloon Lighing Co.       |   |   |
|                     |   | Newell Hong Kong                |   |                                |   |   |
|                     |   |                            |   |                                |   |   |
| Digital Audio            |   | Alco Electronics LTD.           |   | Minton Optic Industry Co. LTD       |   |   |
|                     |   | Amega Group Limited             |   | Newell Hong Kong                    |   |   |
|                     |   | CET LTD.                        |   |                                |   |   |
|                     |   |                            |   |                                |   |   |
| PC Video                 |   | Alcom Electronics               |   | Sinoglobal Technology Inc.          |   |   |
|                     |   | ATD Electronique                |   | Solectron Technology Inc.           |   |   |
|                     |   | Camtel Technology Corp.         |   | Topas Electronic                    |   |   |
|                     |   | Edge Electronics Inc.           |   | WUS Printed Circuit Co. LTD.        |   |   |
|                     |   | Hauppauge Computer Works, Inc.  |   | Zenitron Corporation                |   |   |
|                     |   |                            |   |                                |   |   |
| Filmless Digital Cameras |   | Chicony Electronics Co., LTD.   |   | Newell Hong Kong                    |   |   |
|                     |   | Concord Camera HK Limited       |   | Primax Electronics Ltd.             |   |   |
|                     |   | CRS Electronic Co., LTD.        |   | Samsung Techwin Co. LTD.            |   |   |
|                     |   | DXG Technology Corp.            |   | Sinoglobal Technology Inc.          |   |   |
|                     |   | Edge Electronics Inc.           |   | Smart Generation LTD.               |   |   |
|                     |   | Fly Ring Digital Technology     |   | Sunnic Technology & Merchandise |   |   |
|                     |   | Kinpo International LTD.        |   | Tomen Electronics Corp.             |   |   |
|                     |   | Konica Corporation              |   | World Wide Licenses LTD.            |   |   |
|                     |   | Mustek International Inc.       |   | Zenitron Corporation                |   |   |
|                          |        |                                 |        |                                     |  |  |  |  |  |  |  |

 

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Fujifilm purchases our products primarily as a reseller. Fujifilm actsas our primary reseller in Japan and accounts for most of our product sales inJapan. During 2001, sales to Fujifilm accounted for 29.2% of our totalrevenues, including 30.6% of product sales. During 2002, sales to Fujifilmaccounted for 36.6% of our total revenues, including 38.4% of product sales.During 2001, our four largest customers accounted for 56.3% of our revenues,and during 2002, our four largest customers accounted for 58.6% of ourrevenues.

 

**Researchand 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 and video solutions enabled bycompression. Accordingly, we devote a significant portion of our resources tomaintaining and upgrading our products to reduce integrated circuit cost,feature size, power consumption and the number of integrated circuits requiredto perform compression and other functions necessary for the evolving digitalaudio and video application markets. In addition, we seek to design integratedcircuits and cores, as well as copy-ready reference designs which can reducethe time needed by manufacturers to integrate our products into their ownproducts.

 

We have historically generated a significant percentage of our totalrevenues from development contracts with our strategic partners. Thesedevelopment contracts provide that we will receive payments upon reachingcertain development milestones and that we will retain ownership of theintellectual property developed. Development contracts have enabled us to fundportions of our product development efforts, to respond to the featurerequirements of our customers, to accelerate the incorporation of our products intoour customers’ products and to accelerate the time-to-market of our customers’products. We anticipate however, that in the future, development contracts withstrategic partners will fund a smaller portion of our development efforts thenin the past.

 

We are a party to research and development agreements with the ChiefScientist in Israel’s Ministry of Industry and Trade and the Israel-UnitedStates Binational 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 2000, we earned total grants of $333,000. We did not receive anygrants from these organizations in 2001 or 2002. The terms of IsraeliGovernment 

 

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participation also contain restrictions on the location of research anddevelopment activities, and the terms of the grants from the Chief Scientistprohibit the transfer of technology developed pursuant to these grants to anyperson without the prior written consent of the Chief Scientist.

 

As of December 31, 2002, we had a staff of 136 full-time and 30part-time research and development personnel, 152 of whom are based in Israel.

 

**Salesand Marketing**

 

Our sales and marketing strategy is to focus on providing solutions,primarily compression related, for manufacturers seeking to design audio andvideo products for emerging high volume consumer applications. In cooperationwith leading manufacturers of audio and video equipment in the commercial andconsumer markets, we attempt to identify market segments which have thepotential for substantial growth. To implement our strategy, we have establisheda direct sales force located at several sales and marketing offices, and aworldwide network of independent sales representatives and resellers. In somecases, our strategic 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 29-person direct sales staff, of whom 3 arelocated in the United States and 26 are located internationally. Our UnitedStates sales staff is primarily responsible for sales in North America andSouth America. Our Israeli sales staff is primarily responsible for sales inEurope and the Middle East. Our sales staffs in China, Hong Kong, Japan, Koreaand Taiwan are responsible for sales in their respective regions. In addition,we sell our products indirectly through 5 commissioned sales representatives aswell as selected distributors. We typically warrant our products for a 12-monthperiod. To date, we have not experienced material product returns or warrantyexpense.

 

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, 2002,we had a staff of 77 employees in our China office and 12 employees in ourTaiwan office, including sales, applications and customer support employees. Inaddition, in 2001 we opened offices in Hong Kong and Korea which had staffs ofsix employees and seven employees, respectively, at December 31, 2002. Theseoffices also provide sales, applications and customer support.

 

We distribute our DVD integrated circuit products in Japan primarilythrough Fujifilm. Fujifilm acts as the primary reseller in Japan of productsdeveloped by us under development contracts with Fujifilm. We may sell theseproducts directly in Japan only to specified customers with Fujifilm’s consent.We also operate an office in Tokyo to help promote our products in Japan,manage the sales of products not sold through Fujifilm, such as integratedcircuit cores and certain filmless digital camera and JPEG products, andprovide applications support for some of our customers.

 

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 in thefuture could harm our sales.

 

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We sell our DTSTechnology-based products under a non-exclusive license from DTS Technology LLCto sell products that incorporate the DTS algorithm. We are not required to payroyalties to DTS Technology under this agreement. Our customers enter intolicense agreements directly with DTS, pursuant to which they pay royalties toDTS. Under our agreement with DTS, we may sell our DTS-based products only tocustomers who are licensees of DTS. The failure or refusal of potentialcustomers to enter into license agreements with DTS in the future could harmour sales.

 

 

**Backlog**

 

Sales of our products are made pursuant to firm purchase orders.However, sometimes we allow customers to cancel or reschedule deliveries. Inaddition, 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 business is characterized byshort lead times and quick delivery schedules. As a result of these factors, wedo not believe that backlog at any given time is a meaningful indicator offuture 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 iscurrently manufacturing our DVD, audio, JPEG and some of our digital cameraproducts. In addition, National Semiconductor manufactures some of our digitalcamera products. Hyundai and Fujitsu manufacture 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 0.18 micron to0.8 micron feature sizes. All of our semiconductor products are currently beingassembled by one of seven independent contractors, ASE, Amkor, ASAT, Kingpak,Kyocera, STATS or Vate, and tested by those contractors or other independentcontractors.

 

We currently purchase products from all of our foundries under individuallynegotiated purchase orders. We do not currently have a long-term supplycontract with TSMC, and therefore TSMC is not obligated to manufacture productsfor us for any specific period, in any specific quantity or at any specifiedprice, except as may be provided in a particular purchase order.

 

**Competition**

 

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

 

•                                          finance;

 

•                                          manufacturing;

 

•                                          technology;

 

•                                          marketing;and

 

•                                          distribution.

 

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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, LSILogic, ESS, Cirrus Logic, Matsushita, MediaTek, National Semiconductor,STMicroelectronics, Sony, Texas Instruments and Winbond have introducedintegrated audio and video devices for DVD applications. These manufacturers,as well as others, are licensed by Dolby to incorporate Dolby Digitaltechnology in their products. In addition, some manufacturers, including Sony,incorporate compression technologies other than Dolby Digital in audio productsthat compete with products using our integrated circuits. In the markets forJPEG-based products for use in filmless digital cameras, our principalcompetitors are in-house solutions developed and used by major Japanese OEMs,as well as products sold by Atmel, Omnivision, Sunplus and Texas Instruments.Motorola is providing CMOS sensor products.  In the market for JPEG-based products for desktop video editingapplications, our principal competitors are Divio and Sunplus. Cirrus Logic(Crystal Semiconductor), Fujitsu, Motorola, STMicroelectronics and Yamaha arecurrently shipping Dolby Digital-based audio compression products.

 

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

 

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

 

•                                          thetiming and success of new product introductions by us, our customers and ourcompetitors;

 

•                                          theemergence of new industry standards;

 

•                                          ourability to obtain adequate foundry capacity;

 

•                                          thenumber and nature of our competitors in a given market; and

 

•                                          generalmarket and 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.

 

The DVD market is growing, and additional competitors are expected toenter the market for integrated circuits used in DVD players. We believe thatseveral large Japanese consumer electronics companies may be planning to enterthis market and may attempt to develop MPEG 2 hardware or software to competewith our products. Some of these potential competitors may develop captiveimplementations for use only with their own PC and commercial and consumerelectronics products. This increased competition may result in pricereductions, reduced profit margins and loss of market share.

 

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 likely need to reduce the cost of our products. We intend to accomplishthis by implementing design changes that lower the cost of manufacture,assembly and testing, by negotiating reduced charges by our foundries as and ifvolumes increase, and by successfully managing our manufacturing andsubcontracting relationships. Since we do not operate our own manufacturing,assembly or testing facilities, we may not be able to reduce our costs asrapidly as companies that operate their own facilities. If we fail to introducelower cost versions of our products in a timely manner or to successfullymanage our manufacturing, assembly and testing relationships our business wouldbe harmed.

 

**ProprietaryRights 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 

 

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competitive position. We generally enter into confidentiality orlicense agreements with our employees, resellers, customers and potentialcustomers and limit access to our proprietary information. We currently holdseveral U.S. patents, and have additional patent applications pending, thatpertain to technologies and processes relating to our current business. Ourintellectual property rights, if challenged, may not be upheld as valid, maynot be adequate to prevent misappropriation of our technology or may notprevent the development of competitive products. Additionally, we may not beable to obtain patents or other intellectual property protection in the future.In particular, the existence of several consortiums that license patentsrelating to the MPEG standard has created uncertainty with respect to the useand enforceability of patents implementing that standard. Furthermore, the lawsof 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-basedproducts under a perpetual non-exclusive license from Dolby which permits us toincorporate the Dolby Digital algorithm into our products. Our customers enterinto license agreements with Dolby pursuant to which they pay royaltiesdirectly to Dolby. Under our agreement with Dolby, we may sell our DolbyDigital-based products only to customers who are licensees of Dolby. To date,most potential customers for our Dolby Digital-based products are licensees ofDolby. However, the failure or refusal of potential customers to enter intolicense agreements with Dolby in the future could harm our business. We sellour DTS Technology-based products under a non-exclusive license from DTSTechnology LLC to sell products that incorporate the DTS algorithm. We are notrequired to pay royalties to DTS under this agreement. Our customers enter intolicense agreements directly with DTS, pursuant to which they pay royalties toDTS. Under our agreement with DTS, we may sell our DTS-based products only tocustomers who are licensees of DTS. The failure or refusal of potentialcustomers to enter into license agreements with Dolby in the future could harmour 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 may be subjectto additional claims in the future. In particular, given the uncertaintydiscussed above regarding patents relating to the MPEG standard, it isdifficult for us to assess the possibility that our activities in the MPEGfield may give rise to future patent infringement claims. Litigation by oragainst us relating to patent infringement or other intellectual propertymatters could result in significant expense to us and divert the efforts of ourtechnical and management personnel, whether or not such litigation results in adetermination favorable to us. In the event of an adverse result in any suchlitigation, we could be required to pay substantial damages, cease themanufacture, use and sale of infringing products, expend significant resourcesto develop non-infringing technology, discontinue the use of certain processes orobtain licenses to the infringing technology. Licenses may not be offered orthe terms of any offered licenses may not be acceptable to us. If we fail toobtain a license from a third party for technology used by us we could incursubstantial liabilities and to suspend the manufacture of products, or the useby our foundries of certain processes.

 

**Employees**

 

As of December 31, 2002, we had 311 full-time and 68 part-time andcontract employees, including 136 full-time and 30 part-time and contractemployees primarily involved in research and development activities, 159 inmarketing and sales, 40 in finance and administration and 14 in manufacturingcontrol and quality assurance. We have 151 full-time employees and 36 part-timeand contract employees based in Israel, including 166 employees who areprimarily involved in engineering and research and development. We have 75employees at our facilities in Santa Clara, California. The remaining employeesare located in our international offices in Canada, China, Hong Kong, Japan,Korea and Taiwan. We believe that our future success will depend in large parton our ability to attract and retain highly-skilled, engineering, managerial,sales and 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.

 

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**Item 2.****                Properties.**

 

Our executive offices, our principal administration, marketing andsales operations and a portion of our research and development operations arelocated in approximately 24,000 square feet of leased space in Santa Clara,California under a lease expiring in March 2003. Our principal research anddevelopment and engineering facilities and the balance of our administration,marketing and sales operations are located in approximately 27,000 square feetof leased space in an industrial park in Haifa, Israel under a lease expiringin 2005. In addition, we maintain a small research and development facility inToronto, Canada. The aggregate annual gross rent for our facilities wasapproximately $1.7 million in 2002. We also lease sales offices in Tokyo,Japan, Taipei, Taiwan, Shenzhen, China, Hong Kong and Seoul, Korea. See Note 9of Notes to Consolidated Financial Statements. We believe that our currentfacilities are adequate for our needs for the foreseeable future and that,should it be needed, suitable additional space will be available to accommodateexpansion of our operations on commercially reasonable terms.

 

**Item 3.****                Legal Proceedings.**

 

We are not a party to anypending legal proceedings which we believe will materially affect our financialcondition or results of operations.

 

**Item 4.****                Submission ofMatters to a Vote of Security Holders.**

 

We did not submit any mattersto a vote of security holders during the fourth quarter of the year endedDecember 31, 2002.

 

**Executive Officers**

 

The names of our executive officers and their ages as of December 31,2002 are as follows:

 
| **NAME**             |   | **AGE** |   | **POSITION**                                              |
|----------------------|--------|---------|--------|-----------------------------------------------------------|
|                 |   |    |   |                                                      |
| Levy Gerzberg, Ph.D  |   | 58      |   | President, Chief Executive Officer and Director           |
| Camillo Martino      |   | 41      |   | Executive Vice President and Chief Operating Officer      |
| Isaac Shenberg, Ph.D |   | 51      |   | Senior Vice President, Business and Strategic Development |
| Karl Schneider       |   | 48      |   | Vice President, Finance and Chief Financial Officer       |

 

*Levy Gerzberg*was a co-founder of Zoran in 1981 and has served as our President and ChiefExecutive Officer since December 1988 and as a director since 1981. Dr.Gerzberg also served as our President from 1981 to 1984 and as our ExecutiveVice President and Chief Technical Officer from 1985 to 1988. Prior toco-founding Zoran, Dr. Gerzberg was Associate Director of Stanford University’sElectronics Laboratory. Dr. Gerzberg holds a Ph.D. in Electrical Engineeringfrom Stanford University and an M.S. in Medical Electronics and a B.S. inElectrical Engineering from the Technion-Israel Institute of Technology inHaifa, Israel.

 

*Camillo Martino*joined Zoran as Executive Vice President and Chief Operating Officer in August2001. From January 2001 through July 2001, Mr. Martino served as ChiefExecutive Officer of Merinta Inc., a subsidiary of Boundless Corporation,engaged in the business of delivering integrated Linux-based internet appliancesolutions to network 

 

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operators.  Mr. Martino servedas Marketing Director for National Semiconductor from May 2000 to December2000. From February 2000 to May 2000, he served as Vice President & GeneralManager - International Operations for Netpliance Inc., an internet appliancecompany. From January 1997 through February 2000, Mr. Martino served in variousdirector of marketing positions for National Semiconductor. Mr. Martino holds aM.S. in Digital Communications from Chisholm Institute of Technology, now partof Monash University, and a B.S. in Electrical Engineering from the Universityof Melbourne.

 

*Isaac Shenberg*has served as Vice President, Sales and Marketing of Zoran since January 1995and as Senior Vice President, Business and Strategic Development since October1998. From August 1990 to January 1995, Dr. Shenberg served as our Product LineBusiness Manager. Dr. Shenberg holds a Ph.D. in Electrical Engineering fromStanford University and a B.S. and M.S. in Electrical Engineering from theTechnion.

 

*Karl Schneider*joined Zoran as Corporate Controller in January 1998 and was elected VicePresident, Finance and Chief Financial Officer in July 1998. From September1996 through 1997, Mr. Schneider served as Controller for the Film Measurementand Robotics and Integrated Technologies divisions of KLA-Tencor, asemiconductor equipment company. Mr. Schneider served as the CorporateController for SCM Microsystems, Inc. from October 1995 to September 1996,Controller for Reply Corporation from January 1994 to September 1995, Directorof Finance for Digital F/X from October 1992 to January 1994 and Controller forFlextronics from September 1987 through June 1991. Mr. Schneider holds a B.S.in Business Administration from San Diego State University.

 

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**PART II**

 

**Item 5.****                Market for theRegistrant’s Common Stock and Related Stockholder Matters.**

 

We effected our initial public offering of our common stock on December15, 1995.  Since that date, our commonstock has been quoted on the Nasdaq National Market under the symbol “ZRAN.”The following table sets forth the high and low closing sales price of ourcommon stock as reported on The Nasdaq National Market for the periodsindicated, as adjusted to reflect a three-for-two stock split in May 2002:

 
|           |   | **High** |   | **Low** |   |
|----------------|--------|----------|--------|---------|--------|
| **2001:**      |   |     |   |    |   |
| First Quarter  |   | $        | 14.79  |    | $      | 8.67 |   |
| Second Quarter |   | $        | 19.81  |    | $      | 9.67 |   |
| Third Quarter  |   | $        | 27.03  |    | $      | 11.40 |   |
| Fourth Quarter |   | $        | 25.42  |    | $      | 13.68 |   |
|           |   |     |   |    |   |
| **2002:**      |   |     |   |    |   |
| First Quarter  |   | $        | 29.39  |    | $      | 18.87 |   |
| Second Quarter |   | $        | 31.81  |    | $      | 19.00 |   |
| Third Quarter  |   | $        | 20.99  |    | $      | 10.54 |   |
| Fourth Quarter |   | $        | 23.51  |    | $      | 9.11 |   |

 

As of December 31, 2002, therewere 244 holders of record of our common stock.

 

We have never paid cashdividends on our capital stock.  It isour present policy to retain earnings to finance the growth and development ofour business and, therefore, we do not anticipate paying any cash dividends inthe foreseeable future.

