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**SECURITIES AND EXCHANGE COMMISSION**

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**Washington,D.C. 20549**

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**FORM 10-K**

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| **(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, 2001** |
|--------|---------------------------------------------------------------------------------------------------------------------------------------------|

 
| 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**

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**ZORANCORPORATION**

(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 of Class)

 

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

 

The aggregate market value of registrant’s voting stock held bynon-affiliates of registrant based upon the closing sale price of the CommonStock on March 14, 2002, as reported on the Nasdaq National Market, wasapproximately $693,000,000.  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 other purposes.

 

Outstanding shares of registrant’s Common Stock, $0.001 par value, asof March 14, 2002: 18,178,409

 

DOCUMENTSINCORPORATED BY REFERENCE

 

Parts of the definitive proxy statement for registrant’s 2002 AnnualMeeting of Stockholders to be filed with the Commission pursuant to Regulation 14Anot later than 120 days after the end of the fiscal year covered by this Reportare incorporated by reference into Part III of this Report.

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**PART I**

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***This report includes a number of forward-looking statementswhich reflect the Company’s current views with respect to future events andfinancial performance.  Theseforward-looking statements are subject to certain risks and uncertainties,including those discussed in “Item 7 Management’s Discussion and Analysis ofFinancial Condition and Results of Operations — Future Performance and RiskFactors” and elsewhere in this report, that could cause actual results todiffer materially from historical results or those currently anticipated.  In this report, the words “anticipates,”“believes,” “expects,” “intends,” “future” and similar expressions identifyforward-looking statements.  Readers arecautioned not to place undue reliance on these forward-looking statements,which speak only as of the date hereof.***

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# **Item 1. **     Business.

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**Introduction**

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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 inDecember 1981 and reincorporated in Delaware in November 1996. Our corporateheadquarters are located at 3112 Scott Boulevard, Santa Clara California 95054,and our telephone number is (408) 919-4111. Our website can be found atwww.zoran.com.

 

**Industry Background**

 

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 has been the huge amount of data required to representimages and sounds in a digital format, making cost-effective storage ortransmission impractical. For example, storage of a two-hour movie inuncompressed digital form would require approximately 200 video CDs. Throughdigital compression techniques a substantial number of the redundanciesinherent in audio and video data can be identified and eliminated,significantly reducing the overall amount of data which needs to be retained.Compression techniques introduced in the early 1990s allowed the same two-hourmovie which required 200 video CDs to be compressed and stored on only twovideo CDs with video resolution comparable to that of a standard VHS tape. Morerecent techniques allow the storage of a full-length movie of more than threehours on a single DVD, with substantially improved audio and video quality andthe incorporation of additional data, such as additional languages, scenes anddirector and actor commentary. Additionally, digital compression of video dataallows previously unmanageable amounts of data to be stored in the memory of astandard personal computer, thereby permitting the data to be accessed andedited easily. Digital audio compression allows efficient storage and deliveryof multi-channel audio, making possible high-quality special effects such asmulti-channel surround sound, virtual surround sound and wireless audiodelivery via two speakers or headphones. In the field of still photography,digital compression allows dozens or hundreds of digital pictures to be storedon 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 ratiosnecessary for 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 ina variety of digital multimedia markets, including:

 

•                  *DVD Players*.DVD players use MPEG 2 video compression and Dolby Digital audio technology toprovide significantly higher quality playback than is possible with VCR orvideo CD technology. According to Cahners In-Stat Group, a market researchfirm, worldwide sales of DVD players are expected to grow from 2.4 millionunits in 1998 to 71.1 million units in 2005, a compounded annual growth rate of62.3%.

 

•                  *FilmlessDigital Cameras*. Filmless digital cameras use JPEG compressiontechnology to capture high resolution images that can be viewed, edited andstored on a computer system and transmitted over telephone lines and computernetworks. According to Cahners In-Stat Group, sales of megapixel digital camerasare expected to grow from 3.6 million units in 1998 to 40.8 million units in2004, a compounded annual growth rate of 49.9%.

 

•                  *PC VideoSystems*. JPEG-based PC video systems are used to capture and “cutand paste” video sequences and add special audio and video effects.  The growth in the desktop video editingmarket has slowed  in recent years.However, according to Cahners In-Stat Group, the demand for PC TV tuners that incorporateuniversal serial bus, or USB, connectors is expected to grow from 186,000 unitsin 2000 to 5.8 million units in 2005, a compound annual growth rate of 99.0%.

 

•                  *DigitalAudio Systems*. Dolby Digital and other audio compression techniquesare used in multi-channel surround sound products including movie theater soundsystems, audio/video receivers and digital speakers. According to data gatheredfrom Cahners In Stat Group, the demand for digital audio systems is expected togrow from 980,000 units in 2000 to 9.5 million units in 2005, a compoundedannual growth rate of 57.6%.

 

Additional products and markets are developing based on theseestablished compression standards as well as emerging compression technologiessuch as MLP, a new standard for DVD audio, and MP3, a compression standard forthe download of audio recordings from the Internet.

 

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

 

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degradation in video applications or poor sound quality in audioapplications. As a result there can be significant differences in overall imageor sound quality between two solutions based on the same standard. Therefore,integrated circuit manufacturers can differentiate their products on the basisof the quality of their 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.

 

**The Zoran Solution**

 

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, video and audio compression technologies. We applyour 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.

 

*Expandableand Programmable 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.

 

*IntegratedSystem Solutions*. 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. We also offer the CMOS sensor that istightly integrated with COACH. By delivering a camera on a chip with the CMOSsensor, we enable our customers to reduce the costs of their products and focuson providing products that meet the needs of their end users.

 

*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.

 

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*Copy-ReadySystem Reference 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:

 

*FocusOn High-Growth Applications*. Our strategy is to focus onproviding digital video and audio solutions for emerging high-growth consumerelectronics, PC and communications applications. Our current focus marketsinclude DVD players, filmless digital cameras, professional and consumer videoediting systems and digital speakers and audio systems.

 

*LeverageExisting Technology 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 and compression technologies can be used to serve emergingmarkets for digital video and audio. Potential markets include Internet audioand video appliances, digital television and television set-top boxes, as wellas personal digital video and audio devices.

 

*FurtherPenetrate Key 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 will be able to better provide sales, marketing, andapplications support for these growing consumer electronics markets.

 

*ExtendTechnological Leadership*. Our years of experience in thefields of digital signal processing, integrated circuit design, algorithms andsoftware development have enabled us to become a leader in the development ofdigital audio and video solutions enabled by compression. Using ourmulti-disciplinary expertise, we have developed new technologies forcompression of digital audio and video. For example, our proprietary bit ratecontrol technology has helped us provide reliable and inexpensive JPEG-basedvideo compression, and our proprietary Virtual Multi-Channel Digital, or VMD,technology enables high-quality surround-sound effects from two low-cost audiospeakers, rather than the four or five speakers required by other technologies.During 2000, we acquired PixelCam Inc., which enabled us to develop acompetitive advantage by combining our Camera On A Chip, or COACH, processorwith PixelCam’s CMOS sensor, providing a more integrated system. Furthermore, during2000 we acquired Nogatech Inc., which provided us with low cost PC connectivityand MPEG-4 technologies.  We intend tocontinue to invest in our own research and development, and to evaluateopportunities to acquire additional technologies in order to maintain andextend our technological leadership.

 

*ExpandStrategic Partnerships*. 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, aportion of the development funding. This strategy has enabled us to developproducts with substantial financial and other assistance while retainingownership of the technology and ensuring an established customer for theproduct once development is completed. In some cases, our strategic partnersalso provide sales and marketing support. We have also established long-termrelationships with strategic partners that provide manufacturing capacity andwill seek to develop additional strategic relationships with manufacturers.

 

**Markets and Applications**

 

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

 

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*VideoPlayback 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 have declined. We formerly sold MPEG 1-based productsto manufacturers of stand-alone video CD players but are no longer sellingthese 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 that replaced video CD in Chinais, in turn, being replaced by DVD players.

 

DVD players, the latest generation ofvideo playback systems, use MPEG 2 video compression and Dolby Digital orsimilar audio technology to provide significantly higher quality playback thanis possible with VCRs, Video CD or Super Video CD players. DVD players are soldas stand-alone products and are now also being bundled with other functionsincluding DVD+VCR combinations, DVD-Receivers and DVD+TV combinations. Inaddition, the DVD player can act as a platform for connecting digital camerasso that the player becomes the playback mechanism for digital still images. DVDplayers are also included in place of CD-ROM drives in some newer PCs, wherethey 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.

 

*FilmlessDigital 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 $3,000 to $10,000.As technology has advanced and manufacturing costs have decreased, digitalcameras for the consumer market have been introduced in the $69 to $1,000 pricerange. Compression technology has also enabled the development of digital videosecurity cameras and low cost digital video cameras for use with PCs.

 

*DigitalVideo Recording Systems*

 

Digital video recording systems areaimed at replacing the analog VCR. Digital video recording systems will notonly store home made movies and TV programs but will allow them to be easilyedited. In addition, digital video recording systems will enable high qualitytime shifting of TV program viewing by recording the program so that it can bewatched simultaneously or on a delayed basis. The recording media includes DVDrecordable media and hard disks. Digital video recording systems use MPEG 2 asthe video compression format and Dolby Digital or MPEG audio as the audioformat.

 

*PCVideo 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

 

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consumers. We believe that enhanced support of video in consumer PCs,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.

 

*DigitalAudio 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 standards in use include DolbyDigital, DTS, MLP and MP3. Dolby Digital and DTS are competing standards ofaudio compression for use in multi-channel digital surround sound systems inmovie theaters and at home. MLP was developed for audio compression in DVDaudio. MP3 is one of the compression standards recognized for the download ofaudio recordings over the Internet. Our audio integrated circuits incorporateall of these standards. The principal products using compressed digital audio inthe consumer market are DVD players, PCs incorporating DVD-ROMs, digitalspeakers and portable MP3 players.

 

*OtherApplications*

 

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.

 

**Technology**

 

*Imageand Video Technology*

 

*TheJPEG Standard*. In 1991, the Joint Photographic Experts Group,or JPEG, Committee of the International Standards Organization completed atechnical specification for a standard to compress individual digitized imageswhich may consist of still images or consecutive frames of video data. JPEG hasbeen widely adopted for video editing applications, since each frame in thevideo is individually compressed, allowing cutting and pasting of sequences aswell as modification of individual frames. Images are compressed throughelimination of spatial redundancies within an image and the filtering of highfrequency areas to which the eye is less sensitive. Using these techniques, theJPEG compression standard is able to reduce the data necessary to represent animage without significant degradation of image quality. Still images or motionvideo can be compressed to varying degrees using JPEG, with greater compressionresulting in lower quality. Typically, four-to-one or five-to-one compressionyields broadcast image quality while 20-to-1 compression is similar to VHSquality.

 

*ZoranJPEG Technology*. 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 process resultsin compressed data files of various sizes based on the actual content of theoriginal image given a constant degree of compression. An image with largeamounts of visual detail will generate a larger data file than that generatedfrom an image with less detail. Performance of many video applications ishampered by variability in the size of the compressed images in a videosequence, which can result in inefficient use of available memory, bus speed orcommunication channel capacity or even the loss of images. Our bit rate controlis a “standards-plus” solution that uses real-time digital signal processingalgorithms to optimize video quality based on pre-selected parameters, whichcan be programmed by OEMs, without the loss of any image or video frame. Ourbit rate control has been incorporated in our JPEG-based devices that are usedin video editing systems, filmless and tapeless digital cameras, colorscanners, PC-based security systems, video conferencing and other applications.Other features of our JPEG-based products include their ability to handle awide range of compression ratios, to perform a “lossless” compression algorithmin the same JPEG device, to rapidly scan or browse a large number of images andutilize advanced image processing algorithms that enable bit rate control ofUSB data, vertical blank interval detection, infrared remote control detectionand scene analysis for computer control applications. We implement thesefunctions in a single integrated circuit while we believe most other manufacturerseither offer fewer functions or require multiple chips, resulting in highermanufacturing costs and greater power consumption.

 

*CMOS  Sensor Technology*. Withthe 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 

 

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technology, but with far greater operational flexibility and at muchlower power consumption. CMOS sensors can scan in a variety of modes anddirections and perform analog-domain pre-processing of the signal which may beadvantageous from a system perspective. Although the greater pixel circuitcomplexity results in a larger imager today, progress is being made to bothreduce the geometry of the pixel and use more aggressive design rules. Theresult will be a sensor which provides both cost reduction and performanceenhancement paths to the system designer over the traditional CCD-basedsolution.

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*ZoranCMOS Sensor Technology*. The PixelCam ZR32112 and ZR32212 arehigh performance 1.3 megapixel CMOS image sensors that are ideal for digitalstill and video imaging products. Using our proprietary Distributed-PixelAmplifier design, the pixel response is independent of its distance from eachcolumn’s CDS circuitry. This unique architecture results in an extremely uniformpixel array with low fixed-pattern noise without the need for off-chipbackground frame subtraction circuitry. The bank of analog front-end circuitsquantizes each pixel to 10 bit resolution. This highly parallel approach easesspeed requirements 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”.

 

*TheMPEG Standards*. In 1991, the Moving Pictures Expert Group, orMPEG, Committee of the International Standards Organization completed atechnical specification for a standard to compress moving audio and video intoa single data stream. Like JPEG, MPEG 1 removes spatial redundancies fromsingle frames of video data. MPEG 1 improves on JPEG by also removingredundancies that occur between consecutive video frames. Because videorepresents movement, it is possible to detect and estimate the movement ofsimilar picture elements between video frames, a process called motionestimation. MPEG motion estimation uses the content of previous and futureframes to predict the content of the current frame without using its fullcontent. MPEG 1 implements audio compression by exploiting psycho-acousticmasking, taking advantage of the fact that the ear is less sensitive to a quietnote at one frequency when a much louder note is present at a nearby frequency.MPEG 1 often achieves audio compression ratios of six-to-one and videocompression ratios of over 100-to-1. MPEG 1 is particularly suitable forlow-cost CD-ROM applications due to its low-cost implementation.

 

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

 

MPEG 4 builds on the experience of the MPEG 1 and MPEG 2 standards,which are currently used in digital video applications. MPEG 4 is rich infeatures, and can be customized to serve the needs of specific industries whilepreserving a high level of interoperability across a variety of applications.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

 

*ZoranMPEG Technology*. Beginning in 1997, we established ourselvesas 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.

 

*AudioTechnology*

 

*TheDolby Digital Standard*. In 1992, Dolby Laboratories launchedDolby Digital, 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 

 

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audio compression standard is currently the principal audio compressiontechnique used in DVD players. Dolby Digital has also been adopted as astandard for use in high-definition television and digital cable systems.

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*OtherAudio Standards*. 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.

 

*ZoranAudio Technology*. Working closely with Dolby Laboratories, wehave 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 ourSilicon Software library of advanced audio algorithms, and reduce system costsand time to market. In addition to Dolby Digital, our DVD decoders and audioprocessors implement 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 decompression products based on MPEG, Dolby Digital and DTS;

 

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

 

•                  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.

 

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

 
| **PRODUCTFAMILY**                                                 |           | **PRODUCTS**                                                          |   | **INITIAL  COMMERCIALSHIPMENT** |   | **PRINCIPALAPPLICATIONS**              |   |
|-------------------------------------------------------------------|----------------|-----------------------------------------------------------------------|--------|---------------------------------|--------|----------------------------------------|--------|
| DVD                                                               |           | Vaddis DVD decoder  (ZR36700)                                         |   | December 1997                   |   | DVD players                            |   |
| Vaddis III Integrated DVD   decoder (ZR36710)                     | August 1998    |
| Vaddis IV Integrated DVD   decoder (ZR36730)                      | June 1999      |
| Vaddis IV-LC Integrated DVD   decoder (ZR36732)                   | November 2000  |
| Vaddis V Integrated DVD   decoder (ZR36750)                       | May 2001       |
| Filmless  Digital Cameras                                         |           | Filmless digital camera   processor—COACH (ZR36400)              |   | February 1999                   |   | Filmless digital  cameras,  security   |   |
| Filmless digital camera   processor—COACH-XL (ZR36410)       | March 2000     |
| Filmless digital camera   processor—COACH-LC (ZR36420)       | March 2000     |
| CMOS sensor (ZR32112)                                             | July 2000      |
| CMOS sensor (ZR32212)                                             | February 2001  |
| PC Video                                                          |           | JPEG codec (ZR36050)                                                  |   | April 1993                      |   | PC video  editing, office   automation |   |
| Integrated converter (ZR36016)*                                   | February 1995  | Color scanners  and printers                                          |
| JPEG codec (ZR36060)                                              | February 1997  | PC video  editing, security                                           |
| JPEG PCI multimedia controller  (ZR36067)                         | September 1997 | PC video editing                                                      |
| 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                                                     |           | 6-channel Dolby Digital   decoder (ZR38500)                           |   | December 1994                   |   | Home theater                           |   |
| 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                               |

 

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*   Designed and manufactured bya third party and sold by us under our name pursuant to a non-exclusivelicense. See “Proprietary Rights and Licenses.”

 

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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 incorporates amore powerful audio digital signal processor that enables the support ofadvanced audio algorithms like MPEG 5.1, DTS and audio DVD, which are needed intoday’s DVD player systems. The Vaddis V integrates the host controller andincorporates DVD audio and progressive scan output features that are part ofcurrent high-end DVD player systems. Vaddis decoders are being used in DVDplayers manufactured by Sharp, Toshiba and others. We provide full referencedesigns of DVD players, based on our Vaddis chips, that help our customersaccelerate their time to market for their players.

 

*FilmlessDigital Camera 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, “Cam ON” and “Cam Mini,” shortening the time to market forCOACH customers. Our PixelCam CMOS sensor products currently deliver CCD imagequality with 1.3 megapixel resolution at one-quarter the power dissipation andtwice 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”.

 

*PCVideo Products*. Our ZR36050 and ZR36060 codecs arecompression/decompression devices used for real time encoding and decoding ofJPEG video for editing applications. They are fully compliant with JPEGstandards. The ZR36050 and ZR36060 utilize our proprietary bit rate controltechnology for high quality video capture. The ZR36050 also features a unique,embedded, “lossless” mode that allows customers to elect to use low compressionratio techniques that result in no data loss for applications where quality isthe primary consideration. The ZR36050 and ZR36060 can be installed in achipset that includes the ZR36067 motion controller for PCI board implementationor pre/post-processing devices such as the ZR36016 integrated colorspace/raster-to-block converter. The ZR36060 integrates the functions of theZR36050, ZR36015 and an additional SRAM device in a single chip. The ZR36067 isa PCI motion JPEG controller targeting consumer-priced but professional qualitydesktop PCI video editing systems. The ZR36503 is a video chip for videocommunication across the USB channel to the PC. The ZR36504 chip incorporatesvideo, audio and data streaming into a single chip for video, audio and datatransfer across the USB channel to the PC.

 

*DigitalAudio Products*. 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 ourSilicon Software library. Its eight channel output architecture supports thelatest home theater applications, including Dolby Surround EX 6.1 channelsound. The ZR38601’s ability to accept six individual channels of audio inputalso 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 Silicon Software library. It is designed tosupport the large mid and low range audio/video receiver market, whileproviding features previously available only on more expensive models.

 

*IntegratedCircuit Cores*. We offer multimedia integrated circuit, orintellectual property ("IP"), cores which can be incorporated intoour customers’ 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 ICs for LCD panels, LCD-TVs,Plasma Display TVs, set-top boxes, Digital TVs (“DTVs”), projector systems, PCvideo capture and other applications. Our video encoder IP cores perform thereverse function, converting component video data into an NTSC, PAL or SECAM TVsignal. This IP core has applications in ICs for graphics display, set-topboxes, digital cameras, DTVs, DVD players, gaming systems and otherapplications.

 

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conversion of various digital video formats for display on televisionsand PC monitors, and can be integrated into graphics integrated circuits,digital televisions, television set-top boxes and digital cameras.

 

**Customers**

 

The following table lists representative customers, as well as otherOEMs who purchase our products through our distributors. Each of thesecustomers and OEMs purchased, directly or indirectly, at least $100,000 of ourproducts from January 1, 2001 through December 31, 2001:

 
| **PRODUCT FAMILY**        |   | **DIRECT  CUSTOMERS**                                                                                                                                                                                                                    |   | **OTHER OEMs**                                                                                                                                                                                                                              |   |
|---------------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| DVD                       |   | Alco Electronics LTD.  Amoisonic Electronics Co.,LTD.  Edge Electronics Inc.  Fly Ring Digital Technology   FM COM Corp.  Fujifilm  Jiangsu Hongtu High Technology  Marketa Semiconductor   Newell Hong Kong  Optomedia Electronics Corp |   | Sanyo Electric  Shanghai World Trade Dev. Co.  Shenzhen Bao Tong Electronic  Shenzhen J&S Industrial Co.  Sinoglobal Technology Inc.  Tomen Electronics Corp.  Topas Electronic  World Trade Electronics  Zhongshan Kenloon Lighing Co. |   | Orion  Quisheng  Sharp  Toshiba |   |
|                      |   |                                                                                                                                                                                                                                     |   |                                                                                                                                                                                                                                        |   |   |   |
| Digital Audio             |   | Altec Lansing  ATL Electronics  CET LTD.                                                                                                                                                                                                 |   | Newell Hong Kong   Recoton                                                                                                                                                                                                                  |   |   |   |
|                      |   |                                                                                                                                                                                                                                     |   |                                                                                                                                                                                                                                        |   |   |   |
| PC Video                  |   | Alcom Electronics  Amega Group Limited  ATD Electronique  ATI Technologies LTD.  Belkin Components  China Metal Products Co.Ltd.  CSE Co. LTD.  Dazzle, Inc.  Edge Electronics Inc.  Optibase LTD.                                       |   | Pinnacle Systems  Q.S.R. LTD.  SCI Manufacturing Inc.  SCM Microsystems  Sinoglobal Technology Inc.  Tomen Electronics Corp.  Topas Electronic  USC Corporation  Xanbo Inc.                                                                 |   | Avid  Lucent Technologies  Silicon Graphics |   |
|                      |   |                                                                                                                                                                                                                                     |   |                                                                                                                                                                                                                                        |   |   |   |
| Filmless Digital  Cameras |   | Kinpo Electronics Ltd.  NuCam Corporation   Primax Electronics Ltd.   Samsung Techwin Co. LTD.                                                                                                                                           |   | Silent Witness  Sinoglobal Technology Inc.  Tomen Electronics Corp.                                                                                                                                                                         |   | Minolta  Ricoh |   |

 

Fujifilm purchases our products primarily as a distributor and resellsthese products, in many cases under its own trade name. Fujifilm acts as ourprimary distributor in Japan and accounts for most of our product sales inJapan.

 

During 2000, sales to Fujifilm accounted for 25.2% of our totalrevenues, including 27.5% of product sales. During 2001, sales to Fujifilmaccounted for 29.2% of our total revenues, including 30.6% of product sales. Inaddition, sales to Fly Ring Digital Technology during 2001 accounted for 12.0%of our total revenues, including 12.9% of product sales.  During 2000, our four largest customersaccounted for 45.4% of our revenues, and during 2001, our four largestcustomers accounted for 56.3% of our revenues.

 

**Research and Development**

 

We believe that our future success depends on our ability to continueto enhance our existing products and to develop new products that maintaintechnological competitiveness and compliance with new standards in rapidlyevolving consumer-oriented digital audio and video markets. We attempt toleverage our expertise in the fields of digital signal processing, integratedcircuit design, algorithms and software development to maintain our position asa leader in the 

 

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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 productsinto our customers’ products and to accelerate the time-to-market of ourcustomers’ products. We are currently developing new integrated circuits basedon MPEG and Dolby Digital compression standards pursuant to a developmentcontract with Fujifilm, under which Fujifilm is providing a portion of thedevelopment funding. Fujifilm has participated directly in product definitionfor these development programs and has the right to sell resulting products inJapan under its distribution agreement with us. Fujifilm also has the right tomanufacture a portion of our requirements for which it has contributedsignificant funding.

 

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. Total grants earned in 1999 were $484,000, and in 2000 were $333,000.In 2001 we did not receive any grants from these organizations. The terms ofIsraeli Government participation also contain restrictions on the location ofresearch and development activities, and the terms of the grants from the ChiefScientist prohibit the transfer of technology developed pursuant to thesegrants to any person without the prior written consent of the Chief Scientist.We are currently engaged in the development of improvements to our Camera On ACHip, or COACH, technology under grant from the Chief Scientist. Although wehave received grants from the Chief Scientist and the Foundation in the past,we intend to fund future research and development efforts for new productsprimarily from our own funds and through research and development arrangementswith our major OEM customers.

 

As of December 31, 2001, we had a staff of 118 full-time and 33part-time research and development personnel, 138 of whom are based in Israel.

 

**Sales and Marketing**

 

Our sales and marketing strategy is to focus on providing solutions,primarily compression related, for manufacturers seeking to design audio and videoproducts for emerging high volume consumer applications. In cooperation withleading 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 haveestablished a direct sales force located at several sales and marketingoffices, and a worldwide network of independent sales representatives anddistributors. In some cases, our strategic partners also provide sales andmarketing 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 14-person direct sales staff, of whom four arelocated in the United States and ten are located internationally. Our UnitedStates sales staff is primarily responsible for sales in North 

 

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America, South America and Asia, and our Israeli sales staff isprimarily responsible for sales in Europe and the Middle East. In addition, wesell our products indirectly through 23 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 digital audioand video markets. During 2000, we opened an office in Taipei, Taiwan in aneffort to better address the digital camera market. As of December 31, 2001, wehad a staff of 24 employees in our China office and 8 employees in our Taiwanoffice, including sales, applications and customer support employees. Inaddition, in 2001 we opened offices in Hong Kong and Korea. At December 31,2001 we had a staff of three in each location. These offices also providesales, applications and customer support.

 

We distribute our integrated circuit products in Japan primarily underan agreement with Fujifilm. Under this agreement, Fujifilm acts as the primarydistributor in Japan of products developed by us under development contractswith Fujifilm. Fujifilm also sells some of these products in Japan under itsown name. We may sell these products directly in Japan only to specifiedcustomers and must first buy the products from Fujifilm. Fujifilm also has anonexclusive license to distribute most of our products outside of Japan. Weoperate a representative office in Tokyo to help promote our products in Japanand to manage the sale of products not sold through Fujifilm, such asintegrated circuit cores and certain JPEG products.

 

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

 

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

 

**Backlog**

 

Sales of our products are made pursuant to firm purchase orders.However, sometimes we allow customers to cancel or reschedule deliveries. Inaddition, purchase orders are subject to price renegotiations and to changes inquantities of products ordered as a result of changes in customers’ requirementsand manufacturing availability. Our business is characterized by short leadtimes and quick delivery schedules. As a result of these factors, we do notbelieve that backlog at any given time is a meaningful indicator of futuresales.

 

**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, Fujifilm and National Semiconductor manufacture someintegrated circuit products for us. Fujifilm is currently manufacturing our JPEGcodec, our JPEG-based converter products and our MPEG 1 decoder. NationalSemiconductor manufactures some of our digital camera products. Hyundai andFujitsu manufacture our USB 

 

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multimedia controller chips. Our independent foundries fabricateproducts for other companies and may also 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

five independent contractors, ASE, Amkor, ASAT, Kyocera or Vate, andtested by those contractors or other independent contractors.

 

Our ZR36050 JPEG codec was developed jointly with Fujifilm and iscurrently manufactured by Fujifilm pursuant to an agreement that grantsFujifilm the right to manufacture up to 80% of our requirements for thisproduct subject to Fujifilm’s ability to manufacture the product onsubstantially the same or better terms and conditions as we could obtain from athird party. This agreement also grants Fujifilm marketing rights in Japan withrespect to these products. See “Sales and Marketing.”

 

We currently purchase products from all of our foundries underindividually negotiated purchase orders. Our agreement with Fujifilm entitlesus to obtain wafer foundry services from Fujifilm on most favored pricing andavailability terms, subject to Fujifilm’s technological capabilities andreasonable limitations as to quality and delivery terms requested by us.

 

We do not currently have a long-term supply contract with TSMC, andtherefore TSMC is 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.