 

19

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**Item 6.****                Selected FinancialData.**

 

The following selectedconsolidated financial data should be read in conjunction with the consolidatedfinancial statements and the notes thereto included elsewhere herein.

 
|                                                                                      |   | **Year Ended  December 31,**               |    |
|-------------------------------------------------------------------------------------------|--------|--------------------------------------------|---------|
|                                                                                      |   | **2002**                                   |    | **2001** |   | **2000** |   | **1999** |   | **1998** |   |
|                                                                                      |   | **(in  thousands, except per share data)** |    |
| **Consolidated Statement of Operations Data:**                                            |   |                                       |    |   |   |   |   |   |   |   |   |
|                                                                                      |   |                                       |    |   |   |   |   |   |   |   |   |
| Revenues:                                                                                 |   |                                       |    |   |   |   |   |   |   |   |   |
| Product sales                                                                             |   | $                                          | 141,314 |   | $ | 100,012 |   | $ | 67,782 |   | $ | 52,887 |   | $ | 33,465 |   |
| Software, licensing and development                                                       |   | 7,803                                      |    | 7,697 |   | 11,889 |   | 8,787 |   | 10,760 |   |
| Total revenues                                                                            |   | 149,117                                    |    | 107,709 |   | 79,671 |   | 61,674 |   | 44,225 |   |
|                                                                                      |   |                                       |    |   |   |   |   |   |   |   |   |
| Costs and expenses:                                                                       |   |                                       |    |   |   |   |   |   |   |   |   |
| Cost of product sales                                                                     |   | 86,904                                     |    | 64,740 |   | 37,993 |   | 28,523 |   | 19,036 |   |
| Research and development                                                                  |   | 22,083                                     |    | 23,210 |   | 18,628 |   | 12,651 |   | 13,548 |   |
| Selling, general and administrative                                                       |   | 24,856                                     |    | 21,330 |   | 19,148 |   | 14,251 |   | 11,551 |   |
| Amortization of intangible assets                                                         |   | 8,443                                      |    | 9,697 |   | 1,982 |   | — |   | — |   |
| Amortization of goodwill and write-off of  acquired in-process research & development |   | —                                     |    | 33,536 |   | 29,787 |   | — |   | — |   |
| Total costs and expenses                                                                  |   | 142,286                                    |    | 152,513 |   | 107,538 |   | 55,425 |   | 44,135 |   |
|                                                                                      |   |                                       |    |   |   |   |   |   |   |   |   |
| Operating income (loss)                                                                   |   | 6,831                                      |    | (44,804 | ) | (27,867 | ) | 6,249 |   | 90 |   |
| Interest income                                                                           |   | 7,053                                      |    | 9,853 |   | 9,280 |   | 1,467 |   | 1,194 |   |
| Other income (loss)(1)                                                                    |   | (6,614                                     | )       | 151 |   | (51 | ) | 118 |   | (123 | ) |
| Income (loss) before income taxes                                                         |   | 7,270                                      |    | (34,800 | ) | (18,638 | ) | 7,834 |   | 1,161 |   |
| Provision for income taxes                                                                |   | 1,572                                      |    | 1,265 |   | 1,970 |   | 1,175 |   | 232 |   |
| Net income (loss)                                                                         |   | $                                          | 5,698   |   | $ | (36,065 | ) | $ | (20,608 | ) | $ | 6,659 |   | $ | 929 |   |
| Basic net income (loss) per share(2)                                                      |   | $                                          | 0.21    |   | $ | (1.38 | ) | $ | (0.91 | ) | $ | 0.41 |   | $ | 0.06 |   |
| Diluted net income (loss) per share(2)                                                    |   | $                                          | 0.20    |   | $ | (1.38 | ) | $ | (0.91 | ) | $ | 0.36 |   | $ | 0.06 |   |
| Shares used to compute basic net income  (loss) per share(2)                         |   | 27,095                                     |    | 26,190 |   | 22,605 |   | 16,266 |   | 15,063 |   |
| Shares used to compute diluted net income  (loss) per share(2)                       |   | 28,629                                     |    | 26,190 |   | 22,605 |   | 18,374 |   | 16,679 |   |

 
|                                               |   | **December  31,**  |    |
|----------------------------------------------------|--------|--------------------|---------|
|                                               |   | **2002**           |    | **2001** |   | **2000** |   | **1999** |   | **1998** |   |
|                                               |   | **(in thousands)** |    |
| **Consolidated Balance Sheet Data:**               |   |               |    |   |   |   |   |   |   |   |   |
|                                               |   |               |    |   |   |   |   |   |   |   |   |
| Cash, cash equivalents and short-term  investments |   | $                  | 137,075 |   | $ | 110,105 |   | $ | 175,638 |   | $ | 145,632 |   | $ | 19,175 |   |
| Working capital                                    |   | 159,288            |    | 130,777 |   | 197,719 |   | 157,583 |   | 30,830 |   |
| Total assets                                       |   | 342,616            |    | 331,344 |   | 359,466 |   | 182,468 |   | 49,170 |   |
| Accumulated deficit                                |   | (88,492            | )       | (94,190 | ) | (58,125 | ) | (37,517 | ) | (44,176 | ) |
| Total stockholders’ equity                    |   | 311,012            |    | 297,838 |   | 331,454 |   | 163,445 |   | 36,186 |   |
|                                                    |        |                    |         |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1)          See Note 5 of Notes to Consolidated FinancialStatements

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

 

20

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

 

**Overview**

 

From our inception in 1981 through 1991, we derived the substantialmajority of our revenue from digital filter processors and vector signalprocessors used principally in military, industrial and medical applications.In 1989, we repositioned our business to develop and market data compressionproducts for the evolving multimedia markets and discontinued development ofdigital filter processor and vector signal processor products. In 1994, wediscontinued production of these products. Our current lines of digital audioand video products include integrated circuits and related products used in digitalversatile disc players, movie and home theater systems, filmless digitalcameras and video editing systems.

 

We derive most of our revenues from the sale of our integrated circuitproducts. Historically, average selling prices in the semiconductor industry ingeneral, and for our products in particular, have decreased over the life of aparticular product. Average selling prices for our hardware products havefluctuated substantially from period to period, primarily as a result ofchanges in our customer mix of original equipment manufacturer, or OEM, salesversus sales to distributors and the transition from low-volume to high-volumeproduction. In the past, we have reduced the prices of some of our products inorder to better penetrate the consumer market. We believe that, as our productlines continue to mature and competitive markets evolve, we are likely toexperience further declines in the average selling prices of our products,although we cannot predict the timing and amount of such future changes withany certainty.

 

Our cost of product sales consists primarily of fabrication costs,assembly and test costs, and the cost of materials and overhead fromoperations. If we are unable to reduce our cost of product sales to offsetanticipated decreases in average selling prices, our product gross margins willdecrease. Our product gross margin is also dependent on product mix and on thepercentage of products sold directly to our OEM customers versus indirectlythrough our marketing partners who purchase our products at lower prices butabsorb most of the associated marketing and sales support expenses, maintaininventories and provide customer support and training. Lower gross margins onsales to resellers are partially offset by reduced selling and marketingexpenses related to such sales. Product sales in Japan are primarily madethrough Fujifilm, our strategic partner and reseller in Japan. Fujifilmprovides more sales and marketing support than our other resellers. We expectboth product and customer mix to continue to fluctuate in future periods,causing further fluctuations in margins.

 

We also derive revenue from licensing our software and otherintellectual property. Licensing revenue includes one-time license fees androyalties based on the number of units distributed by the licensee. Inaddition, we have historically generated a significant percentage of our totalrevenues from development contracts, primarily with key customers, althoughdevelopment revenue has declined substantially as a percentage of totalrevenues over the past several years. These development contracts have providedus with partial funding for the development of some of our products. Thesedevelopment contracts provide for license and milestone payments which arerecorded as development revenue. We classify all development costs, includingcosts related to these development contracts, as research and developmentexpenses. We retain ownership of the intellectual property developed by usunder these development contracts. While we intend to continue to enter intodevelopment contracts with certain strategic partners, we expect developmentrevenue to continue to decline as a percentage of total revenues.

 

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

 

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

 

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We conduct most of our research and development and certain sales andmarketing and administrative operations in Israel through our wholly-ownedIsraeli subsidiary. As a result, some of our expenses are incurred in NewIsraeli Shekels. To date, substantially all of our product sales and ourdevelopment and licensing revenue have been denominated in U.S. dollars andmost costs of product sales have been incurred in U.S. dollars. We expect thatmost of our sales and costs of sales will continue to be denominated andincurred in U.S. dollars for the foreseeable future. We have not experiencedmaterial losses or gains as a result of currency exchange rate fluctuations andhave not engaged in hedging transactions to reduce our exposure to suchfluctuations. We may in the future elect to take action to reduce our foreignexchange risk.

 

Our effective income tax rate has benefited from the availability ofnet operating losses which we have utilized to reduce taxable income for U.S.federal income tax purposes and by our Israeli subsidiary’s status as an“Approved Enterprise” under Israeli law, which provides a ten-year tax holidayfor income attributable to a portion of our operations in Israel. Our U.S.federal net operating losses expire at various times between 2003 and 2020, andthe benefits from our subsidiary’s Approved Enterprise status expire at varioustimes beginning in 2003.

 

In June 2000, we acquired PixelCam, Inc., a manufacturer of megapixelCMOS image sensors, in exchange for 556,248 shares of our common stock andoptions to purchase 6,252 shares of our common stock with an aggregate value of$24.6 million. The acquisition was accounted for under the purchase method ofaccounting. See Note 14 of Notes to Consolidated Financial Statements.

 

On October 26, 2000, we acquired Nogatech Inc., a provider of chipsthat compress digital video images and establish connections, or videoconnectivity, between video devices and computers, as well as between videodevices across a variety of networks, in exchange for 3,801,839 shares of ourcommon stock and options to purchase 252,708 shares of our common stock with anaggregate value of $163.6 million. The acquisition was accounted for under thepurchase method of accounting. See Note 14 of Notes to Consolidated FinancialStatements.

 

On April 21, 2002, our Board of Directors approved a three-for-twosplit of our common stock which was effected in the form of a fifty percentstock dividend, paid on May 22, 2002 to stockholders of record on May 7, 2002.All share and per share information for all periods presented in this reportare on a post-split basis.

 

**CriticalAccounting Policies and Estimates**

 

Our 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 in theUnited States of America. The preparation of these financial statementsrequires us to make estimates and judgments that affect the reported amounts ofassets, liabilities, revenues and expenses, and related disclosure ofcontingent assets and liabilities. On an on-going basis, we evaluate ourestimates, including bad debts, inventories, investments, intangible assets andincome taxes. We base these estimates on historical experience and on variousother assumptions that are believed to be reasonable under the circumstances,the results of which form the basis for making judgments about the carryingvalues of assets and liabilities that are not readily apparent from othersources. Actual results may differ from these estimates under differentassumptions or conditions.

 

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

 

•                                          Werecognize development revenue using the percentage-of-completion method. Underthe percentage-of-completion method, revenue recognized is that portion of thetotal contract price equal to the ratio of costs expended to date to theanticipated final total costs, based on current estimates of the costs tocomplete the project. These estimates are reviewed and revised periodicallythroughout the lives of the contracts. Any revisions are recorded in theaccounting period in which the revisions are made.

 

•                                          Inventoriesare recorded at the lower of standard cost, which approximates actual cost on afirst-in-first-out basis, or market value. We write down inventories to netrealizable value based on forecasted demand and market conditions. Actualdemand and market conditions may be different from those projected by our management.This could have a material effect on our operating results and financialposition.

 

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•                                          Wemaintain allowances for doubtful accounts for estimated losses resulting fromthe inability of certain of our customers to make required payments.  If the financial condition of our customerswere to deteriorate, resulting in an impairment of their ability to makepayments, additional allowances may be required.

 

•                                          Wehold minority interests in private companies having operations or technology inareas within our strategic focus. At December 31, 2002, these investmentstotaled $1.2 million. We record an investment impairment charge when we believean investment has experienced a decline in value. 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 market conditions or poor operating resultsof underlying investments could result in losses or an inability to recover thecarrying value of the investments that may not be reflected in an investment’scurrent carrying value thereby possibly requiring an impairment charge in thefuture. In 2002, we recorded non-cash investment impairment charges of $2.4million in conjunction with investments in private companies.

 

•                                          Weassess the impairment of long-lived assets, identifiable intangibles andrelated goodwill annually or sooner if events or changes in circumstances indicatethat the carrying value of such assets exceeds the future undiscounted cashflows attributable to such assets. Factors, which could trigger an impairmentreview, include significant negative industry or economic trends, exiting anactivity in conjunction with a restructuring of operations, current, historicalor projected losses that demonstrate continuing losses associated with an assetor a significant decline in our market capitalization for an extended period oftime, relative to net book value. Impairment evaluations involve managementestimates of asset useful lives and future cash flows. These estimates includeassumptions about future conditions such as future revenues, gross margins,operating expenses, the fair values of certain assets based on appraisals, andindustry trends. Actual useful lives and cash flows could be different fromthose estimated by our management. This could have a material effect on ouroperating results and financial position.

 

•                                          Wefollow the liability method of accounting for income taxes which requiresrecognition of deferred tax liabilities and assets for the expected future taxconsequence of temporary differences between the financial statement carryingamounts and the tax bases of assets and liabilities. In the event actualresults differ from these expectations, then the resulting impact to incomewould be assessed in the period such determination was made.

 

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**Resultsof Operations**

 

The following table sets forthcertain consolidated statement of operations data as a percentage of totalrevenues for the periods indicated:

 
|                                                                                      |   | **Year Ended  December 31,** |   |
|-------------------------------------------------------------------------------------------|--------|------------------------------|--------|
|                                                                                      |   | **2002**                     |   | **2001** |   | **2000** |   |
| Revenues:                                                                                 |   |                         |   |   |   |   |   |
| Product sales                                                                             |   | 94.8                         | %      | 92.9 | % | 85.1 | % |
| Software, licensing and development                                                       |   | 5.2                          |   | 7.1 |   | 14.9 |   |
| Total revenues                                                                            |   | 100.0                        |   | 100.0 |   | 100.0 |   |
|                                                                                      |   |                         |   |   |   |   |   |
| Costs and expenses:                                                                       |   |                         |   |   |   |   |   |
| Cost of product sales                                                                     |   | 58.3                         |   | 60.1 |   | 47.7 |   |
| Research and development                                                                  |   | 14.8                         |   | 21.6 |   | 23.4 |   |
| Selling, general and administrative                                                       |   | 16.7                         |   | 19.8 |   | 24.0 |   |
| Amortization of intangible assets                                                         |   | 5.6                          |   | 9.0 |   | 2.5 |   |
| Amortization of goodwill and write-off of  acquired in-process research & development |   | —                       |   | 31.1 |   | 37.4 |   |
| Total costs and expenses                                                                  |   | 95.4                         |   | 141.6 |   | 135.0 |   |
|                                                                                      |   |                         |   |   |   |   |   |
| Operating income (loss)                                                                   |   | 4.6                          |   | (41.6 | ) | (35.0 | ) |
| Interest income                                                                           |   | 4.7                          |   | 9.2 |   | 11.6 |   |
| Other income (loss)                                                                       |   | (4.4                         | )      | 0.1 |   | — |   |
| Income (loss) before income taxes                                                         |   | 4.9                          |   | (32.3 | ) | (23.4 | ) |
| Provision for income taxes                                                                |   | 1.1                          |   | 1.2 |   | 2.5 |   |
|                                                                                      |   |                         |   |   |   |   |   |
| Net income (loss)                                                                         |   | 3.8                          | %      | (33.5 | )% | (25.9 | )% |

 

*Year Ended December 31, 2002 Compared to YearEnded December 31, 2001*

 

*Revenues*.  Total revenues increased by 38.4% to $149.1million in 2002 from $107.7 million in 2001. Product sales increased by 41.3% to $141.3 million in 2002 from $100.0million in 2001. The increase in product sales resulted primarily from a $38.9million increase in sales of DVD products and a $7.7 million increase in salesof filmless digital camera products. The increased product sales for bothproduct lines were due to increased unit shipments. Offsetting these increasessomewhat was a $6.0 million decrease in sales of PC video products due to lowerunit shipments. Software, licensing and development revenues increased slightlyto $7.8 million in 2002 from $7.7 million in 2001.

 

*Product Gross Margin.  *Product grossmargin increased to 38.5% in 2002 compared to 35.3% in 2001.  The increase was due to margin improvementsin our DVD product line resulting from a shift in product mix to a higherpercentage of newer, more cost effective DVD products that are not required tobe sold in combination with DVD CPU companion chips which, historically, weresold at low margins.

 

*Research and Development. *Research anddevelopment (“R&D”) expenses decreased by 4.9% to $22.1 million in 2002from $23.2 million in 2001. Gross R&D expenses decreased primarily as aresult of the timing of major project expenses such as tape-outs. R&D expenses in 2002 and 2001 did not includeany reimbursements from the Chief Scientist.  R&D expenses decreased as a percentage of total revenues to14.8% in 2002, compared to 21.5% in 2001 due to the increase in revenue. Weanticipate gross R&D expenses to increase in 2003, as we remain committedto enhancing our technology and development capabilities.

 

*Selling, General and Administrative. *Selling, generaland administrative (“SG&A”) expenses increased by 16.5% to $24.9 million in2002 from $21.3 million in 2001.  Theincrease was primarily due to $2.1 million of increased marketing andapplication expenses to support planned revenue growth in our Asia Pacificmarkets and $1.5 million of increased product marketing expenses related to ourdigital camera products. We expect SG&A expenses to increase in 2003 as wecontinue to augment our customer and application support in the Asia Pacificregion.

 

*Amortization of Intangible Assets.* During 2002, we recorded $7.6 million and$567,000 in charges related to the amortization of intangible assets associatedwith our acquisitions of Nogatech and PixelCam, respectively. During 2001, werecorded $8.6 million and $567,000 in such charges for Nogatech and PixelCam,respectively. See Note 6 of Notes to Consolidated Financial Statements.

 

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*Amortization of Goodwill and Write-off of Acquired In-process Researchand Development.*Based on the adoption of Financial Accounting Standards Board (FASB) StatementsNos. 141 and 142, “Business Combinations” and “Goodwill and Other IntangibleAssets” (“SFAS 141” and “SFAS 142”), we did not record charges for theamortization of goodwill during 2002. For 2001, we recorded $33.5 million ingoodwill amortization associated with our acquisitions of PixelCam and Nogatechin 2000. SFAS 142 changed the accounting for goodwill from an amortizationmethod to an impairment-only approach. Under SFAS 142, goodwill will be testedannually and whenever events or circumstances occur indicating that goodwillmight be impaired. During 2002, we conducted our annual impairment assessmentbased on our structure as a single reporting unit and determined that noimpairment exists.

 

The in-process research anddevelopment project acquired from Nogatech relates to MPEG 4 technology to beused in video streaming applications. Our marketing plan at the time of theacquisition indicated that the market that we serve would demand productsincorporating this technology beginning in the 2002 to 2003 timeframe. We nowbelieve that our target market will not require this technology until 2004 dueto market-related pricing considerations. The delay in the project will shiftprojected cash flows out by approximately one to two years. We estimate thatthis project will take approximately one year to complete and will costapproximately $1 million. Completion of this project remains a significant riskto the Company due to the remaining effort to achieve technical feasibility,rapidly changing customer markets and significant competitive threats fromother companies. Failure to bring related products to market in a timely mannercould adversely impact our future sales and profitability. Additionally, thevalue of the intangible assets acquired may become impaired.

 

*Interest Income.*Interest income decreased by $2.8 million to$7.1 million in 2002 compared with $9.9 million in 2001. The reduction was dueto a decline in market interest rates.

 

*Other Income (Loss).*In 2002, we incurred other losses of $6.6million primarily associated with non-cash impairment charges of $6.0 millionand the conversion of equity securities in conjunction with the acquisition ofan investee of $696,000. In 2001, we recorded other income of $151,000primarily associated with foreign exchange gains net of losses. During 2002, werecorded a non-cash impairment charge of $3.6 million associated withmarketable equity securities that were considered to be other than temporarilyimpaired. In determining whether an investment is other than temporarilyimpaired we consider, among other things, the duration and extent to which themarket value has declined relative to our cost basis, the economic factorsinfluencing the markets, the relative performance of the investee and itsnear-term prospects. There were no such impairment charges for marketableequity securities in 2001. Also in 2002, we recorded a non-cash impairmentcharge of $2.4 million associated with non-marketable securities. We review ournon-marketable investments for impairment when circumstances or events indicatethat the carrying value of the investments may not be recoverable. When thefair value of a non-marketable investment declines below its cost basis, weconsider all available evidence to evaluate whether a decline in value hasoccurred. Among other things, we consider the historical and projectedfinancial performance and recent funding events which are ascertained from theinvestee. There were no such impairment charges in 2001. The non-cashloss of $696,000 was associated with the acquisition by Roxio, Inc. of MGISoftware Inc. As of the date of the acquisition, we held approximately 373,000shares of MGI common stock. Upon consummation of the acquisition, our MGIcommon stock was exchanged for 18,843 shares of Roxio common stock. Inconnection with the exchange, we recorded a realized loss of $696,000 andestablished a new cost basis of our Roxio common stock equal to its fair valueon the date of the exchange. See Note 5 of Notes to Consolidated FinancialStatements.

 

*Provision for Income Taxes. *Excluding charges related to theamortization of goodwill and the write-off of acquired in-process research anddevelopment our estimated effective tax rate decreased to 10% for 2002compared with 15% in 2001.

 

*** ***Year Ended December 31, 2001 Compared to Year EndedDecember 31, 2000

* *

*Revenues*.  Total revenues increased by 35.2% to $107.7million in 2001 from $79.7 million in 2000. Product sales increased by 47.5% to $100.0 million in 2001 from $67.8million in 2000. The increase in product sales resulted primarily from a $38.5million increase in the sales of  DVDproducts and a $2.9 million increase in the sales of filmless digital cameraproducts, both of which were associated with increased unit sales. In addition,product sales increased $2.7 in 2001 due to our acquisitions of Nogatech andPixelCam in 2000. Offsetting these increases somewhat were an $8.4 million decreasein sales of our digital audio products and a $3.1 million decrease in sales ofour PC video products. Software, licensing and development revenues decreasedby 35.3% to $7.7 million in 2001 from $11.9 million in 2000. 

 

25

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Of this decrease, $3.6 millionwas due to a decline in the number and size of significant new licensingcontracts and $406,000 related to the timing of revenue recognition on along-term development contract.

 

*Product Gross Margin.  *Product grossmargin decreased to 35.3% in 2001 compared to 43.9% in 2000.  The decrease was due to a substantial shiftin product mix to a higher percentage of lower-margin DVD products, whichinclude CPU companion chips that are sold at low margin, and a shift incustomer mix to a lower percentage of direct sales to OEM customers. Inaddition, we experienced a decline in the average selling price of our olderVaddis III DVD chip that was being phased out as we transitioned our customerbase to our new Vaddis IV Plus DVD chip.