** **

**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.

 

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. In the market forJPEG-based products for desktop video editing applications, our principalcompetitors are Divio and Sunplus. Cirrus Logic (Crystal Semiconductor), Fujitsu,Motorola, STMicroelectronics and Yamaha are currently shipping DolbyDigital-based audio compression products. C-Cube, now part of LSI Logic,ESS,  LuxSonor, Matsushita, NationalSemiconductor,  STMicroelectronics, Sonyand Winbond have introduced integrated audio and video devices for DVD andSuper Video CD applications. These manufacturers, as well as others, arelicensed by Dolby to incorporate Dolby Digital technology in their products. Inaddition, some manufacturers, including Sony, incorporate compressiontechnologies other than Dolby Digital in audio products that compete withproducts using our integrated circuits. In the markets for JPEG-based productsfor use in filmless digital cameras, our principal competitors are in-housesolutions developed and used by major Japanese OEMs, Atmel, Omnivision, Sunplusand Texas Instruments. Motorola is providing CMOS sensor products. In themarket for MPEG-based chip core products, our principal competitors are DavidSarnoff Research Center and SICAN Microelectronics.

 

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;

 

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•                  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.

 

**Proprietary Rights and Licenses**

 

Our ability to compete successfully is dependent in part upon ourability to protect our proprietary technology and information. Although we relyon a combination of patents, copyrights, trademarks, trade secret laws andlicensing arrangements to protect some of our intellectual property, we believethat factors such as the technological and creative skills of our personnel andthe success of our ongoing product development efforts are more important inmaintaining our competitive position. We generally enter into confidentialityor license agreements with our employees, distributors, 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-based products under a perpetualnon-exclusive license from Dolby which permits us to incorporate the DolbyDigital algorithm into our products. Our customers enter into licenseagreements with Dolby pursuant to which they pay royalties directly to Dolby.Under our agreement with Dolby, we may sell our Dolby Digital-based productsonly to customers who are licensees of Dolby. To date, most potential customersfor our Dolby Digital-

 

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based products are licensees of Dolby. However, the failure or refusalof potential customers to enter into license agreements with Dolby in thefuture could harm our business. We sell our DTS Technology-based products undera non-exclusive license from DTS Technology LLC to sell products thatincorporate the DTS algorithm. We are not required to pay royalties to DTSunder this agreement. Our customers enter into license agreements directly withDTS, pursuant to which they pay royalties to DTS. Under our agreement with DTS,we may sell our DTS-based products only to customers who are licensees of DTS. Thefailure or refusal of potential customers to enter into license agreements withDolby in the future could harm our sales.

 

The semiconductor industry is characterized by vigorous protection andpursuit of intellectual property rights, which have resulted in significant andoften protracted and expensive litigation. We or our foundries from time totime are notified of claims that we may be infringing patents or otherintellectual property rights owned by third parties. We have been subject tointellectual property claims and litigation in the past and we 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 processesor obtain 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, 2001, we had 258 full-time and 46 part-time andcontract employees, including 118 full-time and 33 part-time and contractemployees primarily involved in research and development activities, 104 inmarketing and sales, 31 in finance and administration and 18 in manufacturingcontrol and quality assurance. We have 141 full-time employees and 38 part-timeand contract employees based in Israel, including 138 employees who areprimarily involved in engineering and research and development. We have 77 employeesat our facilities in Santa Clara, California. The remaining employees arelocated in our international offices in Canada, Japan, China, Taiwan, Hong Kongand Korea. We believe that our future success will depend in large part on ourability to attract and retain highly-skilled, engineering, managerial, salesand marketing personnel. Competition for such personnel is intense. Ouremployees are not represented by any collective bargaining unit, and we havenever experienced a work stoppage. We believe that our employee relations aregood.

 

# **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 20,000 square feetof leased space in an industrial park in Haifa, Israel under a lease expiringin 2005 and approximately 3,000 square feet of leased space in Kfar Saba,Israel under a lease expiring in 2003. The aggregate annual gross rent for ourfacilities was approximately $1,531,000 in 2001. We also lease sales offices inTokyo, Japan, Taipei, Taiwan, and Shenzhen, China. See Note 6 of Notes toConsolidated Financial Statements. In addition, at the beginning of 2001 weopened offices in Hong Kong and Korea. We believe that our current facilitiesare adequate for our needs for the foreseeable future and that, should it beneeded, suitable additional space will be available to accommodate expansion ofour operations on commercially reasonable terms.

 

# **Item 3.    LegalProceedings.**

 

**Weare not a party to any pending legal proceedings which we believe willmaterially affect our financial condition or results of operations.**

** **

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** **

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

** **

**Wedid not submit any matters to a vote of security holders during the fourthquarter of the year ended December 31, 2001.**

 

**ExecutiveOfficers**

 

The names of our executive officers and their ages as of December 31,2001 are as follows:

 
| **NAME**              |   | **AGE** |   | **POSITION**                                               |   |
|-----------------------|--------|---------|--------|------------------------------------------------------------|--------|
| Levy Gerzberg,  Ph.D  |   | 56      |   | President, Chief Executive Officer and Director            |   |
| Camillo Martino       |   | 39      |   | Executive Vice President and Chief Operating Officer       |   |
| Isaac Shenberg,  Ph.D |   | 50      |   | Senior Vice President, Business and Strategic  Development |   |
| Karl Schneider        |   | 47      |   | Vice President, Finance and Chief Financial Officer        |   |

 

*LevyGerzberg* was a co-founder of Zoran in 1981 and has served asour President and Chief Executive Officer since December 1988 and as a directorsince 1981. Dr. Gerzberg also served as our President from 1981 to 1984 and asour Executive Vice President and Chief Technical Officer from 1985 to 1988.Prior to co-founding Zoran, Dr. Gerzberg was Associate Director of StanfordUniversity’s Electronics Laboratory. Dr. Gerzberg holds a Ph.D. in ElectricalEngineering from Stanford University and an M.S. in Medical Electronics and aB.S. in Electrical Engineering from the Technion-Israel Institute of Technologyin Haifa, Israel.

 

*CamilloMartino* joined Zoran as Executive Vice President and ChiefOperating Officer in August 2001. From January 2001 through July 2001, Mr.Martino served as Chief Executive Officer of Merinta Inc., a subsidiary ofBoundless Corporation, engaged in the business of delivering integratedLinux-based internet appliances solutions to network operators.  Mr. Martino served as Marketing Director forNational Semiconductor from May 2000 to December 2000. From February 2000 toMay 2000, he served as Vice President & General Manager — InternationalOperations for Netpliance Inc., an internet appliance company. From January1997 through February 2000, Mr. Martino served in various director of marketingpositions for National Semiconductor. Mr. Martino holds a M.S. in DigitalCommunications from Chisholm Institute of Technology and a B.S. in ElectricalEngineering from the University of Melbourne.

 

*IsaacShenberg* has served as Vice President, Sales and Marketing ofZoran since January 1995 and as Senior Vice President, Business and StrategicDevelopment since October 1998. From August 1990 to January 1995, Dr. Shenbergserved as our Product Line Business Manager. Dr. Shenberg holds a Ph.D. inElectrical Engineering from Stanford University and a B.S. and M.S. inElectrical Engineering from the Technion.

 

*KarlSchneider* joined Zoran as Corporate Controller in January1998 and was elected Vice President, Finance and Chief Financial Officer inJuly 1998. From September 1996 through 1997, Mr. Schneider served as Controllerfor the Film Measurement and Robotics and Integrated Technologies divisions ofKLA-Tencor, a semiconductor equipment company. Mr. Schneider served as theCorporate Controller for SCM Microsystems, Inc. from October 1995 to September1996, Controller for Reply Corporation from January 1994 to September 1995,Director of Finance for Digital F/X from October 1992 to January 1994 andController for Flextronics from September 1987 through June 1991. Mr. Schneiderholds a B.S. in Business Administration from San Diego State University.

 

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**PART II**

 

# **Item 5. **     Market for the Registrant’sCommon Stock and Related Stockholder Matters.

 

We effected ourinitial public offering of our common stock on December 15, 1995.  Since that date, our common stock has beenquoted on the Nasdaq National Market****under the symbol “ZRAN.” The followingtable sets forth the high and low closing sales price of our common stock asreported on The Nasdaq National Market for the periods indicated:

 
| **2000:**      |   | **High** |   | **Low** |   |
|----------------|--------|----------|--------|---------|--------|
| First Quarter  |   | $        | 74.31  |    | $      | 45.19 |   |
| Second Quarter |   | $        | 68.50  |    | $      | 33.50 |   |
| Third Quarter  |   | $        | 70.06  |    | $      | 39.69 |   |
| Fourth Quarter |   | $        | 51.50  |    | $      | 13.19 |   |

 
| **2001:**      |   |   |   |   |   |
|----------------|--------|--------|--------|--------|--------|
| First Quarter  |   | $      | 22.19  |   | $      | 13.00 |   |
| Second Quarter |   | $      | 29.72  |   | $      | 14.50 |   |
| Third Quarter  |   | $      | 40.55  |   | $      | 17.10 |   |
| Fourth Quarter |   | $      | 38.13  |   | $      | 20.52 |   |

 

As of December 31,2001, there were 290 holders of record of our common stock.

 

We have never paidcash dividends on our capital stock.  Itis our present policy to retain earnings to finance the growth and developmentof our business and, therefore, we do not anticipate paying any cash dividendsin the foreseeable future.

 

19

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# **Item 6. **     Selected Financial Data.

 

The followingselected consolidated financial data should be read in conjunction with theconsolidated financial statements and the notes thereto included elsewhereherein.

 
|                                                                                       |   | **Year Ended  December 31,**              |    |
|--------------------------------------------------------------------------------------------|--------|-------------------------------------------|---------|
|                                                                                       |   | **2001**                                  |    | **2000** |   | **1999** |   | **1998** |   | **1997** |   |
|                                                                                       |   | **(in thousands, except per share data)** |    |
| **Consolidated Statement of  Operations Data:**                                            |   |                                      |    |   |   |   |   |   |   |   |   |
|                                                                                       |   |                                      |    |   |   |   |   |   |   |   |   |
| Revenues:                                                                                  |   |                                      |    |   |   |   |   |   |   |   |   |
| Product sales                                                                              |   | $                                         | 100,012 |   | $ | 67,782 |   | $ | 52,887 |   | $ | 33,465 |   | $ | 32,717 |   |
| Software,  licensing and development                                                       |   | 7,697                                     |    | 11,889 |   | 8,787 |   | 10,760 |   | 12,210 |   |
| Total revenues                                                                             |   | 107,709                                   |    | 79,671 |   | 61,674 |   | 44,225 |   | 44,927 |   |
|                                                                                       |   |                                      |    |   |   |   |   |   |   |   |   |
| Costs and  expenses:                                                                       |   |                                      |    |   |   |   |   |   |   |   |   |
| Cost of product  sales                                                                     |   | 64,740                                    |    | 37,993 |   | 28,523 |   | 19,036 |   | 16,032 |   |
| Research and  development                                                                  |   | 23,210                                    |    | 18,628 |   | 12,651 |   | 13,548 |   | 13,787 |   |
| Selling, general  and administrative                                                       |   | 21,330                                    |    | 19,148 |   | 14,251 |   | 11,551 |   | 11,209 |   |
| Amortization of  goodwill and write-off of acquired in-process  research & development |   | 43,233                                    |    | 31,769 |   | — |   | — |   | — |   |
| Total costs and  expenses                                                                  |   | 152,513                                   |    | 107,538 |   | 55,425 |   | 44,135 |   | 41,028 |   |
|                                                                                       |   |                                      |    |   |   |   |   |   |   |   |   |
| Operating income  (loss)                                                                   |   | (44,804                                   | )       | (27,867 | ) | 6,249 |   | 90 |   | 3,899 |   |
| Interest and  other income, net                                                            |   | 10,004                                    |    | 9,229 |   | 1,585 |   | 1,071 |   | 1,258 |   |
| Income (loss)  before income taxes                                                         |   | (34,800                                   | )       | (18,638 | ) | 7,834 |   | 1,161 |   | 5,157 |   |
| Provision for  income taxes                                                                |   | 1,265                                     |    | 1,970 |   | 1,175 |   | 232 |   | 928 |   |
| Net income  (loss)                                                                         |   | $                                         | (36,065 | ) | $ | (20,608 | ) | $ | 6,659 |   | $ | 929 |   | $ | 4,229 |   |
| Basic net income  (loss) per share(1)                                                      |   | $                                         | (2.07   | ) | $ | (1.37 | ) | $ | 0.61 |   | $ | 0.09 |   | $ | 0.45 |   |
| Diluted net  income (loss) per share(1)                                                    |   | $                                         | (2.07   | ) | $ | (1.37 | ) | $ | 0.54 |   | $ | 0.08 |   | $ | 0.38 |   |
| Shares used to  compute basic net income (loss) per share(1)                               |   | 17,460                                    |    | 15,070 |   | 10,844 |   | 10,042 |   | 9,412 |   |
| Shares used to  compute diluted net income (loss) per share(1)                             |   | 17,460                                    |    | 15,070 |   | 12,249 |   | 11,119 |   | 11,072 |   |

 
|                                               |   | **December  31,**  | ** ** |
|----------------------------------------------------|--------|--------------------|------------|
|                                               |   | **2001**           |       | **2000** |   | **1999** |   | **1998** |   | **1997** |   |
|                                               |   | **(in thousands)** |       |
| **Consolidated Balance Sheet Data:**               |   |               |       |   |   |   |   |   |   |   |   |
|                                               |   |               |       |   |   |   |   |   |   |   |   |
| Cash, cash  equivalents and short-term investments |   | $                  | 110,105    |   | $ | 175,638 |   | $ | 145,632 |   | $ | 19,175 |   | $ | 22,376 |   |
| Working capital                                    |   | 130,777            |       | 197,719 |   | 157,583 |   | 30,830 |   | 28,582 |   |
| Total assets                                       |   | 331,344            |       | 359,466 |   | 182,468 |   | 49,170 |   | 50,944 |   |
| Accumulated  deficit                               |   | (94,190            | )          | (58,125 | ) | (37,517 | ) | (44,176 | ) | (45,105 | ) |
| Total  stockholders’ equity                   |   | 297,838            |       | 331,454 |   | 163,445 |   | 36,186 |   | 34,286 |   |
|                                                    |        |                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1)        See Note 2 of Notes to ConsolidatedFinancial Statements for a description of the computation of the number ofshares and net income (loss) per share.

** **

**20**

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** **

**Item 7.    Management’s Discussion and Analysis ofFinancial 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 indigital versatile disc players, movie and home theater systems, filmlessdigital cameras 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 distributors are partially offset by reduced selling and marketingexpenses related to such sales. Product sales in Japan are primarily madethrough Fujifilm, our strategic partner and distributor in Japan. Fujifilmprovides more sales and marketing support than our other distributors. Weexpect both product and customer mix to continue to fluctuate in futureperiods, 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 as a percentage of total revenues over thepast several years. These development contracts have provided us with partialfunding for the development of some of our products. These developmentcontracts provide for license and milestone payments which are recorded asdevelopment revenue. We classify all development costs, including costs relatedto these development contracts, as research and development expenses. We retainownership of the intellectual property developed by us under these developmentcontracts. While we intend to continue to enter into development contracts withcertain strategic partners, we expect development revenue to continue todecline 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.

 

21

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

 

We conduct 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 2002 and 2020, andthe benefits from our subsidiary’s Approved Enterprise status expire at varioustimes beginning in 2003.

 

In June 1999, we sold to MGI Software of Canada the intellectualproperty related to our SoftDVD product line and transferred to MGI certainrelated software development and support resources in exchange for cash, MGIcommon stock and future royalties. We do not currently expect, however, thatthese royalties will have a material impact on quarterly revenues for the foreseeablefuture. In addition, the shares of MGI stock received by us as part of thistransaction are subject to future appreciation or depreciation. Our softwarerevenues have declined significantly as a result of the sale of the SoftDVDproduct line.

 

In June 2000, we acquired PixelCam, Inc., a manufacturer of megapixelCMOS image sensors, in exchange for 370,832 shares of our common stock andoptions to purchase 4,168 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 11 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 2,534,599 shares of ourcommon stock and options to purchase 168,472 shares of our common stock with anaggregate value of $163.6 million. The acquisition was accounted for under thepurchase method of accounting. See Note 11 of Notes to Consolidated FinancialStatements.

** **

**Critical Accounting 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 inthe United 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 

 

22

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project. These estimatesare reviewed and revised periodically throughout the lives of the contracts.Any revisions are recorded in the accounting period in which the revisions aremade.

 

•                  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 ourmanagement. This could have a material effect on our operating results andfinancial position.

 

•                  Wemaintain allowances for doubtful accounts for estimated losses resulting fromthe inability 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 companies having operations or technology in areaswithin our strategic focus. At December 31, 2001 these investments totaled $3.6million. We record an investment impairment charge when we believe aninvestment has experienced a decline in value that is other than temporary. Weassess the value of this investment principally by using information acquiredfrom the investee, including historical and projected financial performance andrecent funding events. Future adverse changes in market conditions or pooroperating results of underlying investments could result in losses or aninability to recover the carrying value of the investments that may not bereflected in an investment’s current carrying value thereby possibly requiringan impairment charge in the future.

 

•                  Weevaluate the recoverability of our property and equipment and intangible assetsin accordance with Statement of Financial Accounting Standards No. 121Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets tobe Disposed of. This standard requires recognition of impairment of long-livedassets in the event the carrying value of such assets exceeds the futureundiscounted cash flows attributable to such assets. Impairment evaluationsinvolve management estimates of asset useful lives and future cash flows.Actual useful lives and cash flows could be different from those estimated by ourmanagement. This could have a material effect on our operating results andfinancial 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.

** **

23

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**Resultsof Operations**

 

The followingtable sets forth certain consolidated statement of operations data as apercentage of total revenues for the periods indicated:

 
|                                                                                      |   | **Year Ended  December 31,** |   |
|-------------------------------------------------------------------------------------------|--------|------------------------------|--------|
|                                                                                      |   | **2001**                     |   | **2000** |   | **1999** |   |
| Revenues:                                                                                 |   |                         |   |   |   |   |   |
| Product sales                                                                             |   | 92.9                         | %      | 85.1 | % | 85.8 | % |
| Software,  licensing and development                                                      |   | 7.1                          |   | 14.9 |   | 14.2 |   |
| Total revenues                                                                            |   | 100.0                        |   | 100.0 |   | 100.0 |   |
|                                                                                      |   |                         |   |   |   |   |   |
| Costs and  expenses:                                                                      |   |                         |   |   |   |   |   |
| Cost of product  sales                                                                    |   | 60.1                         |   | 47.7 |   | 46.3 |   |
| Research and  development                                                                 |   | 21.6                         |   | 23.4 |   | 20.5 |   |
| Selling, general  and administrative                                                      |   | 19.8                         |   | 24.0 |   | 23.1 |   |
| Amortization of  goodwill and write-off of acquired in-process research & development |   | 40.1                         |   | 39.9 |   | — |   |
| Total costs and  expenses                                                                 |   | 141.6                        |   | 135.0 |   | 89.9 |   |
|                                                                                      |   |                         |   |   |   |   |   |
| Operating income  (loss)                                                                  |   | (41.6                        | )      | (35.0 | ) | 10.1 |   |
| Interest and  other income, net                                                           |   | 9.3                          |   | 11.6 |   | 2.6 |   |
| Income (loss)  before income taxes                                                        |   | (32.3                        | )      | (23.4 | ) | 12.7 |   |
| Provision for  income taxes                                                               |   | 1.2                          |   | 2.5 |   | 1.9 |   |
|                                                                                      |   |                         |   |   |   |   |   |
| Net income  (loss)                                                                        |   | (33.5                        | )%     | (25.9 | )% | 10.8 | % |

 

*** ***

***Year Ended December 31, 2001Compared to Year Ended December 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 fromincreased unit sales of DVD products and to a lesser extent filmless digitalcameras. Offsetting these increases somewhat were decreased unit sales for ourdigital audio and PC video products. Software, licensing and developmentrevenues decreased by 35.3% to $7.7 million in 2001 from $11.9 million in 2000.This decrease was due to a decline in the number and size of significant newlicensing contracts, as well as the timing of revenue recognition on along-term development contract.

* *

*Product Gross Margin.  *Product gross margindecreased to 35.3% in 2001 compared to 43.9% in 2000.  The decrease was due to a substantial shift in product mix to ahigher percentage of lower-margin DVD products, which include CPU companionchips that are sold at low margin, and a shift in customer mix to a lowerpercentage of direct sales to OEM customers. In addition, we experienced adecline in the average selling price of our older Vaddis III DVD chip that isbeing phased out as we transition our customer base to our new Vaddis IV PlusDVD chip.

* *

*Research and Development. *Research and development(“R&D”) expenses increased by 24.6% to $23.2 million in 2001 from $18.6million in 2000. Gross R&D expenses increased primarily as a result of ouracquisitions of PixelCam and Nogatech in June 2000 and October 2000,respectively and the timing of major project expenses such as tape-outs. R&D expenses in 2001 did not includereimbursements from the Chief Scientist. For 2000, Chief Scientist reimbursements were $333,000.  R&D expenses decreased as a percentageof total revenues to 21.5% in 2001, compared to 23.4% in 2000 due to theincrease in revenue.

* *

*Selling, General andAdministrative. *Selling,general and administrative (“SG&A”) expenses increased by 11.4% to $21.3million in 2001 from $19.1 million in 2000. The increase was primarily due to our acquisitions of PixelCam and 

 

24

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Nogatech, and thecontinued expansion of our presence in the Asia Pacific region including theestablishment of offices in Hong Kong and Korea at the beginning of 2001.

* *

*Amortizationof goodwill and write-off of acquired in-process research and development.* The acquisitions of PixelCam and Nogatechresulted in the following charges:

 

•                  PixelCam:During 2001, we recorded $6.0 million in charges related to the amortization ofgoodwill associated with our acquisition of PixelCam compared to $3.0 millionrecorded during 2000.  During 2001, wedid not record any charges related to the write-off of in-process research anddevelopment associated with the PixelCam acquisition. For 2000 we incurred $6.8million in charges associated with the write-off of in process research anddevelopment.

 

•                  Nogatech:During 2001, we recorded $36.7 million in charges related to the amortizationof goodwill associated with our acquisition of Nogatech compared to $6.8million recorded during 2000.  During2001 we did not record any charges related to the write-off of in-processresearch and development associated with the Nogatech acquisition. For 2000 weincurred $15.1 million in charges associated with the write-off of in processresearch and development.

 

The in-process researchand development project related to our PixelCam acquisition was completed andwe began shipping the resulting product in the third quarter of 2001. Theproject associated with the acquisition of Nogatech has been delayed due touncertainty in the market concerning implementation timing of this technology.Completion of this project remains a significant risk to the Company due to theremaining effort to achieve technical feasibility, rapidly changing customermarkets and significant competitive threats from other companies. Failure tobring related products to market in a timely manner could adversely impact ourfuture sales and profitability. Additionally, the value of the intangibleassets acquired may become impaired.

 

We have not yet completed our assessment of goodwill and otherintangibles in accordance with Financial Accounting Standards Board (FASB)Statements Nos. 141 and 142, “Business Combinations” and “Goodwill and OtherIntangible Assets” (“SFAS 141” and “SFAS 142”). SFAS 142 changes the accountingfor goodwill from an amortization method to an impairment-only approach. UnderSFAS 142, goodwill will be tested annually and whenever events or circumstancesoccur indicating that goodwill might be impaired. Upon adoption of SFAS 142,amortization of goodwill recorded for business combinations consummated priorto July 1, 2001 will cease, and intangible assets acquired prior to July 1,2001 that do not meet the criteria for recognition under SFAS 141 will bereclassified to goodwill. Companies are required to adopt SFAS 142 for fiscalyears beginning after December 15, 2001. Accordingly, our amortization ofgoodwill expense, which totaled $33.2 million in 2001, will be discontinued in2002. In connection with the adoption of SFAS 142, the Company will be requiredto perform a transitional goodwill impairment assessment and has six monthsfrom January 1, 2002 to complete this task.

 

*Interest and Other Income (Expense),Net. *Net interest andother income increased by 8.4% to $10.0 million in 2001 from $9.2 million in2000. The increase resulted primarily from increased interest income on highercash balances following our acquisition of Nogatech in October 2000.

* *

*Provision for Income Taxes. *Excluding charges related to the amortization of goodwill and thewrite-off of acquired in-process research and development our estimatedeffective tax rate remained at 15.0% for 2001 and 2000.

 

***Year Ended December 31, 2000Compared to Year Ended December 31, 1999***

*** ***

*Revenues*.  Total revenues increased by 29.2% to $79.7million in 2000 from $61.7 million in 1999. Product sales increased by 28.2% to $67.8 million in 2000 from $52.9million in 1999. The increase in product sales resulted primarily fromincreased unit sales of DVD and Super Video CD products as well as filmlessdigital cameras. Software, licensing and development revenues increased by35.3% to $11.9 million in 2000 from $8.8 million in 1999. This increase was theresult of significant license and development contracts entered into during2000 which offset the decline in revenues resulting from our sale of ourSoftDVD product line in June 1999.

 

25

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*Product Gross Margin.  *Product gross margindecreased to 43.9% in 2000 compared to 46.1% in 1999.  The decrease was due to a shift in product mix to a higherpercentage of lower-margin products and a shift in customer mix to a lowerpercentage of direct sales to OEM customers.

 

*Research and Development. *Research and development(“R&D”) expenses increased by 47.2% to $18.6 million in 2000 from $12.7million in 1999. R&D expenses in 2000were net of reimbursements in the amounts of $333,000 under product developmentagreements with the Chief Scientist.  For1999, Chief Scientist reimbursements were $484,000.  Gross R&D expenses increased primarily as a result of ouracquisitions of PixelCam in June 2000 and Nogatech in October 2000 as well asour planned enhancement to our technology and development capabilities.  R&D expenses increased as a percentageof total revenues to 23.4% in 2000, compared to 20.5% in 1999.

* *

*Selling, General andAdministrative. *Selling,general and administrative (“SG&A”) expenses increased by 34.4% to $19.1million in 2000 from $14.3 million in 1999. The increase was primarily due to our acquisitions of PixelCam andNogatech, the continued expansion of our China office and the opening of ourTaiwan office.

* *

*Amortizationof goodwill and write-off of acquired in-process research and development.* The acquisitions of PixelCam and Nogatechresulted in the following charges:

 

•                  PixelCam:During 2000, we recorded $3.0 million in charges related to the amortization ofgoodwill associated with our acquisition of PixelCam. In addition to theamortization charge, during the second quarter of 2000, we recorded a $6.8million charge related to the write-off of acquired in-process research anddevelopment associated with the PixelCam acquisition. The allocation of $6.8million of the purchase price to the acquired in-process research anddevelopment was determined by identifying the research project for whichtechnological feasibility had not been established at the time of theacquisition and for which no alternative future uses then existed. The valuewas determined by estimating the expected cash flows from the project oncecommercially viable, discounting the net cash flows back to their presentvalue, and then applying a percentage of completion to the calculated value.The percentage 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. We estimatedthat, as of the acquisition date, the project was 62% complete and theestimated costs to complete the project were approximately $4.1 million.

 

•                  Nogatech:During 2000, we recorded $6.8 million in charges related to the amortization ofgoodwill and other intangibles associated with our acquisition of Nogatech. Inaddition to the amortization charge, during the fourth quarter of 2000, werecorded a $15.1 million charge related to the write-off of acquired in-processresearch and development associated with the Nogatech acquisition. Theallocation of $15.1 million of the purchase price to the acquired in-processresearch and development was determined by identifying the research project forwhich technological feasibility had not been established at the time of theacquisition and for which no alternative future uses then existed. The valuewas determined by estimating the expected cash flows from the project oncecommercially viable, discounting the net cash flows back to their presentvalue, and then applying a percentage of completion to the calculated value.The percentage of completion was determined using costs incurred by Nogatechprior to the acquisition date compared to the remaining research anddevelopment to be completed to bring the project to technological feasibility.We estimated that, as of the acquisition date, the project was 60% complete andthe estimated costs to complete the project were approximately $1.2 million.

 

*Interest and Other Income (Expense),Net. *Net interest andother income increased by 482.3% to $9.2 million in 2000 from $1.6 million in1999. The increase resulted primarily from increased interest income on highercash balances following a follow-on public offering of common stock in December1999.

 

*Provision for Income Taxes. *Excluding charges related to the amortization of goodwill and thewrite-off of acquired in-process research and development our estimatedeffective tax rate remained at 15.0% for 2000 and 1999.