 

*Research and Development. *Research anddevelopment (“R&D”) expenses increased by 24.6% to $23.2 million in 2001from $18.6 million in 2000. Gross R&D expenses increased primarily as aresult of our acquisitions of PixelCam and Nogatech, which accounted for $2.7million of the increase, and the timing of major project expenses such astape-outs which accounted for $1.9 million.R&D expenses in 2001 did not include reimbursements from the ChiefScientist.  For 2000, ChiefScientist reimbursements were $333,000. R&D expenses decreased as a percentage of total revenues to 21.5% in2001, compared to 23.4% in 2000 due to the increase in revenue.

 

*Selling, General and Administrative. *Selling, generaland administrative (“SG&A”) expenses increased by 11.4% to $21.3 million in2001 from $19.1 million in 2000.  Theincrease was primarily due to our acquisitions of PixelCam and Nogatech, whichaccounted for $900,000 of the increase, and the continued expansion of ourpresence in the Asia Pacific region, including the establishment of offices inHong Kong and Korea at the beginning of 2001, amounting to approximately$900,000.

 

*Amortization ofGoodwill and Other Intangibles and Write-off of Acquired In-process Researchand Development.*The acquisitions of PixelCam and Nogatech resulted in the following charges:

 

•                                          PixelCam:During 2001, we recorded $6.0 million in charges related to the amortization ofgoodwill and other intangibles associated with our acquisition of PixelCamcompared to $3.0 million recorded during 2000. During 2001, we did not record any charges related to the write-off ofin-process research and development associated with the PixelCam acquisition.For 2000 we incurred $6.8 million in charges associated with the write-off ofin process research and development.

 

•                                          Nogatech:During 2001, we recorded $36.7 million in charges related to the amortizationof goodwill and other intangibles associated with our acquisition of Nogatechcompared to $6.8 million recorded during 2000. During 2001, we did not record any charges related to the write-off ofin-process research and development associated with the Nogatech acquisition.For 2000 we incurred $15.1 million in charges associated with the write-off ofin process research and development.

 

*Interest Income. *Interest income increased by 6.2% to$9.9 million in 2001 from $9.3 million in 2000. The increase resulted primarilyfrom increased interest income on higher cash balances following ouracquisition of Nogatech in October 2000.

 

*Provision for Income Taxes. *Excluding charges related to theamortization of goodwill and the write-off of acquired in-process research anddevelopment our estimated effective tax rate remained at 15.0% for 2001and 2000.

 

**Liquidityand Capital Resources**

 

At December 31, 2002, we had $31.6 million of cash and cashequivalents, $105.5 million of short-term investments and $77.2 million ofinvestments that have maturity dates that are beyond one year and therefore areclassified as other assets. In addition, we had $159.3 million of workingcapital.

 

Our operating activitiesprovided cash of $18.7 million during 2002, primarily due to our net income of$5.7 million, as adjusted for the non-cash impact of amortization of otherintangibles of $8.4 million, investment impairment charges of $6.0 million anddepreciation of $3.2 million. Net income was further adjusted by the cashimpacts of a reduction in inventory of $3.0 million and an increase in accruedexpenses of $2.8 million. Net income was also adjusted by the cash impacts of adecrease in accounts payable of $7.8 million and increases in accountsreceivable of $2.2 million and prepaid expense of $1.3 million. The reductionin inventory was primarily due to a $1.9 million reduction in inventoryassociated with digital camera chips. The change in accounts payable andaccrued expenses was due to the normal timing differences in our paymentpatterns.

 

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Cash used in investing activities was $14.0 million during 2002,principally reflecting the purchases of short-term and long-term marketableinvestments, net of proceeds from sales and maturities of $10.3 million capitalexpenditures for property and equipment of $2.0 million and purchase ofintellectual property of $1.7 million.

 

Cash provided by financing activities was $6.7 million during 2002 andprimarily consisted of proceeds from the issuance of common stock under ourincentive stock option and employee stock purchase plans.

 

As of December 31, 2002, we were responsible for lease commitmentsof  $2.6 million associated with ourworldwide facilities of which $1.1 million is due in 2003, $979,000 is due in2004 and $464,000 is due in 2005. In addition, we had inventory purchasecommitments of $10.2 million at December 31, 2002.

 

At December 31, 2002 and 2001,we did not have any relationships with unconsolidated entities or financialpartnerships, such as entities often referred to as structured finance orspecial purpose entities, established for the purpose of facilitatingoff-balance sheet arrangements or other contractually narrow or limitedpurposes. Accordingly, we are not exposed to the type of financing, liquidity,market or credit risk that could arise if we had engaged in such relationships.

 

We believe that our current balances of cash, cash equivalents andshort-term investments, and anticipated cash flow from operations, will satisfyour anticipated working capital and capital expenditure requirements at leastthrough 2003. Nonetheless, our future capital requirements may vary materiallyfrom those now planned and will depend on many factors including, but notlimited to:

 

•                                          thelevels at which we maintain inventory and accounts receivable;

 

•                                          themarket acceptance of our products;

 

•                                          thelevels of promotion and advertising required to launch our new products or toenter markets and attain a competitive position in the marketplace;

 

•                                          ourbusiness, product, capital expenditure and research and development plans andtechnology roadmap;

 

•                                          volumepricing concessions;

 

•                                          capitalimprovements to new and existing facilities;

 

•                                          technologicaladvances;

 

•                                          theresponse of competitors to our products; and

 

•                                          ourrelationships with our suppliers and customers.

 

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

 

To the extent that our existing resources and cash generated fromoperations, are insufficient to fund our future activities, we may need toraise additional funds through public or private 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 additional equity or convertible debt securities couldresult in additional dilution to our stockholders. We cannot be certain thatadditional financing will be available in amounts or on terms acceptable to us,if at all. If we are unable to obtain this additional financing, we may berequired to reduce the scope of our planned product development and sales andmarketing efforts, which could harm our business, financial condition andoperating results.

 

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**FuturePerformance and Risk Factors**

 

Our future business, operating results andfinancial condition are subject to various risks and uncertainties, includingthose described below.

 

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

 

Our quarterly operating results have varied significantly due to anumber of factors, including:

 

•                                          fluctuationin demand for our products;

 

•                                          thetiming of new product introductions by us and our competitors;

 

•                                          thelevel of market acceptance of new and enhanced versions of our products and ourcustomers’ products;

 

•                                          thetiming of large customer orders;

 

•                                          thelength and variability of the sales cycle for our products;

 

•                                          thecyclical nature of the semiconductor industry;

 

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

 

•                                          changesin the mix of products sold;

 

•                                          seasonalityin demand for our products;

 

•                                          competitivepricing pressures; and

 

•                                          theevolving and unpredictable nature of the markets for products incorporating ourintegrated circuits and embedded software.

 

We expect that our operating results will continue to fluctuate in thefuture as a result of these factors and a variety of other factors, including:

 

•                                          the cost and availability of adequate foundry capacity;

 

•                                          fluctuationsin manufacturing yields;

 

•                                          theemergence of new industry standards;

 

•                                          productobsolescence; and

 

•                                          theamount of research and development expenses associated with new productintroductions.

 

Our operating results could also be harmed by:

 

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

 

•                                          otherconditions affecting the timing of customer orders; or

 

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•                                          adownturn in the markets for our customers’ products, particularly the consumerelectronics market.

 

These factors are difficult or impossible to forecast. We place ordersto purchase our products from independent foundries several months in advanceof the scheduled delivery date, often in advance of receiving non-cancelableorders from our customers. If anticipated shipments in any quarter are canceledor do not occur as quickly as expected, expense and inventory levels could bedisproportionately high. If anticipated license revenues in any quarter arecanceled or do not occur, gross margins may be reduced. A significant portionof our expenses are relatively fixed, and the timing of increases in expensesis based in large part on our forecast of future revenues. As a result, ifrevenues do not meet our expectations we may be unable to quickly adjustexpenses to levels appropriate to actual revenues, which could harm ouroperating results.

 

As a result of these factors, our operating results may varysignificantly from quarter to quarter. Any shortfall in revenues or net incomefrom levels expected by securities analysts could cause a decline in thetrading price of our stock.

 

**Oursuccess for the foreseeable future will be dependent on growth in demand forintegrated circuits for DVD and filmless digital camera applications and, to alesser extent, digital audio and video editing applications and our ability tomarket and sell our products to manufacturers who incorporate those types ofintegrated circuits into their products.**

 

In 2001 and 2002, we derived a substantial majority of our productrevenues from the sale of integrated circuits for DVD applications. We expectthat sales of our products for DVD applications will continue to account for asignificant portion of our revenues for the near future. Our ability to sellour products for filmless digital camera applications and, to a lesser extent,digital audio and video editing applications will also have an impact on ourfinancial performance for the foreseeable future. If the markets for these productsand applications decline or fail to develop as expected, or we are notsuccessful in our efforts to market and sell our products to manufacturers whoincorporate integrated circuits into these products, our financial results willbe harmed.

 

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

 

Because the markets our customers serve are characterized by numerousnew product introductions and rapid product enhancements, our operating resultsmay vary significantly from quarter to quarter. During the final production ofa mature product, our customers typically exhaust their existing inventory ofour products. Consequently, orders for our products may decline in thosecircumstances, even if our products are incorporated into both mature productsand replacement products. A delay in the 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 period, and therefore a disproportionatepercentage of our sales. We expect these sales fluctuations to continue for theforeseeable future.

 

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

 

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

** **

 

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**The development and evolution of markets forour integrated circuits is dependent on factors such as industry standards,over which we have no control; for example, if manufacturers adopt new orcompeting industry standards with which our products are not compatible, ourexisting products would become less desirable to the manufacturers and oursales would suffer.**

 

The emergence of markets for our products is affected by a variety offactors beyond our control. In particular, our products are designed to conformto current specific industry standards. Manufacturers may not continue tofollow these standards, which would make our products less desirable tomanufacturers and reduce our sales. Also, competing standards may emerge thatare preferred by manufacturers, which could also reduce our sales and requireus to make significant expenditures to develop new products. The emergence ofnew markets for our products is also dependent in part upon third partiesdeveloping and marketing content in a format compatible with commercial andconsumer products that incorporate our products. If content compatible withcommercial and consumer products that incorporate our products is notavailable, manufacturers may not be able to sell products incorporating ourintegrated circuits, and our sales to manufacturers would suffer.

 

**Werely on independent foundries and contractors for the manufacture, assembly andtesting of our integrated circuits, and the failure of any of these thirdparties to deliver products or otherwise perform as requested could damage ourrelationships with our customers and harm our sales and financial results.**

 

We do not operate any manufacturing facilities, and we rely onindependent foundries to manufacture substantially all of our products. Theseindependent foundries fabricate products for other companies and may alsoproduce products of their own design. From time to time there are manufacturingcapacity shortages in the semiconductor industry. We do not have long-termsupply contracts with any of our suppliers, including our principal supplier, TaiwanSemiconductor Manufacturing Company, or TSMC. Therefore, TSMC and these 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.

 

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

 

•                                          theinability to obtain adequate manufacturing capacity;

 

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

 

•                                          lackof control over delivery schedules;

 

•                                          lackof control over quality assurance;

 

•                                          lackof control over manufacturing yields and cost; and

 

•                                          potentialmisappropriation of our intellectual property.

 

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

 

We also rely on independent contractors for the assembly and testing ofour products. At present, all of our semiconductor products are assembled byone of seven independent contractors: ASE, Amkor, ASAT, Kingpak, Kyocera, STATSor Vate. Our semiconductor products are tested by these contractors or otherindependent contractors. 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 us to seek alternative sourcesof assembly or testing could lead to supply constraints or delays in thedelivery of our products. These constraints or delays could damage ourrelationships with current and prospective customers and harm our sales andfinancial results.

 

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

 

If we are not able to obtain additional foundry capacity as required,our relationships with our customers would be harmed and our sales would likelybe reduced. In order to secure additional foundry capacity, we have consideredand will continue to consider various arrangements with suppliers, which couldinclude, among others:

 

•                                          optionpayments or other prepayments to a foundry;

 

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

 

•                                          contractsthat commit us to purchase specified quantities of silicon wafers over extendedperiods;

 

•                                          issuanceof our equity securities to a foundry;

 

•                                          investmentin a foundry;

 

•                                          jointventures; or

 

•                                          otherpartnership relationships with foundries.

 

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

 

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

 

The fabrication of silicon wafers is a complex process. Minute levelsof contaminants in the manufacturing environment, defects in photomasks 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 manufacturing process and may be time consuming andexpensive to correct. As a result, foundries often experience problems achievingacceptable yields, which are represented by the number of good integratedcircuits as a proportion of the number of total integrated circuits on anyparticular wafer.  Poor yields from ourindependent foundries would reduce our ability to deliver our products tocustomers, harm our relationships with our customers, and harm our business.

 

**Tobe successful, we must efficiently develop new and enhanced products to meetrapidly changing customer requirements and industry standards.**

 

The markets for our products are characterized by:

 

•                                          rapidlychanging technologies;

 

•                                          evolvingindustry standards;

 

•                                          frequentnew product introductions; and

 

•                                          shortproduct life cycles.

 

Over the long run, we expect to increase our product developmentexpenses, and our future success will depend to a substantial degree upon ourability to develop and introduce, on a timely and cost-effective basis, new andenhanced products that meet rapidly changing customer requirements and industrystandards. We may not successfully develop, introduce or manage the transitionto new products. Delays in the introduction or shipment of new or enhancedproducts, lack of market acceptance for such products or problems associatedwith new product transitions could harm our sales and financial results.

 

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

 

Competition in the compression technology market has historically beendominated by large companies, such as STMicroelectronics, and companies thatdevelop and use their own integrated circuits, such as Sony. As this market continuesto develop, we face competition from other large semiconductor vendors,including:

 

•                                          ALiCorporation;

 

•                                          AtmelCorporation;

 

•                                          CirrusLogic (Crystal Semiconductor);

 

•                                          ESSTechnology, Inc.;

 

•                                          Fujitsu;

 

•                                          LSILogic;

 

•                                          MediaTekInc.;

 

•                                          Motorola;

 

•                                          OmnivisionTechnologies, Inc.;

 

•                                          SunplusTechnology; and

 

•                                          TexasInstruments.

 

We also face competition from internally developed solutions developedand used by major Japanese original equipment manufacturers, who may also beour customers.

 

Many of our existing and potential competitors have substantiallygreater resources than ours in many areas, including:

 

•                                          finances;

 

•                                          manufacturing;

 

•                                          technology;

 

•                                          researchand development;

 

•                                          marketing;and

 

•                                          distribution.

 

Many of our competitors have broader product lines and longer standingrelationships with customers than we do. Moreover, our competitors may foreseethe course of market developments more accurately than we do and could in thefuture develop new technologies that compete with our products or even renderour products obsolete. In addition, a number of private companies haveannounced plans for new products to address the same digital multimediaproblems that our products address. If we are unable to compete successfullyagainst our current and future competitors, we could experience pricereductions, order cancellations and reduced gross margins, any one of whichcould harm our business.

 

The DVD market is growing, 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.

 

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

 

Average selling prices for our products decline over relatively shorttime periods. Many of our manufacturing costs are fixed. When our averageselling prices decline, our revenues decline unless we sell more units, and ourgross margins decline unless we are able to reduce our manufacturing costs by acommensurate amount. Our operating results suffer when gross margins decline.We have experienced these problems and may continue to experience them in thefuture and cannot predict when they may occur or their severity.

 

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

 

Our largest customers account for a substantial percentage of our revenues.In 2002, sales to Fujifilm accounted for 36.6% of our total revenue. Our fourlargest customers in 2002 accounted for approximately 58.6% of our totalrevenues.  During 2001, our four largestcustomers accounted for approximately 56.3% of our revenues with Fujifilmaccounting for 29.2%. Sales to these large customers have varied significantlyfrom year to year and will continue to fluctuate in the future.  These sales also may fluctuate significantlyfrom quarter to quarter. We may not be able to retain our key customers orthese customers may cancel purchase orders or reschedule or decrease theirlevel of purchases from us. Any substantial decrease or delay in sales to oneor more of our key customers could harm our sales and financial results. In addition,any difficulty in collecting amounts due from one or more key customers couldharm our financial results.

 

**Weare dependent on our relationship with Fujifilm for a significant percentage ofour product sales, and if this relationship were terminated, our business wouldbe harmed.**

 

Fujifilm has been our largest customer over the last five years.Fujifilm purchases our products primarily as a reseller. Fujifilm acts as theprimary reseller in Japan of products developed by us under developmentcontracts with Fujifilm. We may sell these products directly in Japan only tospecified customers with Fujifilm’s consent. Fujifilm provides more sales andmarketing support than our other resellers. Fujifilm has provided wafermanufacturing services on a most-favored terms basis to us since 1993 and hasalso provided funding to support our development efforts. If our relationshipwith Fujifilm were terminated, our business would be harmed.

 

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

 

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

 

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

 

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

 

We generally do not enter into long-term purchase contracts with ourcustomers, and we cannot be certain as to future order levels from ourcustomers. When we do enter into a long-term contract, the contract isgenerally terminable at the 

 

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convenience of the customer. In the event of an early termination byone of our major customers, it is unlikely that we will be able to rapidlyreplace that revenue source, which would harm our financial results.

 

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

 

During 2002, 97% of our total revenues were derived from internationalsales. We anticipate that international sales will continue to represent asubstantial majority of our total revenues for the foreseeable future. Inaddition, substantially all of our semiconductor products are manufactured,assembled and tested outside of the United States by independent foundries andsubcontractors.

 

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

 

•                                          unexpectedchanges in regulatory requirements;

 

•                                          fluctuationsin exchange rates;

 

•                                          politicaland economic instability;

 

•                                          impositionof tariffs and other barriers and restrictions; and

 

•                                          theburdens of complying with a variety of foreign laws.

 

The majority of our research and development personnel and facilitiesand a significant portion of our sales personnel are located in Israel.Political, economic and military conditions in Israel directly affect ouroperations. Some of our officers and employees in Israel are obligated toperform approximately 39 days of military reserve duty annually. The absence ofthese employees for significant periods during the work week may cause us tooperate inefficiently during these periods.

 

Our operations in China are subject to the economic and politicaluncertainties affecting that country. For example, the Chinese economy hasexperienced significant growth in the past decade, but such growth has beenuneven across geographic and economic sectors and has recently been slowing.This growth may continue to decrease and any slowdown may have a negativeeffect on our business. During 2000 and 2001, we also opened offices in Taipei,Taiwan, Hong Kong and Seoul, Korea. Our operations are subject to the economicand political uncertainties affecting these countries as well.

 

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

 

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

 

•                                          disruptionin commercial activities associated with heightened security concerns affectinginternational travel and commerce;

 

•                                          reduceddemand for consumer electronic products due to a potential extension of theglobal economic slowdown;

 

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

 

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

 

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

 

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

 

**Ourability to compete could be jeopardized if we are unable to protect ourintellectual property rights from challenges by third parties.**

 

Our success and ability to compete depend in large part upon protectingour proprietary 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-party infringement,or to protect us from the claims of others. Monitoring unauthorized use of ourproducts is difficult and we cannot be certain that the steps we have takenwill prevent unauthorized use of our technology, particularly in foreigncountries where the laws may not protect our proprietary rights as fully as inthe United States. The laws of certain foreign countries in which our productsare or may be developed, manufactured or sold, including various countries inAsia, may not protect our products or intellectual property rights to the sameextent as do the laws of the United States and thus make the possibility ofpiracy of our technology and products more likely in these countries. Ifcompetitors are able to use our technology, our ability to compete effectivelycould be harmed.

 

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

 

In recent years, there has been significant litigation in the UnitedStates involving patents and other intellectual property rights. In the past,we have been subject to claims and litigation regarding alleged infringement ofother parties’ intellectual property rights. We could become subject tolitigation in the future either to protect our intellectual property or as aresult of allegations that we infringe others’ intellectual property rights.Claims that our products infringe proprietary rights would force us to defendourselves and possibly our customers or manufacturers against the allegedinfringement. These claims and any resulting lawsuit, if successful, couldsubject us to significant liability for damages and invalidation of ourproprietary rights. These lawsuits, regardless of their success, would likelybe time-consuming and expensive to resolve and would divert management time andattention. Any potential intellectual property litigation could force us to doone or more of the following:

 

•                                          stopselling our products that incorporate the challenged intellectual property;

 

•                                          obtainfrom the owner of the infringed intellectual property right a license to sellor use the relevant technology, which license may not be available onreasonable terms or at all;

 

•                                          paydamages; or

 

•                                          redesignthose products that use such technology.

 

If we are forced to take any of the foregoing actions, our businesscould be severely harmed.

 

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

 

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

 

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

 

Our future net income and cashflow will be affected by our ability to apply our net operating losses, whichtotaled approximately $34.0 million for federal and $4.0 million for state taxreporting purposes as of December 31, 2002, against taxable income in futureperiods. Our net operating losses incurred prior to the consummation of ourinitial public offering in 1995 that we can use to reduce future taxable incomefor federal tax purposes are limited to approximately $3.0 million per year.Changes in tax laws in the United States may further limit our ability toutilize our net operating losses. Any further limitation on our ability toutilize our net operating losses could harm our financial condition.