** **

**26**

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** **

**Liquidity and Capital Resources**

 

At December 31, 2001, we had $20.3 million of cash and cash equivalents,$89.8 million of short-term investments and $130.8 million of working capital.In addition, we had $86.1 million of investments in other assets that havematurity dates that are beyond one year.

 

Our operating activities providedcash of $12.4 million during 2001, primarily due to the net loss adjusted forthe non-cash impact of depreciation and the amortization of goodwill and otherintangibles associated with our acquisitions of PixelCam and Nogatech during2000. In addition, an increase in accounts payable and decrease in inventory,partially offset by an increase in accounts receivable, also contributed to thecash provided by operating activities.

 

Cash used in investing activities was $11.2 million during 2001. Cashused for short-term investments during the year was $6.2 million. Capitalequipment expenditures accounted for $3.8 million of the cash used while thepurchase of long-term investments used $1.2 million

 

Cash provided by financing activities was $3.0 million during 2001 andprimarily consisted of proceeds from the issuance of common stock under ourincentive stock option and employee stock purchase plans of $6.9 million,offset by the repurchase 255,000 shares of our common stock for $3.9 million.

 

As of December 31, 2001 we are responsible for lease commitmentsof  $2.9 million associated with ourworldwide facilities of which $1.3 million is due in 2002, $649,000 is due in2003 and $464,000 is due in 2004 and 2005, respectively. In addition, we hadinventory purchase commitments of $11.8 million at December 31, 2001.

 

At December 31, 2001 and 2000, we didnot 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 2002. 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.

 

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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.

** **

**Selected Pro Forma Financial Data**

** **

**Thefollowing pro forma consolidated results of operations do no represent ourresults of operations or earnings per share information in accordance withaccounting principles generally accepted in the United States of America. Proforma results of operations have been presented, in addition to the actualresults, to provide period-to-period comparability of our underlying operatingresults excluding the following: amortization of goodwill and otherintangibles, the write-off of acquired in-process technology, and theamortization of deferred stock-based compensation associated with theacquisition of Nogatech, Inc.**

** **
|                                     |   | **Year Ended  December 31,**               |       |
|------------------------------------------|--------|--------------------------------------------|------------|
|                                     |   | **2001**                                   |       | **2000** |   | **1999** |   | **1998** |   | **1997** |   |
|                                     |   | **(in  thousands, except per share data)** | ** ** |
| Pro forma net  revenues                  |   | $                                          | 107,709    |   | $ | 79,671 |   | $ | 61,674 |   | $ | 44,225 |   | $ | 44,927 |   |
|                                     |   |                                       |       |   |   |   |   |   |   |   |   |
| Pro forma income  (loss) from operations |   | $                                          | (1,571     | ) | 3,902 |   | 6,249 |   | 90 |   | 3,899 |   |
|                                     |   |                                       |       |   |   |   |   |   |   |   |   |
| Pro forma net  income                    |   | 7,168                                      |       | 11,161 |   | 6,659 |   | 929 |   | 4,229 |   |
|                                     |   |                                       |       |   |   |   |   |   |   |   |   |
| Pro forma net  income per share:         |   |                                       |       |   |   |   |   |   |   |   |   |
| Basic                                    |   | 0.41                                       |       | 0.74 |   | 0.61 |   | 0.09 |   | 0.45 |   |
| Diluted                                  |   | 0.39                                       |       | 0.68 |   | 0.54 |   | 0.08 |   | 0.38 |   |
|                                          |        |                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

** **

**Future Performance and Risk Factors**

 

The Company’s futurebusiness, operating results and financial condition are subject to variousrisks and uncertainties, including those 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 variedsignificantly due to a number 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;

 

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•                  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 tofluctuate in the future as a result of these factors and a variety of otherfactors, including:

 

•                  thecost 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

 

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

 

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

 

As a result of these factors, our operating resultsmay vary significantly from quarter to quarter. Any shortfall in revenues ornet income from levels expected by securities analysts could cause a decline inthe trading price of our stock.

 

**Our success for theforeseeable future will be dependent on growth in demand for integratedcircuits for DVD, filmless digital camera applications and, to a lesser extent,on digital audio and video editing applications and our ability to market andsell our products to manufacturers who incorporate those types of integratedcircuits into their products.**

 

In 2000 and 2001, we derived a majority of our productrevenues from the sale of integrated circuits for DVD and, to a lesser extent,Super Video CD applications. We expect that sales of our products for DVDapplications will continue to account for a significant portion of our revenuesfor the near future. Our ability to sell our products for filmless digital

 

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camera applications and to a lesser extent digitalaudio and video editing applications will also have an impact on our financialperformance for the foreseeable future. If the markets for these products andapplications decline or fail to develop as expected, or we are not successfulin our efforts to market and sell our products to manufacturers who incorporateintegrated circuits into these products, our financial results will be harmed.

 

**Our customers experiencefluctuating product cycles and seasonality, which causes our sales tofluctuate.**

 

Because the markets our customers serve arecharacterized by numerous new product introductions and rapid productenhancements, our operating results may vary significantly from quarter toquarter. During the final production of a mature product, our customerstypically exhaust their existing inventory of our products. Consequently,orders for our products may decline in those circumstances, even if ourproducts are incorporated into both mature products and replacement products. Adelay in the customer’s transition to commercial production of a replacementproduct would delay our ability to recover the lost sales from thediscontinuation of the related mature product. Our customers also experiencesignificant seasonality in the sales of their consumer products, which affectstheir orders of our products. Typically, the fourth calendar quarter representsa disproportionate percentage of sales for our customers due to the holidayperiod, and therefore a disproportionate percentage of our sales. We expectthese sales fluctuations to continue for the foreseeable future.

** **

**Product supply and demandin the semiconductor industry is subject to cyclical variations.**

 

The semiconductor industry is subject to cyclicalvariations in product supply and demand. Downturns in the industry often occurin connection with, or anticipation of, maturing product cycles for bothsemiconductor companies and their customers and declines in general economicconditions. These downturns have been characterized by abrupt fluctuations inproduct demand, production over-capacity and accelerated decline of averageselling prices. In some cases, these downturns have lasted more than one year.A downturn in the semiconductor industry could harm our sales and revenues ifdemand drops or our gross margins if average selling prices decline.

 

**The development andevolution of markets for our integrated circuits is dependent on factors suchas industry standards, over which we have no control; for example, ifmanufacturers adopt new or competing industry standards with which our productsare not compatible, our existing products would become less desirable to themanufacturers and our sales would suffer.**

 

The emergence of markets for our products is affectedby a variety of factors beyond our control. In particular, our products aredesigned to conform to current specific industry standards. Manufacturers maynot continue to follow these standards, which would make our products lessdesirable to manufacturers and reduce our sales. Also, competing standards mayemerge that are preferred by manufacturers, which could also reduce our salesand require us to make significant expenditures to develop new products. Theemergence of new markets for our products is also dependent in part upon thirdparties developing and marketing content in a format compatible with commercialand consumer 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.

 

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

 

We do not operate any manufacturing facilities, and werely on independent foundries to manufacture substantially all of our products.These independent 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,Taiwan Semiconductor Manufacturing Company, or TSMC. Therefore, TSMC  and these other suppliers are not obligatedto manufacture products for us for any specific period, in any specificquantity or at any specified price, except as may be provided in a particularpurchase order.

 

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Our reliance on independent foundries involves anumber of risks, including:

 

•                  theinability to obtain adequate manufacturing capacity;

 

•                  theunavailability of or interruption in access to certain process technologies necessaryfor manufacture of our products;

 

•                  reducedcontrol over delivery schedules;

 

•                  reducedcontrol over quality assurance;

 

•                  reducedcontrol over manufacturing yields and cost; and

 

•                  potentialmisappropriation of our intellectual property.

 

In addition, TSMC and some of our other foundries arelocated in areas of the world which are subject to natural disasters such asearthquakes. While the 1999 earthquake in Taiwan did not have a material impacton our independent foundries, a similar event centered near TSMC’s facilitycould severely reduce TSMC’s ability to manufacture our integrated circuits.The loss of any of our manufacturers as a supplier, our inability to expand thesupply of our products in response to increased demand, or our inability toobtain timely and adequate deliveries from our current or future suppliers dueto a natural disaster or any other reason could delay or reduce shipments ofour products. Any of these circumstances could damage our relationships withcurrent and prospective customers and harm our sales and financial results.

 

We also rely on independent contractors for theassembly and testing of our products. At present, all of our semiconductorproducts are assembled by one of five independent contractors: ASE, Amkor, ASAT,Kyocera, or Vate. Our semiconductor products are tested by these contractors orother independent 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.

** **

**Because foundry capacityis limited from time to time we may be required to enter into costly long-termsupply arrangements to secure foundry capacity.**

 

If we are not able to obtain additional foundrycapacity as required, our relationships with our customers would be harmed andour sales would likely be reduced. In order to secure additional foundrycapacity, we have considered and will continue to consider various arrangementswith suppliers, which could include, 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;

 

•                    investment ina foundry;

 

•                    jointventures; or

 

•                    otherpartnership relationships with foundries.

 

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We may not be able to make any such arrangement in atimely fashion or at all, and such arrangements, if any, may not be on termsfavorable to us. Moreover, if we are able to secure foundry capacity, we may beobligated to utilize all of that capacity or incur penalties. Such penaltiesmay be expensive and could harm our financial results.

 

**If our independentfoundries do not achieve satisfactory yields, our relationships with ourcustomers may be harmed.**

 

The fabrication of silicon wafers is a complexprocess. Minute levels of contaminants in the manufacturing environment,defects in photomasks used to print circuits on a wafer, difficulties in thefabrication process or other factors can cause a substantial portion of theintegrated circuits on a wafer to be non-functional. Many of these problems aredifficult to detect at an early stage of the manufacturing process and may betime consuming and expensive to correct. As a result, foundries oftenexperience problems achieving acceptable yields, which are represented by thenumber of good integrated circuits as a proportion of the number of totalintegrated circuits on any particular wafer. Poor yields from our independent foundries would reduce our ability todeliver our products to customers, harm our relationships with our customers,and harm our business.

 

**To be successful, we mustefficiently develop new and enhanced products to meet rapidly changing customerrequirements and industry standards.**

 

The markets for our products are characterized by:

 

•                  rapidlychanging technologies;

 

•                  evolvingindustry standards;

 

•                  frequentnew product introductions; and

 

•                    short productlife cycles.

 

Over the long run, we expect to increase our productdevelopment expenses, and our future success will depend to a substantialdegree upon our ability to develop and introduce, on a timely andcost-effective basis, new and enhanced products that meet rapidly changingcustomer requirements and industry standards. We may not successfully develop,introduce or manage the transition to new products. Delays in the introductionor shipment of new or enhanced products, lack of market acceptance for suchproducts or problems associated with new product transitions could harm oursales and financial results.

** **

**We face competition orpotential competition from companies with greater resources than ours, and ifwe are unable to compete effectively with these companies, our market share maydecline and our business could be harmed.**

 

Competition in the compression technology market hashistorically been dominated by large companies, such as STMicroelectronics, andcompanies that develop and use their own integrated circuits, such as Sony. Asthis market continues to develop, we face competition from other largesemiconductor vendors, including:

 

•                  AtmelCorporation;

 

•                  CirrusLogic (Crystal Semiconductor);

 

•                  ESSTechnology, Inc.;

 

•                  Fujitsu;

 

•                  LSILogic (including C-Cube Microsystems Inc. acquired during 2001);

 

•                  Motorola;

 

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•                  OmnivisionTechnologies, Inc.;

 

•                  SunplusTechnology; and

 

•                  TexasInstruments.

 

We also face competition from internally-developedsolutions developed and used by major Japanese original equipmentmanufacturers, who may also be our customers.

 

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

 

•                  finances;

 

•                  manufacturing;

 

•                  technology;

 

•                  marketing;and

 

•                  distribution.

 

Many of our competitors have broader product lines andlonger standing relationships with customers than we do. Moreover, ourcompetitors may foresee the course of market developments more accurately thanwe do and could in the future develop new technologies that compete with ourproducts or even render our products obsolete. In addition, a number of privatecompanies have announced plans for new products to address the same digitalmultimedia compression problems that our products address. If we are unable tocompete successfully against our current and future competitors, we couldexperience price reductions, order cancellations and reduced gross margins, anyone of which could harm our business.

 

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

 

**Our products arecharacterized by average selling prices that decline over relatively short timeperiods; if we are unable to reduce our costs or introduce new products withhigher average selling prices, our financial results would suffer.**

 

Average selling prices for our products decline overrelatively short time periods. Many of our manufacturing costs are fixed. Whenour average selling prices decline, our revenues decline unless we sell moreunits, and our gross margins decline unless we are able to reduce ourmanufacturing costs by a commensurate amount. Our operating results suffer whengross margins decline. We have experienced these problems and may continue toexperience them in the future and cannot predict when they may occur or theirseverity.

 

**We derive most of ourrevenue from sales to a small number of large customers, and if we are not ableto retain these customers, or they reschedule, reduce or cancel orders, ourrevenues would be reduced and our financial results would suffer.**

 

Our largest customers account for a substantialpercentage of our revenues. In 2001, sales to Fujifilm accounted for 29.2% ofour total revenue. Our four largest customers in 2001 accounted forapproximately 56.3% of our total revenues. During 2000, our four largest customers accounted for approximately45.4% of our revenues with Fujifilm accounting for 25.2%. Sales to these largecustomers have varied significantly from year to year and will continue tofluctuate in the future.  These salesalso may fluctuate significantly from quarter to quarter. We may not be able toretain our key customers or these customers may cancel purchase orders orreschedule or decrease their level of purchases from us. Any substantialdecrease or delay in sales to one or more of our key customers could harm oursales and 

 

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financial results. In addition, any difficulty incollecting amounts due from one or more key customers could harm our financialresults.

 

**We are dependent on ourrelationship with Fujifilm for a significant percentage of our product sales,and if this relationship were terminated, our business would be harmed.**

 

Fujifilm has been our largest customer in four of thelast five years. Fujifilm purchases our products primarily as a distributor.Under our arrangement with Fujifilm, Fujifilm acts as the primary distributor inJapan of products developed by us under development contracts with Fujifilm.Fujifilm also sells some of these products in Japan under its own name. We maysell these products directly in Japan only to specified customers and mustfirst buy the products from Fujifilm. Fujifilm provides more sales andmarketing support than our other distributors. Fujifilm also has a nonexclusivelicense to distribute most of our products outside of Japan. Fujifilm hasprovided wafer manufacturing services on a most-favored terms basis to us since1993 and has also provided funding to support our development efforts. If ourrelationship with Fujifilm were terminated, our business would be harmed.