 

**Any acquisitions or strategic investments wemake could disrupt our business and severely harm our financial condition.**

 

We have made investments in, and acquisitions of, complementarycompanies, products and technologies. During 2000, we acquired PixelCam andNogatech, and we may acquire additional businesses, products, or technologiesin the future. In the event of any future acquisitions, we could:

 

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

 

•                  incur debt;

 

•                  assumeliabilities;

 

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

 

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

 

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

 

•                  problemscombining the purchased operations, technologies or products;

 

•                  unanticipatedcosts;

 

•                  diversion ofmanagement’s attention from our core business;

 

•                  adverse effectson existing business relationships with customers;

 

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

 

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

 

We may not be able to successfully integrate any businesses, productsor technologies or personnel that we might acquire in the future and anyfailure to do so could disrupt our business and seriously harm our financialcondition.

 

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

 

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

 

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

 

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and would likely harm our business. Defects, integration issues orother performance problems in our products could result in financial or otherdamages to our customers or could damage market acceptance of our products. Ourcustomers could also seek damages from us for their losses. A product liabilityclaim brought against us, even if unsuccessful, would likely be time consumingand costly to defend.

 

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

 

We historically have generated a significant percentage of our totalrevenues from development contracts, primarily with key customers. Thesedevelopment contracts have provided us with partial funding for the developmentof some of our products. Under these contracts, we receive payments uponreaching certain development milestones. If we fail to achieve the milestonesspecified in our existing development contracts, if our existing contracts areterminated or we are unable to secure future development contracts, our abilityto cost-effectively develop new products would be reduced and our businesswould be harmed.

 

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

 

We may require substantial additional capital to finance our futuregrowth, secure additional foundry capacity and fund our ongoing research anddevelopment activities beyond 2003. Our capital requirements will depend onmany factors, including:

 

•                  acceptance ofand demand for our products;

 

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

 

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

 

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

 

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

 

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

 

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

 

Our success depends to a significant degree upon the continuingcontributions of our senior management. The loss of key management personnelcould delay product development cycles or otherwise harm our business. We maynot be able to retain the services of any of our key employees. We believe thatour future success will also depend in large part on our ability to attract,integrate and retain highly-skilled engineering, managerial, sales andmarketing personnel, both in the United States and in Israel. Competition forsuch personnel is intense, and we may not be successful in attracting,integrating and retaining such personnel. Failure to attract, integrate andretain key personnel could harm our ability to carry out our business strategyand compete with other companies.

 

37

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**The Israeli rate of inflation may negativelyimpact our costs if it exceeds the rate of devaluation of the New IsraeliShekel against the U.S. dollar.**

 

A portion of the cost of our operations, relating mainly to ourpersonnel and facilities in Israel, is incurred in New Israeli Shekels. As aresult, we bear the risk that the rate of inflation in Israel will exceed therate of devaluation of the New Israeli Shekel in relation to the dollar, whichwill increase our costs as expressed in dollars. To date, we have not engagedin hedging transactions. In the future, we may enter into currency hedgingtransactions to decrease the risk of financial exposure from fluctuations inthe exchange rate of the U.S. dollar against the New Israeli Shekel. Thesemeasures may not adequately protect us from the impact of inflation in Israel.

 

**The government programs we participate in andtax benefits we receive require us to meet several conditions and may beterminated or reduced in the future, which would increase our costs.**

 

In 2001 and 2002, we did not receive proceeds from grants for researchand development from the Chief Scientist in Israel’s Ministry of Industry andTrade. However, we did receive an aggregate of $333,000 in such grants during2000. We plan to seek additional grants from the Chief Scientist in the future.To be eligible for these grants, our development projects must be approved bythe Chief Scientist on a case-by-case basis. If our development projects are not approved by the Chief Scientist, wewill not receive grants to fund these projects, which would increase ourresearch and development costs. We also receive tax benefits, in particularexemptions and reductions as a result of the “Approved Enterprise” status ofour existing operations in Israel. To be eligible for these tax benefits, wemust maintain our Approved Enterprise status by meeting conditions, includingmaking specified investments in fixed assets located in Israel and investingadditional equity in our Israeli subsidiary. If we fail to meet theseconditions in the future, the tax benefits would be canceled and we could berequired to refund the tax benefits already received. These tax benefits maynot be continued in the future at their current levels or at any level. Israeligovernmental authorities have indicated that the government may reduce oreliminate these benefits in the future, which would harm our business.

 

**We have anti-takeover provisions in ourcharter documents and there are provisions of Delaware law that could preventor delay a change in control of our company.**

 

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

 

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

 

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

 

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

 

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

 

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

 

The market price of our common stock has fluctuated significantly sinceour initial public offering in 1995. Between January 1, 2002 and December 31,2002, the closing sale price of our common stock, as reported on the NasdaqNational Market, ranged from a low of $9.11 to a high of $31.81.  The market price of our common stock issubject to significant fluctuations in the future in response to a variety offactors, including:

 

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

 

•                  quarterlyvariations in operating results;

 

•                  changes inanalysts’ earnings estimates;

 

•                  announcements oftechnological innovations;

 

38

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•                  the introductionof new products or changes in product pricing policies by us or ourcompetitors;

 

•                  proprietaryrights or other litigation;

 

•                  generalconditions in the semiconductor industry; and

 

•                  developments inthe financial markets.

 

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

 

**Item7A.     Quantitative and Qualitative Disclosures aboutMarket Risks.**

 

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

 

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

 

A majority of our revenue and capital spending is transacted in U.S.dollars, although a portion of the cost of our operations, relating mainly toour personnel and facilities in Israel, is incurred in New Israeli Shekels. Wehave not engaged in hedging transactions to reduce our exposure to fluctuationsthat may arise from changes in foreign exchange rates. Based on our overallcurrency rate exposure at December 31, 2002, a near-term 10% appreciation ordepreciation of the New Israeli Shekel would have an immaterial affect on ourfinancial condition.

 

# **Item8.     Financial Statements and Supplemental Data.**

 

**Index to Consolidated Financial Statements**

 
| Report of Independent Accountants                                                                 |
|---------------------------------------------------------------------------------------------------|
|                                                                                              |
| Consolidated Balance Sheets as of December 31, 2002 and 2001                                      |
|                                                                                              |
| Consolidated Statements of Operations for  each of the three years ended December 31, 2002        |
|                                                                                              |
| Consolidated Statements of Stockholders’  Equity for the three years ended December 31, 2002 |
|                                                                                              |
| Consolidated Statements of Cash Flows for  each of the three years ended December 31, 2002        |
|                                                                                              |
| Notes to Consolidated Financial Statements                                                        |
|                                                                                              |
| Supplemental Data:  Selected Quarterly Financial Information  (Unaudited)                    |

 

39

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**REPORTOF INDEPENDENT ACCOUNTANTS**

 

To the Board of Directors and Stockholders of

Zoran Corporation

 

 

In our opinion, the consolidated financial statements listed in theaccompanying index present fairly, in all material respects, the financialposition of Zoran Corporation and its subsidiaries at December 31, 2002and 2001, and the results of their operations and their cash flows for each ofthe three years in the period ended December 31, 2002 in conformity withaccounting principles generally accepted in the United States of America.  These financial statements are theresponsibility of the Company’s management; our responsibility is to express anopinion on these financial statements based on our audits.  We conducted our audits of these statementsin accordance with auditing standards generally accepted in the United Statesof America, which require that we plan and perform the audit to obtainreasonable assurance about whether the financial statements are free ofmaterial misstatement.  An auditincludes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements, assessing the accounting principlesused and significant estimates made by management, and evaluating the overallfinancial statement presentation.  Webelieve that our audits provide a reasonable basis for our opinion.

 

As discussed in Notes 2 and 6 of the consolidated financial statements,as of January 1, 2002, the Company ceased amortization of goodwill to conformwith the provisions of Statement of Financial Accounting Standards No. 142,“Goodwill and Other Intangible Assets.”

 
| /s/  PricewaterhouseCoopers LLP |   |   |
|---------------------------------|--------|--------|
| San Jose, California            |   |
| January 24, 2003                |   |

 

40

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**ZORAN CORPORATION**

**CONSOLIDATED BALANCE SHEETS**

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

** **
|                                                                                                                         |   | **December  31,** |       |
|------------------------------------------------------------------------------------------------------------------------------|--------|-------------------|------------|
|                                                                                                                         |   | **2002**          |       | **2001** |   |
| **ASSETS**                                                                                                                   |   |              | ** ** |   | ** ** |
| Current Assets:                                                                                                              |   |              |       |   |   |
| Cash and cash equivalents                                                                                                    |   | $                 | 31,607     |   | $ | 20,287 |   |
| Short-term investments                                                                                                       |   | 105,468           |       | 89,818 |   |
| Accounts receivable, net                                                                                                     |   | 34,652            |       | 33,367 |   |
| Inventory                                                                                                                    |   | 12,686            |       | 15,681 |   |
| Prepaid expenses and other current assets                                                                                    |   | 6,479             |       | 5,130 |   |
| Total current assets                                                                                                         |   | 190,892           |       | 164,283 |   |
| Property and equipment, net                                                                                                  |   | 5,848             |       | 7,159 |   |
| Other investments                                                                                                            |   | 78,334            |       | 89,727 |   |
| Goodwill                                                                                                                     |   | 59,131            |       | 59,131 |   |
| Intangible assets                                                                                                            |   | 8,411             |       | 11,044 |   |
|                                                                                                                         |   | $                 | 342,616    |   | $ | 331,344 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                |   |              |       |   |   |
| Current Liabilities:                                                                                                         |   |              |       |   |   |
| Accounts payable                                                                                                             |   | $                 | 9,639      |   | $ | 16,705 |   |
| Accrued expenses and other liabilities                                                                                       |   | 21,965            |       | 16,801 |   |
| Total current liabilities                                                                                                    |   | 31,604            |       | 33,506 |   |
|                                                                                                                         |   |              |       |   |   |
| Commitments and Contingencies (Note 9)                                                                                       |   |              |       |   |   |
|                                                                                                                         |   |              |       |   |   |
| Stockholders’ Equity:                                                                                                   |   |              |       |   |   |
| Common Stock:  $0.001 par value; 55,000,000 shares authorized; 27,395,117 and  26,702,781 shares issued and outstanding |   | 27                |       | 27 |   |
| Additional paid-in capital                                                                                                   |   | 399,052           |       | 391,665 |   |
| Warrants                                                                                                                     |   | —            |       | 717 |   |
| Deferred stock-based compensation                                                                                            |   | (83               | )          | (375 | ) |
| Accumulated other comprehensive income  (loss)                                                                               |   | 508               |       | (6 | ) |
| Accumulated deficit                                                                                                          |   | (88,492           | )          | (94,190 | ) |
| Total stockholders’ equity                                                                                              |   | 311,012           |       | 297,838 |   |
|                                                                                                                         |   | $                 | 342,616    |   | $ | 331,344 |   |

 

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

 

41

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**ZORAN CORPORATION**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

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

 
|                                                                                      |   | **Year Ended  December 31,** |       |
|-------------------------------------------------------------------------------------------|--------|------------------------------|------------|
|                                                                                      |   | **2002**                     |       | **2001** |   | **2000** |   |
|                                                                                      |   |                         | ** ** |   | ** ** |   | ** ** |
| Revenues:                                                                                 |   |                         |       |   |   |   |   |
| Product sales                                                                             |   | $                            | 141,314    |   | $ | 100,012 |   | $ | 67,782 |   |
| Software, licensing and development                                                       |   | 7,803                        |       | 7,697 |   | 11,889 |   |
| Total revenues                                                                            |   | 149,117                      |       | 107,709 |   | 79,671 |   |
|                                                                                      |   |                         |       |   |   |   |   |
| Costs and expenses:                                                                       |   |                         |       |   |   |   |   |
| Cost of product sales                                                                     |   | 86,904                       |       | 64,740 |   | 37,993 |   |
| Research and development                                                                  |   | 22,083                       |       | 23,210 |   | 18,628 |   |
| Selling, general and administrative                                                       |   | 24,856                       |       | 21,330 |   | 19,148 |   |
| Amortization of intangible assets                                                         |   | 8,443                        |       | 9,697 |   | 1,982 |   |
| Amortization of goodwill and write-off of  acquired in-process research & development |   | —                       |       | 33,536 |   | 29,787 |   |
| Total costs and expenses                                                                  |   | 142,286                      |       | 152,513 |   | 107,538 |   |
|                                                                                      |   |                         |       |   |   |   |   |
| Operating income (loss)                                                                   |   | 6,831                        |       | (44,804 | ) | (27,867 | ) |
| Interest income                                                                           |   | 7,053                        |       | 9,853 |   | 9,280 |   |
| Other income (loss), net                                                                  |   | (6,614                       | )          | 151 |   | (51 | ) |
|                                                                                      |   |                         |       |   |   |   |   |
| Income (loss) before income taxes                                                         |   | 7,270                        |       | (34,800 | ) | (18,638 | ) |
| Provision for income taxes                                                                |   | 1,572                        |       | 1,265 |   | 1,970 |   |
| Net income (loss)                                                                         |   | $                            | 5,698      |   | $ | (36,065 | ) | $ | (20,608 | ) |
|                                                                                      |   |                         |       |   |   |   |   |
| Basic net income (loss) per share                                                         |   | $                            | 0.21       |   | $ | (1.38 | ) | $ | (0.91 | ) |
|                                                                                      |   |                         |       |   |   |   |   |
| Diluted net income (loss) per share                                                       |   | $                            | 0.20       |   | $ | (1.38 | ) | $ | (0.91 | ) |
|                                                                                      |   |                         |       |   |   |   |   |
| Shares used to compute basic net income  (loss) per share                                 |   | 27,095                       |       | 26,190 |   | 22,605 |   |
|                                                                                      |   |                         |       |   |   |   |   |
| Shares used to compute diluted net income  (loss) per share                               |   | 28,629                       |       | 26,190 |   | 22,605 |   |

 

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

 

42

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**ZORAN CORPORATION**

**CONSOLIDATED STATEMENTS OF STOCKHOLDERS’EQUITY**

**(in thousands)**

** **
|                                                                                     |   |       |   |   |   | **Additional  Paid-In  Capital** |   | **Warrants** |   | **Deferred  Stock-Based  Compensation** |   | **Accumulated  Other  Comprehensive  Income (Loss)** |   | **Accumulated  Deficit** |   | **Total** |   |
|------------------------------------------------------------------------------------------|--------|------------|--------|--------|--------|----------------------------------|--------|--------------|--------|-----------------------------------------|--------|------------------------------------------------------|--------|--------------------------|--------|-----------|--------|
|                                                                                     |   |       |
| **Common  Stock**                                                                        |
| **Shares**                                                                               |   | **Amount** |
| Balance at December 31, 1999                                                             |   | 20,879     |   | $      | 21     |                             | $      | 195,262      |   | $                                       | 717    |                                                 | $      | —                   |   | $         | 4,962  |   | $ | (37,517 | ) | $ | 163,445 |   |
| Issuance of Common Stock                                                                 |   | 891        |   | 1      |   | 4,216                            |   | —       |   | —                                  |   | —                                               |   | —                   |   | 4,217     |   |
| Income tax benefit of employees’ stock  transactions                                |   | —     |   | — |   | 1,003                            |   | —       |   | —                                  |   | —                                               |   | —                   |   | 1,003     |   |
| Deferred stock-based compensation recorded in  conjunction with the Nogatech acquisition |   | —     |   | — |   | —                           |   | —       |   | (1,018                                  | )      | —                                               |   | —                   |   | (1,018    | )      |
| Amortization of deferred stock-based compensation                                        |   | —     |   | — |   | —                           |   | —       |   | 99                                      |   | —                                               |   | —                   |   | 99        |   |
| Issuance of Common Stock in connection with  acquisitions                                |   | 4,365      |   | 4      |   | 188,165                          |   | —       |   | —                                  |   | —                                               |   | —                   |   | 188,169   |   |
| Decrease in unrealized gain on securities  available for sale                            |   | —     |   | — |   | —                           |   | —       |   | —                                  |   | (3,853                                               | )      | —                   |   | (3,853    | )      |
| Net loss                                                                                 |   | —     |   | — |   | —                           |   | —       |   | —                                  |   | —                                               |   | (20,608                  | )      | (20,608   | )      |
| Balance at December 31, 2000                                                             |   | 26,135     |   | 26     |   | 388,646                          |   | 717          |   | (919                                    | )      | 1,109                                                |   | (58,125                  | )      | 331,454   |   |
| Issuance of Common Stock                                                                 |   | 951        |   | 1      |   | 6,886                            |   | —       |   | —                                  |   | —                                               |   | —                   |   | 6,887     |   |
| Repurchases of Common Stock                                                              |   | (383       | )      | — |   | (3,867                           | )      | —       |   | —                                  |   | —                                               |   | —                   |   | (3,867    | )      |
| Amortization of deferred stock-based compensation                                        |   | —     |   | — |   | —                           |   | —       |   | 544                                     |   | —                                               |   | —                   |   | 544       |   |
| Change in unrealized gain (loss) on securities  available for sale                       |   | —     |   | — |   | —                           |   | —       |   | —                                  |   | (1,115                                               | )      | —                   |   | (1,115    | )      |
| Net loss                                                                                 |   | —     |   | — |   | —                           |   | —       |   | —                                  |   | —                                               |   | (36,065                  | )      | (36,065   | )      |
| Balance at December 31, 2001                                                             |   | 26,703     |   | 27     |   | 391,665                          |   | 717          |   | (375                                    | )      | (6                                                   | )      | (94,190                  | )      | 297,838   |   |
| Issuance of Common Stock                                                                 |   | 692        |   | — |   | 6,670                            |   | —       |   | —                                  |   | —                                               |   | —                   |   | 6,670     |   |
| Expiration of Warrant                                                                    |   | —     |   | — |   | 717                              |   | (717         | )      | —                                  |   | —                                               |   | —                   |   | —    |   |
| Amortization of deferred stock-based compensation                                        |   | —     |   | — |   | —                           |   | —       |   | 292                                     |   | —                                               |   | —                   |   | 292       |   |
| Change in unrealized gain (loss) on securities  available for sale                       |   | —     |   | — |   | —                           |   | —       |   | —                                  |   | 514                                                  |   | —                   |   | 514       |   |
| Net Income                                                                               |   | —     |   | — |   | —                           |   | —       |   | —                                  |   | —                                               |   | 5,698                    |   | 5,698     |   |
| Balance at December 31, 2002                                                             |   | 27,395     |   | $      | 27     |                             | $      | 399,052      |   | $                                       | — |                                                 | $      | (83                      | )      | $         | 508    |   | $ | (88,492 | ) | $ | 311,012 |   |

 

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

 

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**ZORAN CORPORATION**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(in thousands)**

 
|                                                            |   | **Year Ended  December 31,** |   |
|-----------------------------------------------------------------|--------|------------------------------|--------|
|                                                            |   | **2002**                     |   | **2001** |   | **2000** |   |
| Cash flows from operating activities:                           |   |                         |   |   |   |   |   |
| Net income (loss)                                               |   | $                            | 5,698  |   | $ | (36,065 | ) | $ | (20,608 | ) |
| Adjustments:                                                    |   |                         |   |   |   |   |   |
| Depreciation, amortization and other                            |   | 3,247                        |   | 3,700 |   | 2,987 |   |
| Investment impairment charges                                   |   | 6,045                        |   | — |   | — |   |
| Allowance for doubtful accounts                                 |   | 125                          |   | 2,029 |   | 549 |   |
| Amortization of goodwill and other  intangibles                 |   | 8,443                        |   | 43,233 |   | 9,922 |   |
| Write-off of acquired in-process research  and development      |   | —                       |   | — |   | 21,847 |   |
| Income tax benefit of employees’ stock  transactions       |   | —                       |   | — |   | 1,003 |   |
| Realized loss on exchange of marketable  securities             |   | 696                          |   | — |   | — |   |
| Changes in current assets and liabilities:                      |   |                         |   |   |   |   |   |
| Accounts receivable                                             |   | (2,218                       | )      | (7,958 | ) | (4,967 | ) |
| Inventory                                                       |   | 2,995                        |   | 1,772 |   | (7,311 | ) |
| Prepaid expenses and other current assets                       |   | (1,349                       | )      | 328 |   | (2,640 | ) |
| Accounts payable                                                |   | (7,816                       | )      | 5,549 |   | 234 |   |
| Accrued expenses and other liabilities                          |   | 2,812                        |   | (231 | ) | 3,374 |   |
| Net cash provided by operating activities                       |   | 18,678                       |   | 12,357 |   | 4,390 |   |
|                                                            |   |                         |   |   |   |   |   |
| Cash flows from investing activities:                           |   |                         |   |   |   |   |   |
| Capital expenditures for property and  equipment                |   | (1,983                       | )      | (3,771 | ) | (3,251 | ) |
| Purchase of intellectual property                               |   | (1,681                       | )      | — |   | — |   |
| Purchases of investments                                        |   | (155,354                     | )      | (195,588 | ) | (180,324 | ) |
| Sales of investments                                            |   | 45,227                       |   | 25,454 |   | 46,400 |   |
| Maturities of investments                                       |   | 99,763                       |   | 163,887 |   | 134,645 |   |
| Purchases of long-term equity investments                       |   | —                       |   | (1,171 | ) | (2,250 | ) |
| Cash received in acquisitions (net of costs  incurred)          |   | —                       |   | — |   | (393 | ) |
| Net cash used in investing activities                           |   | (14,028                      | )      | (11,189 | ) | (5,173 | ) |
|                                                            |   |                         |   |   |   |   |   |
| Cash flows from financing activities:                           |   |                         |   |   |   |   |   |
| Proceeds from issuance of Common Stock, net                     |   | 6,670                        |   | 6,887 |   | 4,217 |   |
| Repurchases of Common Stock                                     |   | —                       |   | (3,867 | ) | — |   |
| Net cash provided by financing activities                       |   | 6,670                        |   | 3,020 |   | 4,217 |   |
|                                                            |   |                         |   |   |   |   |   |
| Net increase in cash and cash equivalents                       |   | 11,320                       |   | 4,188 |   | 3,434 |   |
| Cash and cash equivalents at beginning of  year                 |   | 20,287                       |   | 16,099 |   | 12,665 |   |
| Cash and cash equivalents at end of year                        |   | $                            | 31,607 |   | $ | 20,287 |   | $ | 16,099 |   |
|                                                            |   |                         |   |   |   |   |   |
| Supplemental disclosures:                                       |   |                         |   |   |   |   |   |
| Income taxes paid                                               |   | $                            | — |   | $ | — |   | $ | 732 |   |
| Purchase of intellectual property included  in accrued expense  |   | 3,150                        |   | — |   | — |   |
| Purchase of intellectual property included  in accounts payable |   | 750                          |   | — |   | — |   |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

44

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**ZORAN CORPORATION**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**Note1 - The Company:**

 

Zoran Corporation (“Zoran” or the “Company”) was incorporated inCalifornia in December 1981 and reincorporated in Delaware in November1986.  Zoran develops and marketsintegrated circuits, integrated circuit cores and embedded software used byoriginal equipment manufacturers, or OEMs, in digital audio and video productsfor commercial and consumer markets. Current applications incorporating Zoran’sproducts and IP include digital versatile disc, or DVD, players andrecorders,  filmless digital cameras,professional and consumer video editing systems and digital speakers and audiosystems. The Company operates in one industry segment.

 

The Company performs research and development and generates asubstantial portion of its sales from its operations located in the State ofIsrael. A significant number of the Company’s full-time employees are locatedin Israel, including a majority of the Company’s research and developmentpersonnel. Therefore, the Company is directly affected by the political,economic and 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. As such, the selling price that the Companyis able to command for its products is highly dependent on industry-wideproduction capacity and demand.  Both ofthese factors could result in rapid deviations in product pricing and, therefore,could adversely effect the Company’s operating results.

 

*Principles of consolidation and basis of presentation*

 

The consolidated financial statements include the accounts of Zoran andall of its subsidiaries. Intercompany transactions and balances have beeneliminated in consolidation.

 

**Note2 - Significant Accounting Policies:**

 

Zoran has adopted accounting policies which are generally accepted inthe industry in which it operates. The following is a summary of the Company’ssignificant accounting policies.

 

*Use of estimates*

 

The preparation of these financial statements in conformity withgenerally accepted accounting principles requires management to make estimatesand assumptions that affect the amounts reported in the financial statementsand accompanying notes. Actual results could differ from those estimates,although such differences are not expected to be material to the consolidatedfinancial statements.

 

*Translation of foreign currencies*

 

ZML, an Israeli subsidiary, treats the U.S. dollar as its functionalcurrency. In accordance with Statement of Financial Accounting Standards No.52, gains and losses resulting from translation of accounts designated in otherthan the functional currency are reflected in results of operations and to datehave been insignificant.

 

To date, substantially all of the Company’s product sales have beendenominated in U.S. dollars and most costs of product sales have been incurredin U.S. dollars. The Company has not experienced material losses or gains as aresult of currency exchange rate fluctuations and has not engaged in hedgingtransactions to reduce its exposure to such fluctuations. The Company may takeaction in the future to reduce its foreign exchange risk.

 

45

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*Revenue recognition*

 

The Company’s standard shipping terms for product sales are FOB pointof origin. 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 and collectibility is reasonably assured. A provisionfor estimated future returns and potential warranty liability is recorded atthe time revenue is recognized. Warranty expense in 2002 and 2001, wasimmaterial. Development revenue under development contracts is recognized onthe percentage-of-completion method. Under the percentage-of-completion method,revenue recognized is that portion of the total contract price equal to theratio of costs expended to date to the anticipated final total costs, based oncurrent estimates of the costs to complete the project. Amounts received inadvance of performance under contracts are recorded as deferred revenue and aregenerally recognized within one year from receipt.  Estimates are reviewed and revised periodically throughout thelives of the contracts. Any revisions are recorded in the accounting period inwhich the revisions are made. Costs associated with development revenues areincluded primarily in research and development expenses. Revenue resulting fromthe licensing of the Company’s technology is recognized when significantcontractual obligations have been fulfilled and the customer has indicatedacceptance. Periodic service and maintenance fees which provide customersaccess to technical support and minor enhancements to licensed releases arerecognized ratably over the service or maintenance period. Royalty revenue isrecognized in the period licensed sales are reported to the Company.

 

*Research and development costs*

 

Costs related to the conceptual formation and design of internallydeveloped software are expensed as research and development as incurred. It isthe Company’s policy that certain internal software development costs incurredafter technological feasibility has been demonstrated and which meetrecoverability tests are capitalized and amortized over the estimated economiclife of the product. To date, the Company has incurred no significant internalsoftware development costs which meet the criteria for capitalization.

 

*Fair value of financial instruments*

 

For certain of Zoran’s financial instruments, including cash and cashequivalents, accounts receivable, accounts payable, accrued expenses and othercurrent liabilities, the carrying values approximate their fair values due tothe relatively short maturity of these items.

 

*Cash equivalents and investments*

 

All highly liquid investments purchased with an original maturity of 90days or less are considered to be cash and cash equivalents.

 

All of Zoran’s investments in marketable securities are classified asavailable-for-sale and, therefore, are reported at fair value with unrealizedgains and losses, net of related tax, if any, included as other comprehensiveincome, a component of stockholders’ equity. Gains and losses realized uponsales of all such securities are reported in interest and other income (loss).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-temporary declinein value has occurred. Among other things, we consider the duration and extentto which the market value has declined relative to our cost basis, the economicfactors influencing the markets, the relative performance of the investee andits near-term prospects.

 

At December 31, 2002, the Company’s marketable securities consisted ofcommercial paper with maturities of less than one year and marketable equitysecurities. Investments in marketable securities also consisted of bonds andmedium term notes with maturities greater than one year, which are included inother assets, and amounted to $77.2 million and $86.1 million at December 31,2002 and 2001, respectively. See Note 3.

 

46

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Other assets also include investments in non-marketable securitieswhich are accounted for on the cost basis and amounted to $1.2 million and $3.6million at December 31, 2002 and 2001, respectively. The Company records aninvestment impairment charge when the fair value of an investment declinesbelow its cost basis. In making this determination the Company considers allavailable evidence including the historical and projected financial performanceand recent funding events which are ascertained from an investee. In 2002, werecorded $2.4 million in such impairment charges. There were no such charges in2001.

 

*Concentration of credit 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, equity securities and tradeaccounts receivable. The Company places its cash in banks and cash equivalentsprimarily in auction rate preferred stock, certificates of deposit andcommercial paper. The Company’s marketable securities portfolio consistsprimarily of corporate bonds, short and medium term notes, Euro dollar bondsand Government securities.  The Company,by policy, limits the amount of its credit exposure through diversification andrestricting its investments to highly rated securities. Individual securitiesare limited to comprising no more than 5% of the portfolio value. Highly ratedsecurities are defined as having a minimum Moody or Standard & Poor’srating of A1 or A+, respectively. The average maturity of the portfolio isrestricted to less than 365 days. The portfolio is overseen by the VicePresident, Finance and Chief Financial Officer and is reported on quarterly tosenior management.  The Company has notexperienced 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 performs ongoing credit evaluations of itscustomers’ financial condition and limits the amount of credit extended whendeemed necessary, but generally does not require collateral. Managementbelieves that any risk of loss is significantly reduced due to the diversity ofits customers and geographic sales areas. The Company maintains a provision forpotential credit losses, and write-offs of accounts receivable wereinsignificant in each of the three years in the period ended December 31, 2002.  As of December 31, 2002, two customersaccounted for approximately 21% and 12% of the accounts receivable balancerespectively. As of December 31, 2001, three customers accounted forapproximately 21%, 12%, and 11% of the accounts receivable balance respectively.

 

*Inventory*

 

Inventories are stated at the lower of standard cost (whichapproximates actual cost on a first-in, first-out basis) or market. Market isbased on estimated net realizable value.

 

*Property and equipment*

 

Property and equipment are recorded at cost. Depreciation is computedusing the straight-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*

 

The Company adopted Financial Accounting Standards Board (“FASB”)Statement No. 142 “Goodwill and Other Intangible Assets” (“SFAS 142”) as ofJanuary 1, 2002. SFAS142 changed the accounting for goodwill from an amortizationmethod to an impairment only approach. In connection with the adoption of SFAS142, the Company conducted a transitional goodwill impairment assessment basedon its structure as one reporting unit and determined that no impairmentexisted at January 1, 2002. During 2002, the Company also completed its annualimpairment assessment and again determined that no impairment existed.

 

47

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*Other intangibles*

 

Acquired technology is amortized to expense on a straight-line basisover two to five years. Other intangible assets recorded in connection with theacquisitions of PixelCam, Inc. and Nogatech, Inc. are amortized on astraight-line basis over the estimated periods of benefit, which isapproximately three years.

 

*Long-lived assets*

 

The Company periodically evaluates the recoverability of its long-livedassets, other than goodwill, by comparing expected undiscounted cash flows tothe carrying value of the related assets. If the expected undiscounted cashflows are less than the carrying value of the assets the Company recognizes animpairment charge based on the fair value of the assets. To date, the Companyhas not recorded any impairment charges against the value of its long-livedassets.

 

*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 twelve month periods ended December 31, 2002 and 2001, theprovision for income taxes reflects the effective tax rate applied to earnings,excluding charges related to the amortization of goodwill and the write-off ofacquired in-process research and development, for the periods. The effectivetax rate differs from the U.S. statutory rate due to utilization of netoperating losses and State of Israel tax benefits on foreign earnings. Theprovision includes primarily taxes on income in excess of net operating losscarryover limitations and 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 thestatement of operations. Basic EPS is based upon the weighted average number ofcommon shares outstanding. Diluted EPS is computed using the weighted averagecommon shares outstanding plus any potential common stock, except when theireffect is anti-dilutive. Potential common stock includes stock options andwarrants. See Note 11.

 

*Stock compensation*

 

The Company accounts for stock-based compensation using the intrinsicvalue method prescribed in Accounting Principles Board Opinion No. 25 (“APB25”), “Accounting for Stock Issued to Employees” and related interpretations.Under APB 25, compensation expense is recognized based on the difference, ifany, on the date of grant between the fair value of the Company’s stock and theamount an employee must pay to acquire the stock.  The compensation expense is recognized over the periods theemployee performs the related services, generally the vesting period of fouryears, consistent with the multiple option method described in FASBInterpretation No. 28 (“FIN 28”). Except for Nogatech options assumed as partof the acquisition, no other stock-based employee compensation cost isreflected in net income as all other options granted under our plans had anexercise price equal to the market value of the underlying common stock on thedate of grant.

 

48

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*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 income (loss) and net income (loss) per share foreach of the three years ended December 31, 2002, would have been asfollows (in thousands, except per share data):

 
|                                                                                                                                          |   | **Year Ended  December 31,** |    |
|-----------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------------|---------|
|                                                                                                                                          |   | **2002**                     |    | **2001** |   | **2000** |   |
|                                                                                                                                          |   |                         |    |   |   |   |   |
| Net income (loss) as reported                                                                                                                 |   | $                            | 5,698   |   | $ | (36,065 | ) | $ | (20,608 | ) |
| Add stock-based employee compensation  expense included in reported net income net of related tax effects                                     |   | 292                          |    | 544 |   | 99 |   |
| Deduct: Total stock-based employee  compensation expense determined under fair value based methods for all awards  net of related tax effects |   | (24,681                      | )       | (21,629 | ) | (13,342 | ) |
| Pro forma loss                                                                                                                                |   | $                            | (18,691 | ) | $ | (57,150 | ) | $ | (33,851 | ) |
|                                                                                                                                          |   |                         |    |   |   |   |   |
| Net income (loss) per share:                                                                                                                  |   |                         |    |   |   |   |   |
| As reported                                                                                                                                   |   |                         |    |   |   |   |   |
| Basic                                                                                                                                         |   | $                            | 0.21    |   | $ | (1.38 | ) | $ | (0.91 | ) |
| Diluted                                                                                                                                       |   | $                            | 0.20    |   | $ | (1.38 | ) | $ | (0.91 | ) |
| Pro forma                                                                                                                                     |   |                         |    |   |   |   |   |
| Basic                                                                                                                                         |   | $                            | (0.69   | ) | $ | (2.18 | ) | $ | (1.50 | ) |
| Diluted                                                                                                                                       |   | $                            | (0.69   | ) | $ | (2.18 | ) | $ | (1.50 | ) |

 

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

 

*Segment reporting*

 

In 1998, the Company adopted Statement of Financial AccountingStandards No. 131 (“SFAS 131”), “Disclosures about Segments of an Enterpriseand Related Information.” The management approach established by SFAS 131designates the internal organization that is used by management for makingoperating decisions and assessing performance as the source of the Company’sreportable segments. SFAS 131 also requires disclosures about products andservices, geographic areas, and major customers. The Company operates in oneindustry segment comprising the development and marketing of integratedcircuits and software products for use in a variety of video and audio productsaddressing PC and consumer multimedia markets.

 

*Comprehensive income*

 

The Company applies Statement of Financial Accounting Standards No.130, “Reporting Comprehensive Income.”

 

49

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The following are the components of comprehensive income (loss) (inthousands):

 
|                                             |   | **Year Ended  December 31,** |   |
|--------------------------------------------------|--------|------------------------------|--------|
|                                             |   | **2002**                     |   | **2001** |   | **2000** |   |
|                                             |   |                         |   |   |   |   |   |
| Net income (loss)                                |   | $                            | 5,698  |   | $ | (36,065 | ) | $ | (20,608 | ) |
| Unrealized gain (loss) on marketable  securities |   | 514                          |   | (1,115 | ) | (3,853 | ) |
| Comprehensive income (loss)                      |   | $                            | 6,212  |   | $ | (37,180 | ) | $ | (24,461 | ) |

 

The components of accumulated other comprehensive income (loss) are asfollows (in thousands):

 
|                                                                   |   | **Year Ended  December 31,** |   |
|------------------------------------------------------------------------|--------|------------------------------|--------|
|                                                                   |   | **2002**                     |   | **2001** |   | **2000** |   |
| Unrealized gain (loss) on marketable  securities, net of related taxes |   | $                            | 508    |   | $ | (6 | ) | $ | 1,109 |   |
|                                                                        |        |                              |        |  |  |  |  |  |  |  |

 

*Recent accounting pronouncements*

 

In August 2001, the FASB issued SFAS No. 143 (“SFAS 143”), “Accountingfor Asset Retirement Obligations”. SFAS 143 addresses financial accounting andreporting for obligations associated with the retirement of tangible long-livedassets and the associated asset retirement costs. SFAS 143 applies to allentities. It applies to legal obligations associated with the retirement oflong-lived assets that result from the acquisition, construction, developmentand/or the normal operation of a long-lived asset, except for certainobligations of lessees. SFAS 143 is effective for financial statements issuedfor fiscal years beginning after June 25, 2002. The Company expects that theinitial application of SFAS 143 will not have a material impact on itsfinancial statements.

 

In April 2002, the FASB issued SFAS No. 145 (“SFAS 145”), “Rescissionof SFAS Nos. 4, 44 and 64, Amendment of SFAS 13, and Technical Corrections.”SFAS 145 rescinds SFAS No. 4, “Reporting Gains and Losses from Extinguishmentof Debt,” and an amendment of that statement, SFAS No. 64, “Extinguishments ofDebt Made to Satisfy Sinking-Fund Requirements,” as well as SFAS No. 44,“Accounting for Intangible Assets of Motor Carriers.” SFAS 145 amends SFAS No.13, “Accounting for Leases,” to eliminate an inconsistency between the requiredaccounting for sale-leaseback transactions and the required accounting forcertain lease modifications that have economic effects that are similar tosale-leaseback transactions. SFAS 145 also amends other existing authoritativepronouncements to make various technical corrections, clarify meanings, ordescribe their applicability under changed conditions. The provisions of SFAS145 will be adopted during fiscal 2003. The Company does not expect that theadoption of SFAS 145 will have a material impact on its financial position,results of operations, or cash flows.

 

In June 2002, the FASB issued SFAS No. 146 (“SFAS 146”), “Accountingfor Exit or Disposal Activities.” SFAS 146 addresses significant issuesregarding the recognition, measurement, and reporting of costs that areassociated with exit and disposal activities, including restructuringactivities that are currently accounted for under EITF No. 94-3, “LiabilityRecognition for Certain Employee Termination Benefits and Other Costs to Exitan Activity (Including Certain Costs Incurred in a Restructuring).” The scopeof SFAS 146 also includes costs related to terminating a contract that is not acapital lease and termination benefits that employees who are involuntarilyterminated receive under the terms of a one-time benefit arrangement that isnot an ongoing benefit arrangement or an individual deferred-compensationcontract. SFAS 146 will be effective for exit or disposal activities that areinitiated after December 31, 2002 and early application is encouraged. TheCompany will adopt SFAS 146 for its fiscal year beginning January 1, 2003 anddoes not expect that the adoption will have a material impact on its financialposition, results of operations, or cash flows.

 

In November 2002, the FASB issued FASB Interpretation No. 45 (“FIN45”), “Guarantor’s Accounting and Disclosure Requirements for Guarantees,Including Indirect Guarantees of Indebtedness of Others.” FIN 45 requires thata liability be recorded in the guarantor’s balance sheet upon issuance of aguarantee. In addition, FIN 45 requires disclosures about the guarantees thatan entity has issued, including a reconciliation of changes in the entity’sproduct warranty liabilities.  The initial recognition and initialmeasurement provisions of FIN 45 are applicable on a prospective basis toguarantees

 

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issued or modified after December 31, 2002, irrespective of theguarantor’s fiscal year-end.  The disclosure requirements of FIN 45 areeffective for financial statements of interim or annual periods ending afterDecember 15, 2002.  The Company does not expect that the adoption of FIN45 will have a material impact on its financial position, results ofoperations, or cash flows. 

 

In November 2002, the Emerging Issues Task Force (“EITF”) reached aconsensus on Issue No. 00-21, “Revenue Arrangements with MultipleDeliverables.” EITF Issue No. 00-21 provides guidance on how to account forarrangements that involve the delivery or performance of multiple products,services and/or rights to use assets. The provisions of EITF Issue No. 00-21will apply to revenue arrangements entered into in fiscal periods beginningafter June 15, 2003 The Company does not expect that this will have a materialimpact on its financial position, results of operations, or cash flows.

 

In December 2002, the FASB issued Statement of Financial AccountingStandards No. 148 (“SFAS 148”), “Accounting for Stock-Based Compensation,Transition and Disclosure.” SFAS 148 provides alternative methods of transitionfor a voluntary change to the fair value based method of accounting forstock-based employee compensation. SFAS 148 also requires that disclosures ofthe pro forma effect of using the fair value method of accounting forstock-based employee compensation be displayed more prominently and in atabular format. Additionally, SFAS 148 requires disclosure of the pro formaeffect in interim financial statements. The transition and annual disclosurerequirements of SFAS 148 are effective for fiscal years ended after December15, 2002.  The interim disclosure requirements are effective for interimperiods beginning after December 15, 2002.  The Company does not expectthat the adoption of SFAS 148 will have a material impact on its financialposition, results of operations, or cash flows.

 

In January 2003, the FASB issued FASB Interpretation No. 46 (“FIN 46”),“Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51.” FIN 46 requires certain variable interest entities to be consolidated bythe primary beneficiary of the entity if the equity investors in the entity donot have the characteristics of a controlling financial interest or do not havesufficient equity at risk for the entity to finance its activities withoutadditional subordinated financial support from other parties. FIN 46 iseffective immediately for all new variable interest entities created oracquired after January 31, 2003. For variable interest entities created oracquired prior to February 1, 2003, the provisions of FIN 46 must be appliedfor the first interim or annual period beginning after June 15, 2003. TheCompany does not expect that the adoption of FIN 46 will have a material impacton its financial position, results of operations, or cash flows.