 

**Our products generallyhave long sales cycles and implementation periods, which increases our costs inobtaining orders and reduces the predictability of our earnings.**

 

Our products are technologically complex. Prospectivecustomers generally must make a significant commitment of resources to test andevaluate our products and to integrate them into larger systems. As a result,our sales process is often subject to delays associated with lengthy approvalprocesses that typically accompany the design and testing of new products. Thesales cycles of our products often last for many months or even years. Longersales cycles require us to invest significant resources in attempting to makesales and delay the generation of revenue.

 

Long sales cycles also subject us to other risks,including customers’ budgetary constraints, internal acceptance reviews andcancellations. In addition, orders expected in one quarter could shift toanother because of the timing of customers’ purchase decisions. The timerequired for our customers to incorporate our products into their own can varysignificantly with the needs of our customers and generally exceeds severalmonths, which further complicates our planning processes and reduces thepredictability of our operating results.

** **

**We are not protected bylong-term contracts with our customers.**

 

We generally do not enter into long-term purchasecontracts with our customers, and we cannot be certain as to future orderlevels from our customers. When we do enter into a long-term contract, thecontract is generally terminable at the convenience of the customer. In theevent of an early termination by one of our major customers, it is unlikelythat we will be able to rapidly replace that revenue source, which would harmour financial results.

 

**We are dependent upon ourinternational sales and operations; economic, political or military events in acountry where we make significant sales or have significant operations couldinterfere with our success or operations there and harm our business.**

 

During 2001, 93% of our total revenues were derivedfrom international sales. We anticipate that international sales will continueto represent a substantial majority of our total revenues for the foreseeablefuture. In addition, substantially all of our semiconductor products aremanufactured, assembled and tested outside of the United States by independentfoundries and subcontractors.

 

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

 

•                  unexpectedchanges in regulatory requirements;

 

•                  fluctuationsin exchange rates;

 

•                  politicaland economic instability;

 

•                  impositionof tariffs and other barriers and restrictions; and

 

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•                  theburdens of complying with a variety of foreign laws.

 

The majority of our research and development personneland facilities and a significant portion of our sales personnel are located inIsrael. Political, economic and military conditions in Israel directly affectour operations. Some of our officers and employees in Israel are obligated toperform up to 39 days of military reserve duty annually. The absence of theseemployees for significant periods during the work week may cause us to operateinefficiently during these periods.

 

Our operations in China are subject to the economicand political uncertainties affecting that country. For example, the Chineseeconomy has experienced significant growth in the past decade, but such growthhas been uneven across geographic and economic sectors and has recently beenslowing. This growth may continue to decrease and any slowdown may have anegative effect on our business. During 2000 and the beginning of 2001 we alsoopened offices in Taipei, Taiwan, Hong Kong and Seoul, Korea. Our operationsare subject to the economic and political uncertainties affecting thesecountries as well.

 

**Our business and futureoperating results could be harmed by terrorist activity or armed conflict.**

** **

**Our business and operating results are subject touncertainties arising out of possible terrorist attacks on the United Statesand other regions of the world including locations where we maintain operationsand by the potential expansion of armed conflict and potential instabilityassociated with terrorism. 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  the global 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.

 

**The prices of ourproducts may become less competitive due to foreign exchange fluctuations.**

 

Foreign currency fluctuations may affect the prices ofour products. Prices for our products are currently denominated in U.S. dollarsfor sales to our customers throughout the world. If there is a significantdevaluation of the currency in a specific country, the prices of our productswill increase relative to that country’s currency and our products may be lesscompetitive in that country. Also, we cannot be sure that our internationalcustomers will continue to be willing to place orders denominated in U.S.dollars. If they do not, our revenue and operating results will be subject toforeign exchange fluctuations.

 

**Our ability to competecould be jeopardized if we are unable to protect our intellectual propertyrights from challenges by third parties.**

 

Our success and ability to compete depend in largepart upon protecting our proprietary technology. We rely on a combination ofpatent, trade secret, copyright and trademark laws, non-disclosure and othercontractual agreements and technical measures to protect our proprietaryrights. These agreements and measures may not be sufficient to protect ourtechnology from third-party infringement, or to protect us from the claims ofothers. Monitoring unauthorized use of our products is difficult and we cannotbe certain that the steps we have taken will prevent unauthorized use of ourtechnology, particularly in foreign countries where the laws may not protectour proprietary rights as fully as in the United States. The laws of certainforeign countries in which our products are or may be developed, manufacturedor sold, including various countries in Asia, may not protect our products orintellectual property rights to the same extent as do the laws of the UnitedStates and thus make the possibility of piracy of our technology and productsmore likely in these countries. If competitors are able to use our technology,our ability to compete effectively could be harmed.

 

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**We could become subjectto claims and litigation regarding intellectual property rights, which couldseriously harm our business and require us to incur significant costs.**

 

In recent years, there has been significant litigationin the United States involving patents and other intellectual property rights.In the past, we have been subject to claims and litigation regarding allegedinfringement of other parties’ intellectual property rights. We could becomesubject to litigation in the future either to protect our intellectual propertyor as a result of allegations that we infringe others’ intellectual propertyrights. Claims that our products infringe proprietary rights would force us todefend ourselves and possibly our customers or manufacturers against thealleged infringement. These claims and any resulting lawsuit, if successful,could subject 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 business could be severely harmed.

** **

**If necessary licenses ofthird-party technology are not available to us or are very expensive, ourproducts could become obsolete.**

 

From time to time we may be required to licensetechnology from third parties to develop new products or product enhancements.Third party licenses may not be available to us on commercially reasonableterms, if at all. If we are unable to obtain any third-party license requiredto develop new products and product enhancements, we may have to obtainsubstitute technology of lower quality or performance standards or at greatercost, either of which could seriously harm the competitiveness of our products.

 

**If we are not able toapply our net operating losses against taxable income in future periods, ourfinancial results will be harmed.**

 

Our future net income and cash flow will be affectedby our ability to apply our net operating losses, which totaled approximately$48.0 million for federal tax reporting purposes as of December 31, 2001,against taxable income in future periods. Our net operating losses incurredprior to the consummation of our initial public offering in 1995 that we canuse to reduce future taxable income for federal tax purposes are limited toapproximately $3.0 million per year. Changes in tax laws in the United Statesmay further limit our ability to utilize our net operating losses. Any furtherlimitation on our ability to utilize our net operating losses could harm ourfinancial condition.

 

**Any acquisitions we makecould disrupt our business and severely harm our financial condition.**

 

We have made investments in, and acquisitions of,complementary companies, products and technologies. During 2000, we acquiredPixelCam and Nogatech, and we may acquire additional businesses, products, ortechnologies in the future. In the event of any future acquisitions, we could:

 

•                  issuestock that would dilute our current stockholders’ percentage ownership;

 

•                  incurdebt;

 

•                  assumeliabilities;

 

•                  incuramortization expenses related to goodwill and other intangible assets; or

 

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•                  incurlarge write-offs immediately or in the future.

 

Our operation of any acquired business will alsoinvolve numerous risks, including:

 

•                  problemscombining the purchased operations, technologies or products;

 

•                  unanticipatedcosts;

 

•                  diversionof management’s attention from our core business;

 

•                  adverseeffects on existing business relationships with customers;

 

•                  risksassociated with entering markets in which we have no or limited priorexperience; and

 

•                  potentialloss of key employees, particularly those of the purchased organizations.

 

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

 

**Our products could containdefects, which could reduce sales of those products or result in claims againstus.**

 

We develop complex and evolving products. Despitetesting by us and our customers, errors may be found in existing or newproducts. This could result in, among other things, a delay in recognition orloss of revenues, loss of market share or failure to achieve market acceptance.These defects may cause us to incur significant warranty, support and repaircosts, divert the attention of our engineering personnel from our productdevelopment efforts and harm our relationships with our customers. Theoccurrence of these problems could result in the delay or loss of marketacceptance of our products and would likely harm our business. Defects,integration issues or other performance problems in our products could resultin financial or other damages to our customers or could damage marketacceptance of our products. Our customers could also seek damages from us fortheir losses. A product liability claim brought against us, even ifunsuccessful, would likely be time consuming and costly to defend.

 

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

 

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

 

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

 

We may require substantial additional capital tofinance our future growth, secure additional foundry capacity and fund ourongoing research and development activities beyond 2002. Our capitalrequirements will depend on many factors, including:

 

•                  acceptanceof and demand for our products;

 

•                  thetypes of arrangements that we may enter into with our independent foundries;and

 

•                  theextent to which we invest in new technology and research and developmentprojects.

 

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To the extent that our existing sources of liquidityand cash flow from operations are insufficient to fund our activities, we mayneed to raise additional funds. If we raise additional funds through theissuance of equity securities, the percentage ownership of our existingstockholders would be reduced. Further, such equity securities may have rights,preferences or privileges senior to those of our common stock. Additionalfinancing may not be available to us when needed or, if available, it may notbe available on terms favorable to us.

 

**If we fail to manage ourfuture growth, if any, our business would be harmed.**

 

We anticipate that our future growth, if any, willrequire us to recruit and hire a substantial number of new engineering,managerial, sales and marketing personnel. Our ability to manage our growthsuccessfully will also require us to expand and improve our administrative,operational, management and financial systems and controls. Many of our keyoperations, including the major portion of our research and developmentoperations and a significant portion of our sales and administrativeoperations, are located in Israel. A majority of our sales and marketing andcertain of our research and development and administrative personnel, includingour President and Chief Executive Officer and other officers, are based in theUnited States. The geographic separation of these operations places additionalstrain on our resources and our ability to effectively manage our growth. If weare unable to manage growth effectively, our business would be harmed.

 

**We rely on the servicesof our executive officers and other key personnel, whose knowledge of ourbusiness and industry would 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.

 

**The Israeli rate ofinflation may negatively impact our costs if it exceeds the rate of devaluationof the New Israeli Shekel against the U.S. dollar.**

 

A portion of the cost of our operations, relatingmainly to our personnel and facilities in Israel, is incurred in New IsraeliShekels. As a result, we bear the risk that the rate of inflation in Israelwill exceed the rate of devaluation of the New Israeli Shekel in relation tothe dollar, which will increase our costs as expressed in dollars. To date, wehave not engaged in hedging transactions. In the future, we may enter intocurrency hedging transactions to decrease the risk of financial exposure fromfluctuations in the exchange rate of the U.S. dollar against the New IsraeliShekel. These measures may not adequately protect us from the impact ofinflation in Israel.

 

**The government programswe participate in and tax benefits we receive require us to meet severalconditions and may be terminated or reduced in the future, which would increaseour costs.**

 

In the year ended December 31, 2001, we did notreceive proceeds from grants for research and development from the ChiefScientist in Israel’s Ministry of Industry and Trade. However, we did receivean aggregate of $333,000 in such grants during 2000. We plan to seek additional grants from the Chief Scientistin the future. To be eligible for these grants, our development projects mustbe approved by the Chief Scientist on a case-by-case basis.  If our development projects are not approvedby the Chief Scientist, we will not receive grants to fund these projects,which would increase our research and development costs. We also receive taxbenefits, in particular exemptions and reductions as a result of the “ApprovedEnterprise” status of our existing operations in Israel. To be eligible for thesetax benefits, we must maintain our Approved Enterprise status by meetingconditions, including making specified investments in fixed assets located inIsrael and investing additional equity in our Israeli subsidiary. If we fail tomeet these conditions in the future, the tax benefits would be canceled and wecould be required to refund the tax benefits already received. These taxbenefits may not be continued in the future at their current levels or at anylevel. Israeli governmental authorities have indicated that the government mayreduce or eliminate these benefits in the future, which would harm ourbusiness.

 

38

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**We have anti-takeoverprovisions in our charter documents and there are provisions of Delaware lawthat could prevent or delay a change in control of our company.**

 

Our certificate of incorporation, our bylaws andDelaware law contain provisions that could make it more difficult for a thirdparty to acquire us, even if doing so would be beneficial to our stockholders.These include provisions:

 

•                  prohibitinga merger with a party that has acquired control of 15% or more of ouroutstanding common stock, such as a party that has completed a successfultender offer, until three years after that party acquired control of 15% of ouroutstanding common stock;

 

•                  authorizingthe issuance 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 hasfluctuated and may continue to fluctuate widely.**

 

The market price of our common stock has fluctuatedsignificantly since our initial public offering in 1995. Between January 1,2001 and December 31, 2001, the closing sale price of our common stock, asreported on the Nasdaq National Market, ranged from a low of $13.00 to a highof $40.55.  The market price of ourcommon stock is subject to significant fluctuations in the future in responseto a variety of factors, including:

 

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

 

•                  quarterlyvariations in operating results;

 

•                  changesin analysts’ earnings estimates;

 

•                  announcementsof technological innovations;

 

•                  theintroduction of new products or changes in product pricing policies by us orour competitors;

 

•                  proprietaryrights or other litigation;

 

•                  generalconditions in the semiconductor industry; and

 

•                  developmentsin the financial markets.

 

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

 

**Item7A.      Quantitative and QualitativeDisclosures about Market 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 interest ratesdue mainly to the short-term nature of the major portion of our investmentportfolio.

 

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 

 

39

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rates. Based on our overall currency rate exposure at December 31, 2001a near-term 10% appreciation or depreciation of the New Israeli Shekel wouldhave an immaterial affect on our financial condition.

 

40

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# **Item 8. **     Financial Statements andSupplemental Data.