 

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**NOTE 3 - MARKETABLESECURITIES**

 

The Company’s portfolio of marketable securities at December 31, 2002was as follows (in thousands):

 
|                                        |   | **Cost** |    | **Gross  Unrealized  Gains** |   | **Gross  Unrealized  Losses** |   | **Estimated  Fair  Value** |   |
|---------------------------------------------|--------|----------|---------|------------------------------|--------|-------------------------------|--------|----------------------------|--------|
|                                        |   |     |    |                         |   |                          |   |                       |   |
| Corporate bonds                             |   | $        | 130,337 |                         | $      | 733                           |   | $                          | (390   | ) | $ | 130,680 |   |
| Short/Medium term notes                     |   | 30,609   |    | 186                          |   | (10                           | )      | 30,785                     |   |
| U.S. government securities                  |   | 3,000    |    | 4                            |   | —                        |   | 3,004                      |   |
| Foreign bonds                               |   | 16,404   |    | 103                          |   | (62                           | )      | 16,445                     |   |
| Marketable equity securities                |   | 1,709    |    | —                       |   | —                        |   | 1,709                      |   |
| Total marketable securities                 |   | 182,059  |    | 1,026                        |   | (462                          | )      | 182,623                    |   |
| Less amounts classified as long-term assets |   | 76,914   |    | 438                          |   | (197                          | )      | 77,155                     |   |
| Total                                       |   | $        | 105,145 |                         | $      | 588                           |   | $                          | (265   | ) | $ | 105,468 |   |

 

The Company’s portfolio of marketable securities at December 31, 2001was as follows (in thousands):

 
|                                        |   | **Cost** |    | **Gross  Unrealized  Gains** |   | **Gross  Unrealized  Losses** |   | **Estimated  Fair  Value** |   |
|---------------------------------------------|--------|----------|---------|------------------------------|--------|-------------------------------|--------|----------------------------|--------|
|                                        |   |     |    |                         |   |                          |   |                       |   |
| Corporate bonds                             |   | $        | 123,427 |                         | $      | 992                           |   | $                          | (530   | ) | $ | 123,889 |   |
| Short/Medium term notes                     |   | 40,948   |    | 253                          |   | (52                           | )      | 41,149                     |   |
| Foreign bonds                               |   | 7,380    |    | 70                           |   | —                        |   | 7,450                      |   |
| Time deposits                               |   | 3,171    |    | —                       |   | —                        |   | 3,171                      |   |
| Marketable equity securities                |   | 1,000    |    | —                       |   | (742                          | )      | 258                        |   |
| Total marketable securities                 |   | 175,926  |    | 1,315                        |   | (1,324                        | )      | 175,917                    |   |
| Less amounts classified as long-term assets |   | 85,741   |    | 644                          |   | (286                          | )      | 86,099                     |   |
| Total                                       |   | $        | 90,185  |                         | $      | 671                           |   | $                          | (1,038 | ) | $ | 89,818 |   |

 

Gross realized gains on the sales of marketable securities were$165,357 in 2002 and insignificant in 2001. Gross realized losses on sales ofmarketable securities were $103,664 in 2002 and insignificant in 2001.

 

In 2002, the Company recorded a non-cash loss of $696,000 realized uponthe conversion of equity securities in conjunction with the acquisition of aninvestee as a result of the acquisition by Roxio, Inc. of MGI Software Inc. Asof the date of the acquisition, we held approximately 373,000 shares of MGIcommon stock. Upon consummation of the acquisition, our MGI common stock wasexchanged for 18,843 shares of Roxio common stock. In connection with theexchange, we recorded a realized loss of $696,000 and established a new costbasis of our Roxio common stock equal to its fair value on the date of theexchange.

 

At the end of 2002, the Company recorded $3.6 million in non-cashimpairment charges for marketable equity securities that were determined to beother than temporarily impaired as the quoted market price of the relatedsecurities dropped below its carrying value for an extended period of time.There were no such impairment charges in 2001.

 

Interest income on marketable securities was $6.9 million, $9.6 millionand $8.8 million for the years ended December 31, 2002, 2001 and 2000,respectively.

 

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**NOTE 4 - BALANCESHEET COMPONENTS (in thousands):**

 
|                          |   | **December  31,** |   |
|-------------------------------|--------|-------------------|--------|
|                          |   | **2002**          |   | **2001** |   |
| **Accounts receivable, net:** |   |              |   |   |   |
| Trade                         |   | $                 | 35,240 |   | $ | 32,491 |   |
| Unbilled                      |   | 1,286             |   | 2,802 |   |
|                          |   | 36,526            |   | 35,293 |   |
| Less:   allowance        |   | (1,874            | )      | (1,926 | ) |
|                          |   |              |   |   |   |
|                          |   | $                 | 34,652 |   | $ | 33,367 |   |

 

Unbilled accounts receivable consists of development revenuerecognized, but not yet billed. Unbilled development revenue represents revenue recognized under thepercentage-of-completion method prior to achievement of the related contractmilestones.  The Company billsdevelopment revenue when contract milestones are achieved.  During 2002 and 2001, we wrote-off $180,000and $2.4 million, respectively, against the allowance for doubtful accountsreserve.

 
|                                                   |   | **December  31,** |   |
|--------------------------------------------------------|--------|-------------------|--------|
|                                                   |   | **2002**          |   | **2001** |   |
| **Inventory:**                                         |   |              |   |   |   |
| Work-in-process                                        |   | $                 | 6,365  |   | $ | 3,119 |   |
| Finished goods                                         |   | 6,321             |   | 12,562 |   |
|                                                   |   | $                 | 12,686 |   | $ | 15,681 |   |
|                                                   |   |              |   |   |   |
| **Property and equipment:**                            |   |              |   |   |   |
| Computer equipment                                     |   | $                 | 18,608 |   | $ | 17,717 |   |
| Office equipment and furniture                         |   | 1,014             |   | 923 |   |
| Machinery and equipment                                |   | 672               |   | 760 |   |
| Leasehold improvements                                 |   | 1,010             |   | 993 |   |
|                                                   |   | 21,304            |   | 20,393 |   |
| Less:   accumulated depreciation and amortization |   | (15,456           | )      | (13,234 | ) |
|                                                   |   | $                 | 5,848  |   | $ | 7,159 |   |

 
|                                        |   |   | ** ** |
|---------------------------------------------|--------|--------|------------|
|                                        |   |   |       |   | ** ** |
|                                        |   |   |       |   |   |
| **Accrued expenses and other liabilities:** |   |   |       |   |   |
| Accrued payroll and related expenses        |   | $      | 4,752      |   | $ | 4,036 |   |
| Accrued royalties                           |   | 2,054  |       | 1,883 |   |
| Taxes payable                               |   | 5,721  |       | 4,350 |   |
| Deferred revenue                            |   | 627    |       | 1,435 |   |
| Other accrued liabilities                   |   | 8,811  |       | 5,097 |   |
|                                        |   | $      | 21,965     |   | $ | 16,801 |   |

 

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**NOTE 5 – OTHER INCOME(LOSS), NET**

 

The following table provides the components of other income (loss),net. (in thousands)

** **
|                                                               |   | **December 31,** |   |
|--------------------------------------------------------------------|--------|------------------|--------|
|                                                               |   | **2002**         |   | **2001** |   | **2000** |   |
|                                                               |   |             |   |   |   |   |   |
| Investment impairment charges on marketable  equity securities     |   | $                | (3,595 | ) | $ | — |   | $ | — |   |
| Investment impairment charges on  non-marketable equity securities |   | (2,450           | )      | — |   | — |   |
| Realized loss on marketable equity  securities                     |   | (696             | )      | — |   | — |   |
| Other income (loss), net                                           |   | 127              |   | 151 |   | (51 | ) |
|                                                               |   | $                | (6,614 | ) | $ | 151 |   | $ | (51 | ) |

 

See Note 3 regarding investment impairment charges on marketable equitysecurities and realized loss on marketable equity securities. See Note 2regarding investment impairment charges on non-marketable equity securities.

** **

**NOTE 6 - GOODWILL ANDOTHER INTANGIBLE ASSETS**

 

The Company adopted Financial Accounting Standards Board (“FASB”)Statement No. 142 “Goodwill and Other Intangible Assets” (“SFAS 142”) as ofJanuary 1, 2002. SFAS 142 changed the accounting for goodwill from anamortization method to an impairment only approach. Under SFAS 142, goodwillwill be tested annually and whenever events or circumstances occur indicatingthat goodwill might be impaired. In connection with the adoption of SFAS 142,the Company has performed a transitional goodwill impairment assessment basedon its structure as one reporting unit and determined that no impairmentexisted at January 1, 2002. The Company also completed its annual impairmentassessment based on its structure as one reporting unit and determined that noimpairment currently exists.

 

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

 
|                        |   |                            |   | **December  31, 2002**     |   | **December  31, 2001**        |   |
|-----------------------------|--------|---------------------------------|--------|----------------------------|--------|-------------------------------|--------|
|                        |   | **Weighted  Avg. Life (Years)** |   | **Gross  carrying Amount** |   | **Accumulated  Amortization** |   | **Gross  carrying Amount** |   | **Accumulated  Amortization** |   |
| Amortized intangible assets |   |                            |   |                       |   |                          |   |   |   |   |   |
| Covenant not to compete     |   | 3                               |   | $                          | 800    |                          | $      | 667 |   | $ | 800 |   | $ | 400 |   |
| Patents                     |   | 3                               |   | 900                        |   | 750                           |   | 900 |   | 450 |   |
| Core technology             |   | 3                               |   | 8,060                      |   | 5,874                         |   | 8,060 |   | 3,187 |   |
| Completed technology        |   | 2                               |   | 10,760                     |   | 10,760                        |   | 10,760 |   | 6,382 |   |
| Customer base               |   | 3                               |   | 1,560                      |   | 1,137                         |   | 1,560 |   | 617 |   |
| Purchased core technology   |   | 4                               |   | 5,582                      |   | 63                            |   | — |   | — |   |
| Total                       |   |                            |   | $                          | 27,662 |                          | $      | 19,251 |   | $ | 22,080 |   | $ | 11,036 |   |

 

For the year ended December 31, 2002, the Company incurred $8.2 millionin charges related to the amortization of acquired intangible assets associatedwith the acquisitions of PixelCam Inc. and Nogatech Inc. in June and October2000, respectively. In addition, the Company recorded $63,000 in chargesrelated to the amortization of purchased core technology which is classified ascost of product sales. The Company will incur charges of $4.2 million for 2003,$1.3 million each in 2004 and 2005 and approximately $780,000 each in 2006 and2007 related to the amortization of purchased intangible assets.

 

54

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**Reconciliation of NetIncome (Loss) Excluding Goodwill Amortization**(inthousands except per share data):

 
|                                 |   | **Year Ended December 31,** |   |
|--------------------------------------|--------|-----------------------------|--------|
|                                 |   | **2002**                    |   | **2001** |   | **2000** |   |
| Net income (loss):                   |   |                        |   |   |   |   |   |
| Net income (loss), as reported       |   | $                           | 5,698  |   | $ | (36,065 | ) | $ | (20,608 | ) |
| Add back goodwill amortization       |   | —                      |   | 33,536 |   | 7,940 |   |
| Adjusted net income (loss)           |   | $                           | 5,698  |   | $ | (2,529 | ) | $ | (12,668 | ) |
|                                 |   |                        |   |   |   |   |   |
| Basic net income (loss) per share:   |   |                        |   |   |   |   |   |
| Net income (loss), as reported       |   | $                           | 0.21   |   | $ | (1.38 | ) | $ | (0.91 | ) |
| Add back goodwill amortization       |   | —                      |   | 1.28 |   | 0.35 |   |
| Adjusted net income (loss)           |   | $                           | 0.21   |   | $ | (0.10 | ) | $ | (0.56 | ) |
|                                 |   |                        |   |   |   |   |   |
| Diluted net income (loss) per share: |   |                        |   |   |   |   |   |
| Net income (loss), as reported       |   | $                           | 0.20   |   | $ | (1.38 | ) | $ | (0.91 | ) |
| Add back goodwill amortization       |   | —                      |   | 1.28 |   | 0.35 |   |
| Adjusted net income (loss)           |   | $                           | 0.20   |   | $ | (0.10 | ) | $ | (0.56 | ) |

 

**Note 7 - Research andDevelopment Arrangements:**

 

The Company is a party to certain research and development agreementswith the Chief Scientist in Israel’s Ministry of Industry and Trade Department(the “Chief Scientist”) and the Israel-United States Binational IndustrialResearch and Development Foundation (“BIRDF”), which fund up to 50% of incurredproject costs for approved products up to specified contract maximums.  The Company is not obligated to repayfunding regardless of the outcome of its development efforts; however, theseagreements require the Company to use its best efforts to achieve specifiedresults and require the Company to pay royalties at rates of 3% to 5% ofresulting products sales, and up to 30% of resulting license revenues, up to amaximum of 100% to 150% of the total funding received.  Reported research and development expensesare net of these grants, which fluctuate from period to period.

 

Gross research and development expenses and the related grants are asfollows: 

 
|                                    |   | **Year Ended  December 31,** |   |
|-----------------------------------------|--------|------------------------------|--------|
|                                    |   | **2002**                     |   | **2001** |   | **2000** |   |
|                                    |   | **(in  thousands)**          |   |
| Research and development expenses:      |   |                         |   |   |   |   |   |
| Gross research and development expenses |   | $                            | 22,083 |   | $ | 23,210 |   | $ | 18,961 |   |
| Less: grants earned                     |   | —                       |   | — |   | (333 | ) |
|                                    |   | $                            | 22,083 |   | $ | 23,210 |   | $ | 18,628 |   |

 

Royalty expenses related to these grants were $260,000, $502,000, and$299,000 in 2002, 2001 and 2000, respectively.

 

**Note 8 - DevelopmentContracts:**

 

The Company has generated a portion of its total revenues fromdevelopment contracts, primarily with key customers.  These development contracts have provided the Company withpartial funding for the development of certain of its products. The Companyclassifies costs related to these development contracts as research anddevelopment expenses.  The Company isnot obligated to repay funding regardless of the outcome of its developmentefforts; however, the agreements require the Company to use its best efforts toachieve specified results as per the agreements. The Company retains ownershipof the intellectual property developed under the contracts; however, somecontracts limit the product

 

55

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markets in which the Company may directly sell the developedproduct.  Revenues generated under thesecontracts were $1.4 million, $4.7 million and $5.1 million in 2002, 2001 and2000, respectively.

 

**Note 9 – Commitmentsand contingencies:**

 

From time to time, the Company may have certain contingent liabilitiesthat arise in the ordinary course of its business activities. The Companyaccrues contingent liabilities when it is probable that future expenditureswill be made and such expenditures can be reasonably estimated.  In the opinion of management, there are nopending claims of which the outcome is expected to result in a material adverseeffect in the financial position or results of operations of the Company.

 

*Lease commitments*

 

The Company rents facilities and equipment under various leaseagreements expiring through 2005.  Rentexpense for 2002, 2001 and 2000 totaled approximately $1.7 million, $1.5million and $1.2 million respectively. Future minimum lease payments required under noncancelable leases atDecember 31, 2001 are as follows: (in thousands) 

 

| **Year Ending  December 31,** |   |   |   |
|-------------------------------|--------|--------|--------|
| 2003                          |   | $      | 1,120  |   |
| 2004                          |   | 979    |   |
| 2005                          |   | 464    |   |
| Total minimum lease payments  |   | $      | 2,563  |   |

 

In addition, the Company had inventory purchase commitments of $10.2million at December 31, 2002.

 

**Note 10 -Stockholders’ Equity:**

 

*Common Stock*

 

In June 2000, the Company acquired PixelCam, Inc. in exchange for556,248 shares of Zoran common stock and options to purchase 6,252 shares ofZoran common stock. In October 2000, the Company acquired Nogatech, Inc. inexchange for 3,801,839 shares of Zoran common stock and options to purchase252,708 shares of Zoran common stock. Both acquisitions were accounted forunder the purchase method of accounting (see Note 14). During 2001, the Companyrepurchased 382,500 shares of its common stock for $3.9 million. On April 21,2002, the Company’s Board of Directors approved a three-for-two split of ourcommon stock which was effected in the form of a fifty percent stock dividend,paid on May 22, 2002 to stockholders of record on May 7, 2002. All share andper share information for all periods presented in this report are on apost-split basis.

 

*Warrants*

 

In September 1997, in connection with a software licenseagreement, the Company issued a warrant to purchase 112,500 shares of itsCommon Stock at an exercise price of $16.21 per share.  The warrant was exercisable for a period offour years from a date beginning one year after the issuance date of thewarrant.  The $717,000 estimated valueof the warrant, was amortized over the four-year period of the licenseagreement. In September 2002, the warrant expired.

 

56

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***Stock option plans***

 

*1993 Stock Option Plan*

 

The Company’s 1993 Stock Option Plan (the “1993 Option Plan”) wasadopted by the Board of Directors of the Company and approved by thestockholders of the Company in July 1993. A total of 7,755,000 shares ofcommon stock have been reserved for issuance under the 1993 Option Plan.  The 1993 Option Plan provides for grants ofoptions to employees, non-employee directors and consultants.  The 1993 Option Plan is currently beingadministered by the Compensation Committee of the Board of Directors of theCompany, which determines the optionees and the terms of the options granted,including the exercise price, number of shares subject to the option plan andthe exercisability thereof.  The optionprice for shares granted under the 1993 Option Plan is typically equal to thefair market value of the common stock at the date of grant.  The 1993 Option Plan will terminate inJuly 2003, unless terminated sooner by the Board of Directors.

 

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 without cause.  The Company’s right lapses as shares subjectto the option become vested.  Suchshares generally vest in monthly installments over two or four years followingthe date of grant (as determined by the Compensation Committee of the Board ofDirectors), 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.

 

At December 31, 2002, shares available for grant under this planwere 1,330,000.

* *

*2000 Stock Option Plan*

 

The Company’s 2000 Nonstatutory Stock Option Plan (the “2000 OptionPlan”) was adopted by the Board of Directors of the Company inOctober 2000. A total of 450,000 shares of preferred stock were initiallyreserved for issuance under the 2000 Option Plan. The options to purchasepreferred stock automatically converted to options to purchase common stockhowever, upon the filing of an amendment of the certificate of incorporation ofthe Company with the Secretary of State of Delaware to effect an increase inthe number of authorized shares of common stock to 55,000,000 in October 2000.A total of 5,325,000 shares of common stock have been reserved for issuanceunder the 2000 Option Plan.  The 2000Option Plan provides for grants of options to employees or consultants.  The 2000 Option Plan is currently beingadministered by the Compensation Committee of the Board of Directors of theCompany, which determines the optionees and the terms of the options granted,including the exercise price, number of shares subject to the option plan andthe exercisability thereof. The 2000 Option Plan was modified in 2001 to allowfor exercisability of stock options ahead of vesting subject to the Company’sright to repurchase the associated stock at the option exercise price throughthe original vesting schedule.  Theoption price for shares granted under the 2000 Option Plan is typically equalto the fair market value of the common stock at the date of grant. Options expireten years from the date of grant and an option shall generally terminate threemonths after termination of employment. The 2000 Option Plan will terminate in October 2010, unlessterminated sooner by the Board of Directors.

 

At December 31, 2002, shares available for grant under this plan were1,579,000.

* *

*1995 Outside Directors Stock Option Plan*

 

The Company’s Outside Directors Stock Option Plan (the “DirectorsPlan”) was adopted by the Company’s Board of Directors in October 1995, and wasapproved by its stockholders in December 1995. A total of 525,000 shares of Common Stock have been reserved forissuance under the Directors Plan.  TheDirectors Plan provides for the grant of nonstatutory stock options tononemployee directors of the Company. The Directors Plan provides that each new nonemployee director willautomatically be granted an option to purchase 30,000 shares on the date theoptionee first becomes a nonemployee director (the “Initial Grant”).  Thereafter, on the date immediatelyfollowing each annual

 

57

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stockholders’ meeting, each nonemployee director who is reelected atthe meeting to an additional term shall be granted an additional option topurchase 15,000 shares of Common Stock if, on such date, he or she shall haveserved on the Company’s Board of Directors for at least six months (the “AnnualGrant”).  The Initial Grant isexercisable in four equal annual installments, and each Annual Grant shallbecome exercisable in full one year after the date of grant, subject to thedirector’s continuous service.  Theexercise price of all stock options granted under the Directors Plan is equalto the fair market value of the Company’s Common Stock on the date of grant.  Options granted under the Directors Planhave a term of ten years.

 

At December 31, 2002 shares available for grant under this plan were160,000.