 

**Index to Consolidated Financial Statements**

 
| Report of Independent  Accountants                                                                 |
|----------------------------------------------------------------------------------------------------|
|                                                                                               |
| Consolidated Balance Sheets  as of December 31, 2001 and 2000                                      |
|                                                                                               |
| Consolidated  Statements of Operations for each of the three years ended December 31, 2001         |
|                                                                                               |
| Consolidated  Statements of Stockholders’ Equity for the three years ended December 31,  2001 |
|                                                                                               |
| Consolidated  Statements of Cash Flows for each of the three years ended December 31, 2001         |
|                                                                                               |
| Notes to  Consolidated Financial Statements                                                        |
|                                                                                               |
| Supplemental  Data:  Selected Quarterly Financial  Information (Unaudited)                    |

 

41

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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, 2001and 2000, and the results of their operations and their cash flows for each ofthe three years in the period ended December 31, 2001, 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.

 
| /s/ PricewaterhouseCoopers LLP |
|--------------------------------|
| San Jose, California           |
| January 30, 2002               |

 

42

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**ZORANCORPORATION**

**CONSOLIDATED BALANCE SHEETS**

**(Inthousands, except share data)**

 
|                                                                                                                            |   | **December  31,** |       |
|---------------------------------------------------------------------------------------------------------------------------------|--------|-------------------|------------|
|                                                                                                                            |   | **2001**          |       | **2000** |   |
| **ASSETS**                                                                                                                      |   |              | ** ** |   | ** ** |
| Current Assets:                                                                                                                 |   |              |       |   |   |
| Cash and cash  equivalents                                                                                                      |   | $                 | 20,287     |   | $ | 16,099 |   |
| Short-term  investments                                                                                                         |   | 89,818            |       | 159,539 |   |
| Accounts  receivable, net                                                                                                       |   | 33,367            |       | 27,065 |   |
| Inventory                                                                                                                       |   | 15,681            |       | 17,453 |   |
| Prepaid expenses  and other current assets                                                                                      |   | 5,130             |       | 5,575 |   |
| Total current  assets                                                                                                           |   | 164,283           |       | 225,731 |   |
| Property and  equipment, net                                                                                                    |   | 7,159             |       | 6,972 |   |
| Other  investments                                                                                                              |   | 89,727            |       | 13,899 |   |
| Goodwill and  other intangibles                                                                                                 |   | 70,175            |       | 112,864 |   |
|                                                                                                                            |   | $                 | 331,344    |   | $ | 359,466 |   |
|                                                                                                                            |   |              |       |   |   |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                  |   |              |       |   |   |
| Current  Liabilities:                                                                                                           |   |              |       |   |   |
| Accounts payable                                                                                                                |   | $                 | 16,705     |   | $ | 11,156 |   |
| Accrued expenses  and other liabilities                                                                                         |   | 16,801            |       | 16,856 |   |
| Total current  liabilities                                                                                                      |   | 33,506            |       | 28,012 |   |
|                                                                                                                            |   |              |       |   |   |
| Commitments and  Contingencies (Note 6)                                                                                         |   |              |       |   |   |
|                                                                                                                            |   |              |       |   |   |
| Stockholders’  Equity:                                                                                                     |   |              |       |   |   |
| Common Stock:  $0.001 par value; 55,000,000   shares authorized; 17,801,854 and 17,423,216 shares   issued and outstanding |   | 18                |       | 17 |   |
| Additional  paid-in capital                                                                                                     |   | 391,674           |       | 388,655 |   |
| Warrants                                                                                                                        |   | 717               |       | 717 |   |
| Deferred  stock-based compensation                                                                                              |   | (375              | )          | (919 | ) |
| Accumulated  other comprehensive income (loss)                                                                                  |   | (6                | )          | 1,109 |   |
| Accumulated  deficit                                                                                                            |   | (94,190           | )          | (58,125 | ) |
| Total  stockholders’ equity                                                                                                |   | 297,838           |       | 331,454 |   |
|                                                                                                                            |   | $                 | 331,344    |   | $ | 359,466 |   |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

43

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**ZORANCORPORATION**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(Inthousands, except share data)**

 
|                                                                                        |   | **Year Ended  December 31,** |    |
|---------------------------------------------------------------------------------------------|--------|------------------------------|---------|
|                                                                                        |   | **2001**                     |    | **2000** |   | **1999** |   |
| Revenues:                                                                                   |   |                         |    |   |   |   |   |
| Product sales                                                                               |   | $                            | 100,012 |   | $ | 67,782 |   | $ | 52,887 |   |
| Software,  licensing and development                                                        |   | 7,697                        |    | 11,889 |   | 8,787 |   |
| Total revenues                                                                              |   | 107,709                      |    | 79,671 |   | 61,674 |   |
|                                                                                        |   |                         |    |   |   |   |   |
| Costs and  expenses:                                                                        |   |                         |    |   |   |   |   |
| Cost of product  sales                                                                      |   | 64,740                       |    | 37,993 |   | 28,523 |   |
| Research and  development                                                                   |   | 23,210                       |    | 18,628 |   | 12,651 |   |
| Selling, general  and administrative                                                        |   | 21,330                       |    | 19,148 |   | 14,251 |   |
| Amortization of  goodwill and write-off of   acquired in-process research & development |   | 43,233                       |    | 31,769 |   | — |   |
| Total costs and  expenses                                                                   |   | 152,513                      |    | 107,538 |   | 55,425 |   |
|                                                                                        |   |                         |    |   |   |   |   |
| Operating income  (loss)                                                                    |   | (44,804                      | )       | (27,867 | ) | 6,249 |   |
| Interest and  other income, net                                                             |   | 10,004                       |    | 9,229 |   | 1,585 |   |
|                                                                                        |   |                         |    |   |   |   |   |
| Income (loss)  before income taxes                                                          |   | (34,800                      | )       | (18,638 | ) | 7,834 |   |
| Provision for  income taxes                                                                 |   | 1,265                        |    | 1,970 |   | 1,175 |   |
| Net income  (loss)                                                                          |   | $                            | (36,065 | ) | $ | (20,608 | ) | $ | 6,659 |   |
|                                                                                        |   |                         |    |   |   |   |   |
| Basic net income  (loss) per share                                                          |   | $                            | (2.07   | ) | $ | (1.37 | ) | $ | 0.61 |   |
|                                                                                        |   |                         |    |   |   |   |   |
| Diluted net  income (loss) per share                                                        |   | $                            | (2.07   | ) | $ | (1.37 | ) | $ | 0.54 |   |
|                                                                                        |   |                         |    |   |   |   |   |
| Shares used to  compute basic net income (loss) per share                                   |   | 17,460                       |    | 15,070 |   | 10,844 |   |
|                                                                                        |   |                         |    |   |   |   |   |
| Shares used to  compute diluted net income (loss) per share                                 |   | 17,460                       |    | 15,070 |   | 12,249 |   |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

44

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**ZORANCORPORATION**

**CONSOLIDATEDSTATEMENTS OF STOCKHOLDERS' EQUITY**

**(Inthousands)**

 
|                                                                                      |   | **Common  Stock** |   | **Additional  Paid-In** |   |        |   | **Stock  Based  Deferred** |   | **Accumulated  Other  Comprehensive** |   | **Accumulated**    |   |        | ** ** |
|-------------------------------------------------------------------------------------------|--------|-------------------|--------|-------------------------|--------|-------------|--------|----------------------------|--------|---------------------------------------|--------|--------------------|--------|-------------|------------|
|                                                                                      |   | **Shares**        |   | **Amount**              |   | **Capital** |   | **Warrants**               |   | **Compensation**                      |   | **Income  (Loss)** |   | **Deficit** |       | **Total** |   |
| Balance at  December 31, 1998                                                             |   | 10,213            |   | $                       | 10     |        | $      | 79,635                     |   | $                                     | 717    |               | — |        | —     |   | $ | (44,176 | ) | $ | 36,186 |   |
| Issuance of  Common Stock, net                                                            |   | 3,706             |   | 4                       |   | 115,634     |   | —                     |   | —                                |   | —             |   | —      |       | 115,638 |   |
| Unrealized gain  on securities available for sale                                         |   | —            |   | —                  |   | —      |   | —                     |   | —                                |   | 4,962              |   | —      |       | 4,962 |   |
| Net income                                                                                |   | —            |   | —                  |   | —      |   | —                     |   | —                                |   | —             |   | 6,659       |       | 6,659 |   |
| Balance at  December 31, 1999                                                             |   | 13,919            |   | 14                      |   | 195,269     |   | 717                        |   | —                                |   | 4,962              |   | (37,517     | )          | 163,445 |   |
| Issuance of  Common Stock                                                                 |   | 594               |   | 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                                 |   | 2,910             |   | 2                       |   | 188,167     |   | —                     |   | —                                |   | —             |   | —      |       | 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                                                             |   | 17,423            |   | 17                      |   | 388,655     |   | 717                        |   | (919                                  | )      | 1,109              |   | (58,125     | )          | 331,454 |   |
| Issuance of  Common Stock                                                                 |   | 634               |   | 1                       |   | 6,886       |   | —                     |   | —                                |   | —             |   | —      |       | 6,887 |   |
| Repurchases of  Common Stock                                                              |   | (255              | )      | —                  |   | (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                                                             |   | 17,802            |   | $                       | 18     |        | $      | 391,674                    |   | $                                     | 717    |               | $      | (375        | )          | $ | (6 | ) | $ | (94,190 | ) | $ | 297,838 |   |
|                                                                                           |        |                   |        |                         |        |             |        |                            |        |                                       |        |                    |        |             |            |  |  |  |  |  |  |  |  |  |  |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

45

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**ZORANCORPORATION**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(Inthousands)**

 
|                                                       |   | **Year Ended  December 31,** |    |
|------------------------------------------------------------|--------|------------------------------|---------|
|                                                       |   | **2001**                     |    | **2000** |   | **1999** |   |
| Cash flows from  operating activities:                     |   |                         |    |   |   |   |   |
| Net income  (loss)                                         |   | $                            | (36,065 | ) | $ | (20,608 | ) | $ | 6,659 |   |
| Adjustments:                                               |   |                         |    |   |   |   |   |
| Depreciation,  amortization and other                      |   | 3,700                        |    | 2,987 |   | 2,166 |   |
| Allowance for  doubtful accounts                           |   | 2,029                        |    | 549 |   | 517 |   |
| Amortization of  goodwill and other intangibles            |   | 43,233                       |    | 9,922 |   | — |   |
| Write-off of  acquired in-process research and development |   | —                       |    | 21,847 |   | — |   |
| Income tax  benefit of employees’ stock transactions  |   | —                       |    | 1,003 |   | — |   |
| Changes in  current assets and liabilities:                |   |                         |    |   |   |   |   |
| Accounts  receivable                                       |   | (7,958                       | )       | (4,967 | ) | (7,345 | ) |
| Inventory                                                  |   | 1,772                        |    | (7,311 | ) | (96 | ) |
| Prepaid expenses  and other current assets                 |   | 328                          |    | (2,640 | ) | (108 | ) |
| Accounts payable                                           |   | 5,549                        |    | 234 |   | 1,457 |   |
| Accrued expenses  and other liabilities                    |   | (231                         | )       | 3,374 |   | 3,706 |   |
| Net cash provided by  operating activities                 |   | 12,357                       |    | 4,390 |   | 6,956 |   |
|                                                       |   |                         |    |   |   |   |   |
| Cash flows from  investing activities:                     |   |                         |    |   |   |   |   |
| Capital  expenditures for property and equipment           |   | (3,771                       | )       | (3,251 | ) | (2,775 | ) |
| Purchases of  investments                                  |   | (195,588                     | )       | (180,324 | ) | (130,112 | ) |
| Sales and  maturities of investments                       |   | 189,341                      |    | 181,045 |   | 14,937 |   |
| Purchases of  long-term equity investments                 |   | (1,171                       | )       | (2,250 | ) | (200 | ) |
| Cash received in  acquisitions (net of costs incurred)     |   | —                       |    | (393 | ) | — |   |
| Net cash used in  investing activities                     |   | (11,189                      | )       | (5,173 | ) | (118,150 | ) |
|                                                       |   |                         |    |   |   |   |   |
| Cash flows from  financing activities:                     |   |                         |    |   |   |   |   |
| Proceeds from  issuance of Common Stock, net               |   | 6,887                        |    | 4,217 |   | 115,638 |   |
| Repurchases of  Common Stock                               |   | (3,867                       | )       | — |   | — |   |
| Net cash  provided by financing activities                 |   | 3,020                        |    | 4,217 |   | 115,638 |   |
|                                                       |   |                         |    |   |   |   |   |
| Net increase in  cash and cash equivalents                 |   | 4,188                        |    | 3,434 |   | 4,444 |   |
| Cash and cash  equivalents at beginning of year            |   | 16,099                       |    | 12,665 |   | 8,221 |   |
| Cash and cash  equivalents at end of year                  |   | $                            | 20,287  |   | $ | 16,099 |   | $ | 12,665 |   |
|                                                       |   |                         |    |   |   |   |   |
| Supplemental  disclosures:                                 |   |                         |    |   |   |   |   |
| Income taxes  paid                                         |   | $                            | —  |   | $ | 732 |   | $ | 506 |   |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

46

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**ZORANCORPORATION**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE 1 - 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, Super Video CDplayers, filmless digital cameras, professional and consumer video editingsystems and digital speakers and audio systems. The Company operatespredominantly 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, economicand military conditions to which that country is subject.

 

The semiconductor business is highly cyclical and has been subject tosignificant downturns at various times that have been characterized bydiminished product demand, decreased production, overcapacity, and acceleratederosion of average selling prices. 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 thereforecould 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.

 

**NOTE 2 - 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.

 

47

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*Revenue recognition*

 

Revenue from product sales is generally recognized upon shipment. Aprovision for estimated future returns and potential warranty liability isrecorded at the time revenue is recognized. Development revenue underdevelopment contracts is recognized on the percentage-of-completion method.Under the percentage-of-completion method, revenue recognized is that portionof the total 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. Amounts received in advance of performance undercontracts are recorded as deferred revenue and are generally recognized withinone year from receipt.  Estimates arereviewed and revised periodically throughout the lives of the contracts. Anyrevisions are recorded in the accounting period in which the revisions aremade. Costs associated with development revenues are included primarily inresearch and development expenses. Revenue resulting from the licensing of theCompany’s technology is recognized when significant contractual obligationshave been fulfilled and the customer has indicated acceptance. The Company doesnot provide customers with product return or exchange rights in connection withthe sale of software licenses. Periodic service and maintenance fees providecustomers access to technical support and minor enhancements to licensedreleases are recognized ratably over the service or maintenance period. Royaltyrevenue is recognized 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 and havenot been significant to date.

 

At December 31, 2001, the Company’s marketable securities consistedprimarily of commercial paper with maturities of less than one year and thestock acquired as a result of the MGI transaction (See Note 11). The unrealizedloss on the MGI stock amounting to $630,659 at December 31, 2001, is includedin comprehensive income (loss). Investments in marketable securities alsoconsisted of bonds and medium term notes with maturities greater than one year,which are included in other assets, and amounted to $86.1 million and $11.4million at December 31, 2001 and 2000, respectively.