 

The following table summarizes the Company’s stock option activity forthe years ended December 31, 2002, 2001 and 2000.  The weighted average exercise price for eachcategory presented is also shown in the table below:

 
|                               |   | **Year Ended  December 31,** |   |
|------------------------------------|--------|------------------------------|--------|
|                               |   | **2002**                     |   | **2001** |   | **2000** |   |
|                               |   | **Shares**                   |   | **Weighted  Average  Exercise  Price** |   | **Shares** |   | **Weighted  Average  Exercise  Price** |   | **Shares** |   | **Weighted  Average  Exercise  Price** |   |
|                               |   |                         |   |   |   |   |   |   |   |   |   |   |   |
| Outstanding at beginning of period |   | 5,359,152                    |   | $ | 15.44 |   | 3,959,575 |   | $ | 15.97 |   | 2,898,834 |   | $ | 7.48 |   |
| Assumed                            |   | —                       |   |   |   | — |   |   |   | 252,708 |   | 7.59 |   |
| Granted                            |   | 2,722,500                    |   | 14.18 |   | 2,964,135 |   | 13.29 |   | 1,960,575 |   | 25.49 |   |
| Exercised                          |   | (584,740                     | )      | 9.17 |   | (853,338 | ) | 6.62 |   | (727,295 | ) | 4.56 |   |
| Canceled                           |   | (443,370                     | )      | 15.77 |   | (711,220 | ) | 20.03 |   | (425,247 | ) | 16.64 |   |
|                               |   |                         |   |   |   |   |   |   |   |   |   |   |   |
| Options outstanding at period end  |   | 7,053,542                    |   | 15.45 |   | 5,359,152 |   | 15.44 |   | 3,959,575 |   | 15.97 |   |
|                               |   |                         |   |   |   |   |   |   |   |   |   |   |   |
| Options exercisable at period end  |   | 7,053,542                    |   |   |   | 5,359,152 |   |   |   | 3,612,150 |   |   |   |
|                                    |        |                              |        |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

58

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Significant option groups outstanding as of December 31, 2002 and therelated weighted average exercise price and contractual life information, areas follows:

 
|                         |   | **Options  Outstanding and  Exercisable** |       |                                   |       |
|------------------------------|--------|-------------------------------------------|------------|----------------------------------------|------------|
| **Exercise Price**           |   | **Number**                                |       | **Weighted  Average  Exercise  Price** |       | **Weighted  Average  Contractual  Life (Years)** |   |
|                         |   |                                      | ** ** |                                   | ** ** |   | ** ** |
| $    0.09 - $11.52 |   | 2,107,324                                 |       | $                                      | 9.00       |   | 7.5 |   |
| $ 11.54 - $12.36             |   | 1,770,328                                 |       | 12.33                                  |       | 9.6 |   |
| $ 12.96 - $20.57             |   | 1,444,102                                 |       | 15.73                                  |       | 8.4 |   |
| $ 20.95 - $27.33             |   | 1,498,292                                 |       | 25.41                                  |       | 8.1 |   |
| $ 27.50 - $41.33             |   | 233,496                                   |       | 31.78                                  |       | 7.7 |   |
|                         |   | 7,053,542                                 |       | 15.45                                  |       | 8.4 |   |
|                              |        |                                           |            |                                        |            |  |  |  |

 

The weighted average grant date fair value of options granted duringthe years ended December 31, 2002, 2001 and 2000 as defined bySFAS 123, were $11.55, $10.80 and $22.79 per share, respectively.

*** ***

*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.  The ESPPenables 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 ESPPis intended to qualify as an “employee stock purchase plan” under Section 423of the U.S. Internal Revenue Code. During the years ended December 31, 2002 and 2001, 107,596 and 98,010shares were purchased by employees under the terms of the plan agreements at aweighted average price of $12.94 and $12.43 per share, respectively.  At December 31, 2002, 201,985 shares werereserved and available for issuance under this plan.

 

The weighted average grant date fair value of rights granted during theyear ended December 31, 2002, 2001 and 2000 as defined by SFAS 123,was $8.47, $7.81 and $11.51 per share, respectively.

 

For the Fair Value disclosure in Note 2 and as required under Statementof Financial Accounting Standards No. 123 (“SFAS 123”), Accounting forStock-Based Compensation” the fair value of each option grant is estimated onthe date of grant using the Black Scholes model with the following assumptionsused for options and purchase grants during the applicable period.

 
|                     |   | **Year Ended  December 31,** |   |
|--------------------------|--------|------------------------------|--------|
|                     |   | **2002**                     |   | **2001** |   | **2000** |   |
|                     |   |                         |   |   |   |   |   |
| Dividend rate            |   | 0.0                          | %      | 0.0 | % | 0.0 | % |
| Risk-free interest rates |   | 2.9 to 4.7                   | %      | 3.9 to 4.9 | % | 5.2 to 6.7 | % |
| Volatility               |   | 92.0                         | %      | 90.0 | % | 91.0 | % |
| Expected life            |   |                         |   |   |   |   |   |
| Option plans             |   | 5                            | years  | 5 | years | 5 | years |
| Purchase plan            |   | 0.5                          | years  | 0.5 | years | 0.5 | years |

 

59

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**Note 11 - EARNINGSPER SHARE:**

 

A reconciliation of the numerators and the denominators of the basicand diluted per share computation are as follows (in thousands): 

 
|                                        |              | **2002**        |              | **2001**        |              | **2000**                |       |
|---------------------------------------------|-------------------|-----------------|-------------------|-----------------|-------------------|-------------------------|------------|
|                                        |              |            |              |            |              | **Per   Share  Amount** |       |   |   |   |   | **Per Share  Amount** |   |   |   |   |   | **Per Share  Amount** |   |
| **Income**                                  | **Shares**        | **Income**      | **Shares**        | **Income**      | **Shares**        |
| **(Numerator)**                             | **(Denominator)** | **(Numerator)** | **(Denominator)** | **(Numerator)** | **(Denominator)** |
|                                        |              |            |              |            |              |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
|                                        |              |            | ** **        |            | ** **        |                    | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
| Basic EPS:                                  |              |            |              |            |              |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income (loss)                           |              | $               | 5,698             |            | 27,095            |                    | $          | 0.21 |   | $ | (36,065 | ) | 26,190 |   | $ | (1.38 | ) | $ | (20,608 | ) | 22,605 |   | $ | (0.91 | ) |
|                                        |              |            |              |            |              |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Effects of  dilutive  securities: |              |            |              |            |              |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Stock options                               |              | —          |              | 1,523           |              |                    |       | — |   | — |   |   |   | — |   | — |   |   |   |
| Warrants                                    |              | —          |              | 11              |              |                    |       | — |   | — |   |   |   | — |   | — |   |   |   |
|                                        |              |            |              |            |              |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Diluted EPS:                                |              |            |              |            |              |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income (loss)                           |              | $               | 5,698             |            | 28,629            |                    | $          | 0.20 |   | $ | (36,065 | ) | 26,190 |   | $ | (1.38 | ) | $ | (20,608 | ) | 22,605 |   | $ | (0.91 | )  |

 

Stock options and a warrant to purchase 5,472,000 and 4,073,000 sharesof common stock were outstanding at December 31, 2001 and 2000 respectively,but were not included in the weighted average diluted earnings per sharecalculation as they were antidilutive. All shares for the respective periodspresented in the above table have been adjusted for the three-for-two stocksplit of our common stock effected in May of 2002.

 

**Note12 - INCOME TAXES:**

 

The components of income before income taxes are as follows: 

 
|    |   | **Year Ended  December 31,** |       |
|---------|--------|------------------------------|------------|
|    |   | **2002**                     |       | **2001** |   | **2000** |   |
|    |   | **(in thousands)**           | ** ** |
| U.S.    |   | $                            | 2,788      |   | $ | (33,478 | ) | $ | (25,941 | ) |
| Foreign |   | 4,482                        |       | (1,322 | ) | 7,303 |   |
|    |   | $                            | 7,270      |   | $ | (34,800 | ) | $ | (18,638 | ) |

 

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

 
|          |   | **Year Ended  December 31,** |       |
|---------------|--------|------------------------------|------------|
|          |   | **2002**                     |       | **2001** |   | **2000** |   |
|          |   | **(in  thousands)**          | ** ** |
| Current:      |   |                         |       |   |   |   |   |
| U.S.          |   | $                            | 179        |   | $ | 927 |   | $ | 267 |   |
| State         |   | 89                           |       | 115 |   | 827 |   |
| Foreign       |   | 1,304                        |       | 223 |   | 876 |   |
| Total current |   | 1,572                        |       | 1,265 |   | 1,970 |   |
| Deferred      |   | —                       |       | — |   | — |   |
| Total         |   | $                            | 1,572      |   | $ | 1,265 |   | $ | 1,970 |   |

 

60

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

 

*Tax provisiondifference*

** **
|                                          |   | **Year Ended  December 31,** |   |
|-----------------------------------------------|--------|------------------------------|--------|
|                                          |   | **2002**                     |   | **2001** |   | **2000** |   |
|                                          |   | **(in  thousands)**          |   |
| Tax at U.S. statutory rate                    |   | $                            | 4,408  |   | $ | (11,832 | ) | $ | (6,337 | ) |
| Utilization of net operating loss  carryovers |   | (1,078                       | )      | — |   | (2,075 | ) |
| Foreign Earnings                              |   | (2,555                       | )      | (213 | ) | (635 | ) |
| State taxes net of federal benefit            |   | (152                         | )      | 416 |   | 443 |   |
| Other differences not benefited               |   | 751                          |   | 1,640 |   | 433 |   |
| Permanent differences                         |   | —                       |   | 16 |   | (72 | ) |
| Alternative minimum tax                       |   | 198                          |   | 208 |   | 122 |   |
| In-process research and development           |   | —                       |   | — |   | 7,428 |   |
| Non-deductible goodwill amortization          |   | —                       |   | 11,251 |   | 2,663 |   |
| Other                                         |   | —                       |   | (221 | ) | — |   |
|                                          |   | $                            | 1,572  |   | $ | 1,265 |   | $ | 1,970 |   |

 

Deferred income tax assets comprise the following: 

 
|                                                |   | **Year Ended  December 31,** |   |
|-----------------------------------------------------|--------|------------------------------|--------|
|                                                |   | **2002**                     |   | **2001** |   | **2000** |   |
|                                                |   | **(in  thousands)**          |   |
| Deferred tax assets                                 |   |                         |   |   |   |   |   |
| Federal and state net operating loss  carryforwards |   | $                            | 12,117 |   | $ | 16,865 |   | $ | 18,605 |   |
| Capitalized research and development  expenses      |   | —                       |   | — |   | 543 |   |
| Nondeductible reserves and accruals                 |   | 2,855                        |   | 2,154 |   | 1,841 |   |
| Total deferred tax assets                           |   | 14,972                       |   | 19,019 |   | 20,989 |   |
| Deferred tax liabilities                            |   |                         |   |   |   |   |   |
| Intangible assets                                   |   | (1,889                       | )      | (4,858 | ) | (8,468 | ) |
| Total deferred tax assets                           |   | (1,889                       | )      | (4,858 | ) | (8,468 | ) |
| Net deferred tax assets                             |   | 13,083                       |   | 14,161 |   | 12,521 |   |
| Valuation allowance                                 |   | (13,083                      | )      | (14,161 | ) | (12,521 | ) |
|                                                |   | $                            | — |   | $ | — |   | $ | — |   |
|                                                     |        |                              |        |  |  |  |  |  |  |  |  |

 

As of December 31, 2002, the Company had net operating losses (“NOLs”)of approximately $34.0 million for federal and $4.0 million for state taxreporting purposes. The federal NOLs expire on various dates between 2003 and2020. The State NOLs expire between 2005 and 2008.  Management has recorded a full valuation allowance against allU.S. deferred tax assets on the basis that significant uncertainty existsregarding the realizability of the assets.

 

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.  The Company’sinitial public offering resulted in a cumulative change of ownership of greaterthan

 

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50%.  Accordingly, the Company’sNOLs incurred prior to the completion of the IPO that can be utilized to reducefuture taxable income for federal tax purposes will be limited to approximately$3.0 million per year.

 

The Company’s Israeli subsidiary has been granted the status of an“Approved Enterprise” pursuant to the Israeli law for the Encouragement ofCapital Investments, 1959, as amended. The Company has six approved programs pursuant to this law.  The first program was approved in 1984.  Income subject to this program is taxed atan annual rate of 10% from the first year in which the enterprise generatestaxable income (net of NOLs).  Benefitsunder the first program expired in 1997. The second program was approved in 1991.  Income subject to this program is exempt from tax for two yearsfrom the first year in which the Company has taxable income (net of NOLs) andis taxed at a rate of 10% thereafter. Benefits under the second program expire in 2003.  The third program was approved in 1995.  Income subject to this program is exemptfrom tax for four years from the first year in which the Company has taxableincome (net of NOLs) and is taxed at a rate of 10% during the remaining periodof six years.  The fourth program wasapproved in 1997.  Income subject tothis program 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 third and the fourth program are limited to fourteenyears from approval or twelve years from commencement of production. The fifthprogram was approved in 2000. Income subject to this program is exempt from taxfor two years from the first year in which the Company has taxable income (netof NOLs) and is taxed at a rate of 10% during the remaining period of eightyears. The sixth program was approved in 2001. Income subject to this programis exempt from tax for two years from the first year in which the Company hastaxable income (net of NOLs) and is taxed at a rate of 10% during the remainingperiod of eight years. The net impact of the tax holidays was an increase innet income of $369,000 in fiscal 2002 and $635,000 in fiscal 2000, and anincrease in net income per share of $0.01 and $0.03 in 2002 and 2000respectively. There was no impact for tax holidays in 2001.

 

**Note 13 - SEGMENTREPORTING:**

 

The Company operates in one industry segment comprising the design,development, manufacture and sale of integrated circuits.  The following is a summary of the Company’soperations:

 

Sales to customers located in:

 
|          |   | **Year Ended  December 31,** |    |
|---------------|--------|------------------------------|---------|
|          |   | **2002**                     |    | **2001** |   | **2000** |   |
|          |   | **(in  thousands)**          |    |
| Pacific Rim   |   | $                            | 140,602 |   | $ | 90,137 |   | $ | 51,985 |   |
| Europe        |   | 4,514                        |    | 9,805 |   | 12,951 |   |
| United States |   | 4,001                        |    | 7,767 |   | 14,735 |   |
|          |   | $                            | 149,117 |   | $ | 107,709 |   | $ | 79,671 |   |

 
|                 |   | **December  31,**   |    |
|----------------------|--------|---------------------|---------|
|                 |   | **2002**            |    | **2001** |   |
|                 |   | **(in  thousands)** |    |
| Identifiable assets: |   |                |    |   |   |
| U.S.                 |   | $                   | 311,551 |   | $ | 299,026 |   |
| Israel               |   | 31,065              |    | 32,318 |   |
| Total                |   | $                   | 342,616 |   | $ | 331,344 |   |

 

62

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Significant customers are as follows:

 
|                                                                                             |   | **Year Ended  December 31,** |   |
|--------------------------------------------------------------------------------------------------|--------|------------------------------|--------|
|                                                                                             |   | **2002**                     |   | **2001** |   | **2000** |   |
| Customers comprising 10% or more of the  Company’s total revenues for the period indicated: |   |                         |   |   |   |   |   |
| A                                                                                                |   | 37                           | %      | 29 | % | 25 | % |
| B                                                                                                |   | —                       |   | 12 | % | — |   |

 

**NOTE 14 – ACQUISITIONAND DISPOSITION OF ASSETS:**

 

*PixelCam:*On June 29, 2000, the Company acquired PixelCam, Inc. (“PixelCam”), amanufacturer of megapixel CMOS image sensors, in exchange for 556,248 shares ofZoran common stock and options to purchase 6,252 shares of Zoran common stockwith an aggregate value of $24.6 million. The common stock issued includes185,418 shares of restricted stock subject to repurchase by the Companyexchanged for restricted stock of PixelCam. The restrictions and vestingperiods of the PixelCam shares were maintained and will apply to the convertedshares of the Company. The agreement also included shares that werecontingently issuable to former PixelCam shareholders upon achievement ofcertain milestones. These milestones were not met and therefore no additionalshares will be issued. The common stock issued was valued using the average ofthe market price per share of the Company’s common stock for the three tradingdays prior to the date the acquisition was consummated. The options were valuedusing the Black-Scholes valuation model. The results of operations of PixelCamare included in the Company’s financial statements from the date ofacquisition.

 

The acquisition was accounted for under the purchase method ofaccounting.  The Company had a valuationperformed of the in-process research and development and the intangible assetsacquired.  The allocation of thepurchase price based on independent appraisal and estimates of fair value andincluding acquisition costs of $575,000, is as follows (in thousands):

 
| Net tangible assets                   |   |   |   | $      | 419    |   |
|---------------------------------------|--------|--------|--------|--------|--------|--------|
| In-process research and development   |   |   |   | 6,769  |   |
|                                  |   |   |   |   |   |
| Goodwill and other intangible assets: |   |   |   |   |   |
| Goodwill                              |   | 15,956 |   |   |   |
| Covenant not to compete               |   | 800    |   |   |   |
| Patents                               |   | 900    |   |   |   |
| Acquired employees                    |   | 380    |   |   |   |
|                                  |   |   |   | 18,036 |   |
| Net assets acquired                   |   |   |   | $      | 25,224 |   |

 

The net tangible assets acquired were comprised primarily of propertyand equipment, inventory, and cash offset by accrued liabilities. The acquiredin-process research and development was written-off in the second quarter of2000. The estimated weighted average useful life of the intangible assets for purchasedtechnology, covenant not to compete, acquired employees, patents and residualgoodwill, created as a result of the acquisition of PixelCam, is approximatelythree years.

 

The allocation of $6.8 million of the purchase price to the acquiredin-process research and development has been determined by identifying theresearch project for which technological feasibility had not been establishedand no

 

63

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alternative future uses existed. The value was determined by estimatingthe expected cash flows from the project once commercially viable, discountingthe net cash flows back to their present value, and then applying a percentageof completion to the calculated value as defined below.

 

NET CASH FLOWS.  The net cashflows from the identified project was based on estimates of revenues, cost ofsales, research and development costs, selling, general and administrativecosts, and income taxes from the project. These estimates were based on theassumptions discussed below. The research and development costs excluded coststo bring the acquired in-process project to technological feasibility.

 

The estimated revenues were based on management projections of theacquired in-process project. The business projections were compared with andfound to be in line with industry analysts’ forecasts of growth insubstantially all of the relevant markets. Estimated total revenues from theacquired in-process research and development product are expected to peak infiscal 2002 and decline in fiscal 2003 as other new products are expected tobecome available. These projections were based on estimates of market size andgrowth, expected trends in technology, and the nature and expected timing ofnew product introductions by the Company and its competitors.

 

Projected gross margins as well as selling, general and administrativecosts were based on management’s estimates.

 

DISCOUNT RATE.  Discounting thenet cash flows back to their present value was based on the cost of capital forwell managed venture capital funds which typically have similar risks andreturns on investments. The cost of capital used in discounting the net cashflows from acquired in-process research was 25%.

 

PERCENTAGE OF COMPLETION.  Thepercentage of completion was determined using costs incurred by PixelCam priorto the acquisition date compared to the remaining research and development tobe completed to bring the project to technological feasibility. The Companyestimated, as of the acquisition date, the project was 62% complete and theestimated costs to complete the project were approximately $4.1 million.

 

The Company has completed the project and the related IC began shippingin the third quarter of 2001.

 

*Nogatech:*On October 26, 2000, the Company acquired Nogatech, Inc. (“Nogatech”), amanufacturer of integrated circuits that establish connections between videodevices and computers as well as connections between video devices across avariety of networks, in exchange for 3,801,839 shares of Zoran common stockwith a fair value of $154.4 million and options to purchase 252,708 shares ofZoran common stock with a fair value of $9.2 million. The common stock issuedwas valued using the average of the market price per share of the Company’scommon stock on the date the proposed merger was announced and the threetrading days before and two trading days subsequent to the date of theannouncement. The options were valued using the Black-Scholes valuation model.The results of operations of Nogatech are included in the Company’s financialstatements from the date of acquisition.

 

The acquisition was accounted for under the purchase method ofaccounting.  The Company had a valuationperformed of the in-process research and development and the intangible assetsacquired.  The allocation of thepurchase price

 

64

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based on independent appraisal and estimates of fair value includingacquisition costs of approximately $1.5 million is as follows (in thousands):

 

 
| Net tangible assets                        |   |   |   | $       | 44,246  |   |
|--------------------------------------------|--------|--------|--------|---------|---------|--------|
| In-process research and development        |   |   |   | 15,078  |    |
| Deferred compensation for unvested options |   |   |   | 1,018   |    |
| Goodwill and other intangible assets:      |   |   |   |    |    |
| Goodwill                                   |   | 83,571 |   |    |    |
| Core technology                            |   | 8,060  |   |    |    |
| Completed technology                       |   | 10,760 |   |    |    |
| Assembled workforce                        |   | 700    |   |    |    |
| Customer base                              |   | 1,560  |   |    |    |
|                                       |   |   |   | 104,651 |    |
| Net assets acquired                        |   |   |   | $       | 164,993 |   |

 

The net tangible assets acquired were comprised primarily of cash,inventory, and prepaid expense offset by accrued liabilities. The acquiredin-process research and development was written-off in the fourth quarter of2000. The intangible assets for core technology, assembled workforce, customerbase and residual goodwill, created as a result of the acquisition of Nogatechwill be amortized on a straight line basis over their estimated useful lives ofthree years. The completed technology will be amortized on a straight linebasis over its estimated useful life of two years.

 

The allocation of $15.1 million of the purchase price to the acquiredin-process research and development has been determined by identifying theresearch project for which technological feasibility had not been establishedand no alternative future uses existed. The value was determined by estimatingthe expected cash flows from the project once commercially viable, discountingthe net cash flows back to their present value, and then applying a percentageof completion to the calculated value as defined below.

 

NET CASH FLOWS.  The net cashflows from the identified project was based on estimates of revenues, cost ofsales, research and development costs, selling, general and administrativecosts, and income taxes from the project. These estimates were based on theassumptions discussed below. The research and development costs excluded coststo bring the acquired in-process project to technological feasibility.

 

The estimated revenues were based on management projections of theacquired in-process project. The business projections were compared with andfound to be in line with industry analysts’ forecasts of growth insubstantially all of the relevant markets. Estimated total revenues from theacquired in-process research and development product are expected to peak infiscal 2006 and decline in fiscal 2007 as other new products are expected tobecome available. These projections were based on estimates of market size andgrowth, expected trends in technology, and the nature and expected timing ofnew product introductions by the Company and its competitors.

 

Projected gross margins as well as selling, general and administrativecosts were based on management’s estimates.

 

DISCOUNT RATE.  Discounting thenet cash flows back to their present value was based on the cost of capital forwell managed venture capital funds which typically have similar risks andreturns on investments. The cost of capital used in discounting the net cashflows from acquired in-process research was 25%.

 

PERCENTAGE OF COMPLETION.  Thepercentage of completion was determined using costs incurred by Nogatech priorto the acquisition date compared to the remaining research and development tobe completed to bring the project to technological feasibility. The Companyestimated, as of the acquisition date, the project was 60% complete and theestimated costs to complete the project were approximately $1.2 million.

 

65

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The in-process research and development project acquired from Nogatechrelates to MPEG 4 technology to be used in video streaming applications. Ourmarketing plan at the time of the acquisition indicated that the market that weserve would demand products incorporating this technology beginning in the 2002to 2003 timeframe. We now believe that our target market will not require thistechnology until 2004 due to market-related pricing considerations. The delayin the project will shift projected cash flows out by approximately one to twoyears. We estimate that this project will take approximately one year tocomplete and will cost approximately $1 million. Completion of this projectremains a significant risk to the Company due to the remaining effort toachieve technical feasibility, rapidly changing customer markets andsignificant competitive threats from other companies. Failure to bring relatedproducts to market in a timely manner could adversely impact sales andprofitability of the Company in the future. Additionally, the value of theintangible assets acquired may become impaired.

 

*Unaudited pro forma results*

 

The unaudited pro forma information below assumes that PixelCam andNogatech had been acquired on January 1, 2000 and includes the effect ofamortization of goodwill and other identified intangibles from that date. Theimpact of charges for in-process research and development has been excluded.This information is presented for informational purposes only and is notnecessarily indicative of the results of future operations or results thatwould have been achieved had the acquisition taken place at the beginning ofthe period presented.

 
| **(in thousands, except per share amounts)** |   | **Twelve Months Ended  December 31,****2000** |    |
|----------------------------------------------|--------|-----------------------------------------------|---------|
|                                         |   |                                          |    |
| Net revenues                                 |   | $                                             | 88,136  |   |
| Net loss                                     |   | $                                             | (43,666 | ) |
| Basic and diluted loss per common share      |   | $                                             | (2.43   | ) |

 

**NOTE 15 -RELATED-PARTY TRANSACTIONS:**

 

In January 1996, the Company spun off its wholly-owned subsidiary, OrenSemiconductor, to the Company’s stockholders. One of the Company’s directors isalso a member of Oren’s board of directors. The Company has no ownershipinterest in Oren.

 

In December 2002, the Company entered into a technology licenseagreement with Oren. Under the license arrangement the Company agreed to payOren a license fee totaling $675,000. There are no royalties associated with this agreement.

 

66

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**ZORAN CORPORATION**

**SELECTED QUARTERLY FINANCIAL INFORMATION****(Unaudited)**

 
|                                                        |   | **Quarters  Ended**                        |   |
|-------------------------------------------------------------|--------|--------------------------------------------|--------|
|                                                        |   | **Dec 31,  2002**                          |   | **Sept 30,  2002** |   | **June 30,  2002** |   | **March 31,  2002** |   | **Dec 31,  2001** |   | **Sept 30,  2001** |   | **June 30,  2001** |   | **March 31,  2001** |   |
|                                                        |   | **(in  thousands, except per share data)** |   |
| Revenues:                                                   |   |                                       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Product sales                                               |   | $                                          | 36,196 |   | $ | 43,814 |   | $ | 32,199 |   | $ | 29,105 |   | $ | 33,099 |   | $ | 28,976 |   | $ | 20,622 |   | $ | 17,315 |   |
| Software, licensing and development                         |   | 3,780                                      |   | 243 |   | 1,795 |   | 1,985 |   | 2,669 |   | 1,448 |   | 1,302 |   | 2,278 |   |
| Total revenues                                              |   | 39,976                                     |   | 44,057 |   | 33,994 |   | 31,090 |   | 35,768 |   | 30,424 |   | 21,924 |   | 19,593 |   |
|                                                        |   |                                       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Cost and expenses:                                          |   |                                       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Cost of product sales                                       |   | 22,164                                     |   | 25,349 |   | 20,559 |   | 18,832 |   | 21,665 |   | 18,971 |   | 13,228 |   | 10,876 |   |
| Research and development                                    |   | 5,161                                      |   | 5,880 |   | 5,521 |   | 5,521 |   | 6,110 |   | 5,210 |   | 5,922 |   | 5,968 |   |
| Selling, general and administrative                         |   | 6,514                                      |   | 6,697 |   | 5,905 |   | 5,740 |   | 5,511 |   | 5,416 |   | 5,160 |   | 5,243 |   |
| Amortization of intangible assets                           |   | 1,234                                      |   | 2,319 |   | 2,445 |   | 2,445 |   | 2,424 |   | 2,424 |   | 2,425 |   | 2,424 |   |
| Amortization of goodwill                                    |   | —                                     |   | — |   | — |   | — |   | 8,384 |   | 8,384 |   | 8,384 |   | 8,384 |   |
| Total costs and expenses                                    |   | 35,073                                     |   | 40,245 |   | 34,430 |   | 32,538 |   | 44,094 |   | 40,405 |   | 35,119 |   | 32,895 |   |
|                                                        |   |                                       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Operating income (loss)                                     |   | 4,903                                      |   | 3,812 |   | (436 | ) | (1,448 | ) | (8,326 | ) | (9,981 | ) | (13,195 | ) | (13,302 | ) |
| Interest income                                             |   | 1,546                                      |   | 1,684 |   | 1,766 |   | 2,057 |   | 2,237 |   | 2,451 |   | 2,587 |   | 2,578 |   |
| Other income (loss), net (1)                                |   | (6,094                                     | )      | (8 | ) | 86 |   | (598 | ) | 4 |   | (39 | ) | 19 |   | 167 |   |
| Income (loss) before taxes                                  |   | 355                                        |   | 5,488 |   | 1,416 |   | 11 |   | (6,085 | ) | (7,569 | ) | (10,589 | ) | (10,557 | ) |
| Provision for income taxes                                  |   | 159                                        |   | 781 |   | 386 |   | 246 |   | 708 |   | 486 |   | 28 |   | 43 |   |
| Net income (loss)                                           |   | $                                          | 196    |   | $ | 4,707 |   | $ | 1,030 |   | $ | (235 | ) | $ | (6,793 | ) | $ | (8,055 | ) | $ | (10,617 | ) | $ | (10,600 | ) |
| Net income (loss) per share:                                |   |                                       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                                       |   | $                                          | 0.01   |   | $ | 0.17 |   | $ | 0.04 |   | $ | (0.01 | ) | $ | (0.26 | ) | $ | (0.31 | ) | $ | (0.41 | ) | $ | (0.41 | ) |
| Diluted                                                     |   | $                                          | 0.01   |   | $ | 0.17 |   | $ | 0.04 |   | $ | (0.01 | ) | $ | (0.26 | ) | $ | (0.31 | ) | $ | (0.41 | ) | $ | (0.41 | ) |
| Shares used to compute basic net income  (loss) per share   |   | 27,284                                     |   | 27,150 |   | 27,054 |   | 26,774 |   | 26,534 |   | 26,253 |   | 25,895 |   | 25,971 |   |
| Shares used to compute diluted net income  (loss) per share |   | 28,462                                     |   | 28,089 |   | 28,923 |   | 26,774 |   | 26,534 |   | 26,253 |   | 25,895 |   | 25,971 |   |

 

----

 

(1) Includes $6.0 million in investment impairment charges for thequarter ended December 31, 2002.  SeeNote 5.

 

67

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# **Item9.     Changes in and Disagreements with Accountantson Accounting and Financial Disclosure.**

 

Not applicable.

 

68

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**PART III**

 

Certain information required by Part III is omitted from this report inthat the Company intends to file its definitive proxy statement pursuant toRegulation 14A (the “Proxy Statement”) not later than 120 days after the end ofthe fiscalyear covered by this report and certain information therein isincorporated herein by reference.

 

# **Item10.     Directors and Executive Officers of theRegistrant.**

 

The information required by this Item is incorporated by reference to informationset forth in the Proxy Statement under the heading “Proposal No. 1 — Electionof 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.”

 

# **Item11.     Executive Compensation.**

 

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

 

# **Item12.     Security Ownership of Certain BeneficialOwners 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 

“Principal Stockholders and Share Ownership by Management” and “EquityCompensation Plan Information.”

 

# **Item 13.     CertainRelationships and Related Transactions.**

 

The information required by this Item is incorporated by reference toinformation set forth in the Proxy Statement under the headings “CertainTransactions.”

 

# **Item14.     Controls and Procedures.**

 

(a) Evaluation of Disclosure Controls and Procedures.

 

Within 90 days prior to the date of filing of this Report, we carriedout an evaluation, under the supervision and with the participation ofmanagement, including our Chief Executive Officer and Chief Financial Officer,of the design and operation of our disclosure controls and procedures (asdefined in Rules 13a-14(c) under the Securities Exchange Act of 1934, asamended (the “Exchange Act”)). Based on this evaluation, our Chief ExecutiveOfficer and Chief Financial Officer concluded that our disclosure controls andprocedures are effective for gathering, analyzing and disclosing theinformation we are required to disclose in the reports we file under theExchange Act, within the time periods specified in the SEC’s rules and forms.

 

(b) Changes in Internal Controls.

 

There have been no significant changes in our internal controls, or inother factors that could significantly affect our internal controls subsequentto the date of the evaluation described above.

 

69

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**PART IV**

** **

# **Item15.     Exhibits, Financial Statement Schedules andReports on Form 8-K.**

 
| (a)    | The following documents are filed as a part of this report:     |
|--------|-----------------------------------------------------------------|
|   |                                                            |   |
|   | (1)                                                             | Financial Statements: |
|   |                                                            |   |
|   |                                                            | See Index to Consolidated Financial Statements at page 39 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. |
|   |                                                            |   |
| (b)    | Reports on Form 8-K during the quarter ended December 31, 2002: |
|   |                                                            |   |
|   |                                                            | None |

 

70

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**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned, thereunto duly authorized.

 
| Dated:  March 31, 2003 | ZORAN CORPORATION |
|-----------------------------|-------------------|
|                        |              |   |
|                        |              |   |
|                        | By:               | /s/ Levy Gerzberg |
|                        |              | Levy Gerzberg, President and  Chief Executive Officer |

 

Pursuant to the requirements of the Security Exchange Act of 1934, thisreport has been signed by the following persons on behalf of the registrant andin the capacities and on the dates indicated.

 
| **Signature**          |   | **Title**                                           |   | **Date**       |
|------------------------|--------|-----------------------------------------------------|--------|----------------|
|                   |   |                                                |   |           |
| /s/ Levy Gerzberg      |   | President, Chief Executive Officer and Director     |   | March 31, 2003 |
| Levy Gerzberg          |   | (Principal Executive Officer)                       |   |           |
|                   |   |                                                |   |           |
| /s/ Karl Schneider     |   | Vice President, Finance and Chief Financial Officer |   | March 31, 2003 |
| Karl Schneider         |   | (Principal Financial and Accounting Officer)        |   |           |
|                   |   |                                                |   |           |
| /s/ Uzia Galil         |   | Chairman of the Board of Directors                  |   | March 31, 2003 |
| Uzia Galil             |   |                                                |   |           |
|                   |   |                                                |   |           |
| /s/ James D. Meindl    |   | Director                                            |   | March 31, 2003 |
| James D. Meindl        |   |                                                |   |           |
|                   |   |                                                |   |           |
| /s/ Arthur B. Stabenow |   | Director                                            |   | March 31, 2003 |
| Arthur B. Stabenow     |   |                                                |   |           |
|                   |   |                                                |   |           |
| /s/ Philip M. Young    |   | Director                                            |   | March 31, 2003 |
| Philip M. Young        |   |                                                |   |           |

 

71

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CERTIFICATION OFCHIEF EXECUTIVE  OFFICER

 

I, Levy Gerzberg, certify that:

 

1.             I have reviewedthis annual report on Form 10-K of Zoran Corporation;

 

2.             Based on myknowledge, this annual report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with a respect to the period covered by this annual report;

 

3.             Based on myknowledge, the financial statements, and other financial information includedin this annual report, fairly present in all material respects the financialcondition, results of operations and cash flows of the registrant as of, andfor, the periods presented in this annual report;

 

4.             The registrant’sother certifying officer and I are responsible for establishing and maintainingdisclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and15d-14) for the registrant and we have:

 

(a)                                  designed suchdisclosure controls and procedures to ensure that material information relatingto the registrant, including its consolidated subsidiaries, is made known to usby others within those entities, particularly during the period in which thisannual report is being prepared;

 

(b)                                 evaluated theeffectiveness of the registrant’s disclosure controls and procedures as of adate within 90 days prior to the filing date of this annual report (the“Evaluation Date”); and

 

(c)                                  presented in thisannual report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation as of the Evaluation Date;

 

5.             The registrant’sother certifying officer and I have disclosed, based on our most recentevaluation, to the registrant’s auditors and the audit committee of theregistrant’s board of directors:

 

(a)                                  all significantdeficiencies in the design or operation of internal controls which couldadversely affect the registrant’s ability to record, process, summarize andreport financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

(b)                                 any fraud, whether ornot material, that involves management or other employees who have asignificant role in the registrant’s internal controls; and

 

6.             The registrant’sother certifying officer and I have indicated in this annual report whether ornot there were significant changes in internal controls or in other factorsthat could significantly affect internal controls subsequent to the date of ourmost recent evaluation, including any corrective actions with regard tosignificant deficiencies and material weaknesses.

 
|   |   | /s/ Levy Gerzberg                      |   |   |   |   |
|--------|--------|----------------------------------------|--------|--------|--------|--------|
|   |   | Levy Gerzberg                          |   |   |   |
|   |   | President and  Chief Executive Officer |   |   |   |

 

Dated:  March 31, 2003

 

72

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CERTIFICATION OF

CHIEF FINANCIAL OFFICER

 

I, Karl Schneider, certify that:

 

1.             I have reviewedthis annual report on Form 10-K of Zoran Corporation;

 

2.             Based on myknowledge, this annual report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with a respect to the period covered by this annual report;

 

3.             Based on myknowledge, the financial statements, and other financial information includedin this annual report, fairly present in all material respects the financialcondition, results of operations and cash flows of the registrant as of, andfor, the periods presented in this annual report;

 

4.             The registrant’sother certifying officer and I are responsible for establishing and maintainingdisclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and15d-14) for the registrant and we have:

 

(a)                                  designed suchdisclosure controls and procedures to ensure that material information relatingto the registrant, including its consolidated subsidiaries, is made known to usby others within those entities, particularly during the period in which thisannual report is being prepared;

 

(b)                                 evaluated theeffectiveness of the registrant’s disclosure controls and procedures as of adate within 90 days prior to the filing date of this annual report (the“Evaluation Date”); and

 

(c)                                  presented in thisannual report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation as of the Evaluation Date;

 

5.             The registrant’sother certifying officer and I have disclosed, based on our most recentevaluation, to the registrant’s auditors and the audit committee of theregistrant’s board of directors:

 

(a)                                  all significantdeficiencies in the design or operation of internal controls which couldadversely affect the registrant’s ability to record, process, summarize andreport financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

(b)                                 any fraud, whether ornot material, that involves management or other employees who have asignificant role in the registrant’s internal controls; and

 

6.             The registrant’sother certifying officer and I have indicated in this annual report whether ornot there were significant changes in internal controls or in other factorsthat could significantly affect internal controls subsequent to the date of ourmost recent evaluation, including any corrective actions with regard tosignificant deficiencies and material weaknesses.

 
|   |   | /s/ Karl Schneider                          |   |   |   |   |
|--------|--------|---------------------------------------------|--------|--------|--------|--------|
|   |   | Karl Schneider                              |   |   |   |
|   |   | Vice President and  Chief Financial Officer |   |   |   |

 

Dated:  March 31, 2003

 

73

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EXHIBIT INDEX

 

Exhibit Title

 
| **Exhibit   Number** |   |                                                                                                                                                                                                                                                                                                                           |
|----------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                 |   |                                                                                                                                                                                                                                                                                                                           |
| 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(4)             |   | 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(5)             |   | Summary of Discussion dated April 23, 1996 between ZML and Matam  regarding Lease Agreement dated October 1, 1992 between ZML and Matam.                                                                                                                                                                                       |

 

74

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| 10.30(6)  |   | 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(7)  |   | Sub-Sublease dated April 1, 1997 between the Registrant and  Integrated Silicon Solutions, Inc.                                                         |
|      |   |                                                                                                                                                         |
| 10.35(8)  |   | Agreement for Purchase and Sale of Assets between the Registrant and  MGI Software Corp. dated June 15, 1999.                                                |
|      |   |                                                                                                                                                         |
| 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. |
|      |   |                                                                                                                                                         |
| 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    |   | 2000 Nonstatutory Stock Option Plan.                                                                                                                         |
|      |   |                                                                                                                                                         |
| *10.40    |   | Executive Retention and Severence Plan.                                                                                                                      |
|      |   |                                                                                                                                                         |
| 21.1      |   | List of subsidiaries of the Registrant.                                                                                                                      |
|      |   |                                                                                                                                                         |
| 23.1      |   | Consent of PricewaterhouseCoopers LLP.                                                                                                                       |
|      |   |                                                                                                                                                         |
| 99.1      |   | Certification of Chief Executive Officer, pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002.                                                        |
|      |   |                                                                                                                                                         |
| 99.2      |   | Certification of Chief Financial Officer, pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002.                                                        |

 

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| *      |   | Constitutes a management contact or compensatory plan required to be  filed pursuant to Item 14(c) of Form 10-K.                                                      |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                       |
| † |   | Confidential treatment has been granted as to a portion of this  Exhibit.                                                                                                  |
|   |   |                                                                                                                                                                       |
| (1)    |   | Incorporated by reference to identically numbered exhibit to  Registrant’s Form 10-K Annual Report for the year ended December 31, 2000.                              |
|   |   |                                                                                                                                                                       |
| (2)    |   | Incorporated by reference to Exhibit 3.3 to Registrant’s Form 10-Q  Quarterly Report for the quarter ended September 30, 1998.                                        |
|   |   |                                                                                                                                                                       |
| (3)    |   | Incorporated by reference to identically numbered exhibit to the 1995  Registration Statement.                                                                             |
|   |   |                                                                                                                                                                       |
| (4)    |   | Incorporated by reference to identically numbered exhibit to  Registrant's Form 10-Q Quarterly Report for the quarter ended June 30, 2002.                                 |
|   |   |                                                                                                                                                                       |
| (5)    |   | Incorporated by reference to Exhibit 10.1 to the Registrant’s Form  10-Q Quarterly Report for the quarter ended June 30, 1996 (the “June 1996  Form 10-Q”). |
|   |   |                                                                                                                                                                       |
| (6)    |   | Incorporated by reference to Exhibit 10.2 to the June 1996 Form 10-Q.                                                                                                      |
|   |   |                                                                                                                                                                       |
| (7)    |   | Incorporated by reference to identically numbered exhibit to  Registrant’s Form 10-Q Quarterly Report for the quarter ended March 31,  1997.                     |
|   |   |                                                                                                                                                                       |
| (8)    |   | Incorporated by reference to identically numbered exhibit to  Registrant’s Form 10-Q Quarterly Report for the quarter ended June 30, 1999.                            |
|   |   |                                                                                                                                                                       |
| (9)    |   | Incorporated by reference to identically numbered exhibit to  Registrant’s Form 10-K Annual Report for the year ended December 31, 1999.                              |
|   |   |                                                                                                                                                                       |
| (10)   |   | Incorporated by reference to identically numbered exhibit to  Registrant's Form 10-Q Quarterly Report for the quarter ended June 30, 2001.                                 |

 

75

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