 

Other assets also include investments in non-marketable securitieswhich are accounted for on the cost basis and amounted to $3.6 million and $2.5million at December 31, 2001 and 2000, respectively. We record an investmentimpairment charge when a decline in value of a cost basis investment isdetermined to be other than temporary.

 

48

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*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, short-term investments and trade accounts receivable. The Companyplaces its cash in banks and cash equivalents primarily in auction ratepreferred, certificates of deposit and commercial paper. The Company, bypolicy, limits the amount of credit exposure through diversification andrestricting its investments to highly rated securities. The Company has notexperienced any significant losses on its cash equivalents or short-terminvestments.

 

The Company marketsintegrated circuits and technology to manufacturers and distributors ofelectronic equipment primarily in North America, Europe and the Pacific Rim.The Company performs ongoing credit evaluations of its customers’ financialcondition and limits the amount of credit extended when deemed necessary, butgenerally does not require collateral. Management believes that any risk ofloss is significantly reduced due to the diversity of its customers andgeographic sales areas. The Company maintains a provision for potential creditlosses, and write-offs of accounts receivable were insignificant in each of thethree years in the period ended December 31, 2001.  As of December 31, 2001, three customers accounted forapproximately 21%, 12% and 11% of the accounts receivable balance. As ofDecember 31, 2000, three customers accounted for approximately 15%, 10%, and 7%of the accounts receivable balance.

 

*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 and other intangibles*

 

Acquired technology is amortized to expense on a straight-line basisover two to three years. Goodwill and other intangible assets recorded inconnection with the acquisitions of PixelCam, Inc., and Nogatech, Inc., areamortized  on a straight-line basis overthe estimated periods of benefit, which is approximately three years.

 

*Long-lived assets*

 

The Company periodically evaluates the recoverability of its long-livedassets based on expected undiscounted cash flows and recognizes impairment fromthe carrying value of long-lived assets, if any, based on the fair value ofsuch assets. To date, the Company has not recorded any impairment chargesagainst the value of its long-lived assets.

 

*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, 2001 and 2000 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-

 

49

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process research and development, for the periods. The effective taxrate differs from the U.S. statutory rate due to utilization of net operatinglosses and State of Israel tax benefits on foreign earnings. The provisionincludes primarily taxes on income in excess of net operating loss carryoverlimitations and foreign withholding taxes.

 

*Earnings per share*

 

In accordance withStatement of Financial Accounting Standards No. 128, Zoran reports Earnings perShare (“EPS”), both basic and diluted, on the statement of operations. BasicEPS is based upon the weighted average number of common shares outstanding.Diluted EPS is computed using the weighted average common shares outstandingplus any potential common stock, except when their effect is anti-dilutive.Potential common stock includes stock options and warrants. See Note 8.

 

*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”). The Company provides additional pro formadisclosures as required under Statement of Financial Accounting Standards No.123 (“SFAS 123”), “Accounting for Stock-Based Compensation.” See Note 7.

 

*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.”

 

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

 
|                                             |   | **Year Ended  December 31,** |    |
|--------------------------------------------------|--------|------------------------------|---------|
|                                             |   | **2001**                     |    | **2000** |   | **1999** |   |
| Net income  (loss)                               |   | $                            | (36,065 | ) | $ | (20,608 | ) | $ | 6,659 |   |
| Unrealized gain  (loss) on short-term investment |   | (1,115                       | )       | (3,853 | ) | 4,962 |   |
| Comprehensive  income (loss)                     |   | $                            | (37,180 | ) | $ | (24,461 | ) | $ | 11,621 |   |

 

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

 
|                                              |   | **Year Ended  December 31,** |   |
|---------------------------------------------------|--------|------------------------------|--------|
|                                              |   | **2001**                     |   | **2000** |   | **1999** |   |
| Unrealized gain  (loss) on short term-investments |   | $                            | (6     | ) | $ | 1,109 |   | $ | 4,962 |   |
|                                                   |        |                              |        |  |  |  |  |  |  |  |

 

*Recent accounting pronouncements*

 

In July 2001, the FASB issued FASB Statements Nos. 141 and 142 (“SFAS141” and “FAS 142”), “Business Combinations” and “Goodwill and Other IntangibleAssets.” SFAS 141 replaced APB 16 and eliminated pooling-of-interestsaccounting prospectively. It also provides guidance on purchase accountingrelated to the recognition of intangible assets and accounting for negativegoodwill. SFAS 142 changes 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. SFAS 141 and SFAS 142 are effective for all businesscombinations completed after June 30, 2001. Upon adoption of SFAS 142,amortization of goodwill recorded for business combinations consummated priorto July 1, 2001 will cease, and intangible assets acquired prior to July 1,2001 that do not meet the criteria for recognition under SFAS 141 will bereclassified to goodwill. Companies are required to adopt SFAS 142 for fiscalyears beginning after December 15, 2001, and interim periods within thosefiscal years, but early adoption is permitted. The Company will adopt SFAS 142on January 1, 2002. Accordingly, our amortization of goodwill expense, whichtotaled $33.2 million in 2001, will be discontinued in 2002. In connection withthe adoption of SFAS 142, the Company will be required to perform atransitional goodwill impairment assessment and has six months from January 1,2002 to complete this evaluation. The Company has not yet determined the impactthese standards will have on its results of operations and financial position.

 

In August 2001, the FASB issued SFAS No. 143 (“SFAS 143”), “Accountingfor Asset Retirement Obligations”. This Statement addresses financial accountingand reporting for obligations associated with the retirement of tangiblelong-lived assets and the associated asset retirement costs. This Statementapplies to all entities. It applies to legal obligations associated with theretirement of long-lived assets that result from the acquisition, construction,development and (or) the normal operation of a long-lived asset, except forcertain obligations of lessees. SFAS 143 is effective for financial statementsissued for fiscal years beginning after June 25, 2002. The Company expects thatthe initial application of SFAS 143 will not have a material impact on itsfinancial statements.

 

In October 2001, the FASB issued SFAS No. 144 (“SFAS 144”), “Accountingfor the Impairment or Disposal of Long-lived Assets”. The objectives of SFAS144 are to address significant issues relating to the implementation of SFASNo. 121 (“SFAS 121”), “Accounting for the Impairment of Long-lived Assets andfor Long-lived assets to be Disposed Of,” and to develop a single accounting model,based on the framework established by SFAS 121, for long-lived assets to bedisposed of by sale, whether previously held and used or newly acquired.Although SFAS 144 supersedes SFAS 121, it retains some fundamental provisionsof SFAS 121. SFAS No. 144 is effective for financial statements issued forfiscal years beginning after December 15, 2001, and interim periods withinthose fiscal years. The Company expects that the initial application of SFAS144 will not have a material impact on its financial statements.

 

51

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**NOTE 3 - BALANCE SHEET COMPONENTS (in thousands):**

 
|                          |   | **December  31,** |   |
|-------------------------------|--------|-------------------|--------|
|                          |   | **2001**          |   | **2000** |   |
| **Accounts receivable, net:** |   |              |   |   |   |
| Trade                         |   | $                 | 32,491 |   | $ | 26,207 |   |
| Unbilled                      |   | 2,802             |   | 3,115 |   |
|                          |   | 35,293            |   | 29,322 |   |
| Less: allowance               |   | (1,926            | )      | (2,257 | ) |
|                          |   |              |   |   |   |
|                          |   | $                 | 33,367 |   | $ | 27,065 |   |

 

Unbilledaccounts receivable consists of both development revenue recognized, but notyet billed and research and development funding not yet received.  Unbilled development revenue representsrevenue recognized under the percentage-of-completion method prior toachievement of the related contract milestones.  The Company bills development revenue when contract milestonesare achieved.  The Company recognizesresearch and development funding as reimbursable expenses, under research anddevelopment agreements, as incurred. This funding is offset against research and development expenses. During2001, we wrote-off $2.4 million against the allowance for doubtful accountsreserve.

 
|                                             |   | **December  31,** |   |
|--------------------------------------------------|--------|-------------------|--------|
|                                             |   | **2001**          |   | **2000** |   |
| **Inventory:**                                   |   |              |   |   |   |
| Work-in-process                                  |   | $                 | 3,119  |   | $ | 6,913 |   |
| Finished goods                                   |   | 12,562            |   | 10,540 |   |
|                                             |   | $                 | 15,681 |   | $ | 17,453 |   |
|                                             |   |              |   |   |   |
| **Property and equipment:**                      |   |              |   |   |   |
| Computer  equipment                              |   | $                 | 17,717 |   | $ | 14,769 |   |
| Office equipment  and furniture                  |   | 923               |   | 961 |   |
| Machinery and  equipment                         |   | 760               |   | 1,148 |   |
| Leasehold  improvements                          |   | 993               |   | 968 |   |
|                                             |   | 20,393            |   | 17,846 |   |
| Less:  accumulated depreciation and amortization |   | (13,234           | )      | (10,874 | ) |
|                                             |   | $                 | 7,159  |   | $ | 6,972 |   |
|                                             |   |              |   |   |   |
| **Intangibles and other assets:**                |   |              |   |   |   |
| Goodwill and other intangible assets             |   | $                 | 99,527 |   | $ | 99,527 |   |
| Other identifiable intangibles                   |   | 23,160            |   | 23,160 |   |
|                                             |   | 122,687           |   | 122,687 |   |
| Less: amortization                               |   | (52,512           | )      | (9,823 | ) |
|                                             |   | $                 | 70,175 |   | $ | 112,864 |   |

 

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|                                         |   | **December 31,** |   |
|----------------------------------------------|--------|------------------|--------|
|                                         |   | **2001**         |   | **2000** |   |
| **Accrued expenses and other  liabilities:** |   |             |   |   |   |
| Accrued payroll  and related expenses        |   | $                | 4,036  |   | $ | 5,410 |   |
| Accrued  royalties                           |   | 1,883            |   | 1,381 |   |
| Taxes payable                                |   | 4,350            |   | 3,323 |   |
| Deferred revenue                             |   | 1,435            |   | 1,062 |   |
| Other accrued  liabilities                   |   | 5,097            |   | 5,680 |   |
|                                         |   | $                | 16,801 |   | $ | 16,856 |   |

 

**NOTE 4 - RESEARCH AND DEVELOPMENT ARRANGEMENTS:**

 

TheCompany is a party to certain research and development agreements with theChief Scientist in Israel’s Ministry of Industry and Trade Department (the“Chief Scientist”) and the Israel-United States Binational Industrial Researchand Development Foundation (“BIRDF”), which fund up to 50% of incurred projectcosts 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.

 

Grossresearch and development expenses and the related grants are as follows: 

 
|                                     |   | **Year Ended  December 31,** |   |
|------------------------------------------|--------|------------------------------|--------|
|                                     |   | **2001**                     |   | **2000** |   | **1999** |   |
|                                     |   | **(in thousands)**           |   |
| Research and  development expenses:      |   |                         |   |   |   |   |   |
| Gross research  and development expenses |   | $                            | 23,210 |   | $ | 18,961 |   | $ | 13,135 |   |
| Less: grants  earned                     |   | —                       |   | (333 | ) | (484 | ) |
|                                     |   | $                            | 23,210 |   | $ | 18,628 |   | $ | 12,651 |   |

 

Royaltyexpenses related to these grants were $502,000, $299,000, and $5,000 in 2001,2000 and 1999, respectively.

** **

**NOTE 5 - DEVELOPMENT CONTRACTS:**

 

TheCompany has generated a portion of its total revenues from developmentcontracts, primarily with key customers. These development contracts have provided the Company with partialfunding for the development of certain of its products. The Company classifiescosts related to these development contracts as research and developmentexpenses.  The Company is not obligatedto repay funding regardless of the outcome of its development efforts; however,the agreements require the Company to use its best efforts to achieve specifiedresults as per the agreements. The Company retains ownership of theintellectual property developed under the contracts; however, some contractslimit the product markets in which the Company may directly sell the developedproduct.  Revenues generated under thesecontracts were $4,674,000, $5,080,000 and $1,185,000 in 2001, 2000 and 1999,respectively.

 

53

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**NOTE 6 – COMMITMENTS AND CONTINGENCIES:**

 

Fromtime to time, the Company may have certain contingent liabilities that arise inthe ordinary course of its business activities. The Company accrues contingentliabilities when it is probable that future expenditures will be made and suchexpenditures can be reasonably estimated. In the opinion of management, there are no pending claims of which theoutcome is expected to result in a material adverse effect in the financialposition or results of operations of the Company.

* *

*Leasecommitments*

 

TheCompany rents facilities and equipment under various lease agreements expiringthrough 2005.  Rent expense for 2001,2000 and 1999 totaled approximately $1,531,000, $1,239,000 and $1,010,000respectively.  Future minimum leasepayments required under noncancelable leases at December 31, 2001 are asfollows: (in thousands) 

 
| **Year Ending  December 31,** |   |   |   |   |
|-------------------------------|--------|--------|--------|--------|
| 2002                          |   | $      | 1,329  |   |
| 2003                          |   | 649    |   |
| 2004                          |   | 464    |   |
| 2005                          |   | 464    |   |
| Total minimum  lease payments |   | $      | 2,906  |   |

 

In addition, the Company hadinventory purchase commitments of $11.8 million at December 31, 2001.

** **

**NOTE 7 - STOCKHOLDERS’ EQUITY:**

*** ***

***Common Stock***

 

In December1999, the Company issued 2,917,800 shares of common stock in conjunction with afollow-on public offering that also included underwriters’ exercise of theirover-allotment option.  Gross proceedsfrom this offering were $119.6 million with underwriters’ discount and offeringexpenses of $6.7 million. In June 2000, the Company acquired PixelCam, Inc. inexchange for 370,832 shares of Zoran common stock and options to purchase 4,168shares of Zoran common stock. In October 2000, the Company acquired Nogatech,Inc. in exchange for 2,534,559 shares of Zoran common stock and options topurchase 168,472 shares of Zoran common stock. Both acquisitions were accountedfor under the purchase method of accounting (see Note 11). During 2001, theCompany repurchased 255,000 shares of its common stock for $3.9 million.

 

***Warrants***

 

InSeptember 1997, in connection with a software license agreement, theCompany issued a warrant to purchase 75,000 shares of its Common Stock at anexercise price of $24.31 per share.  Thewarrant is exercisable for a period of four years from a date beginning oneyear after the issuance date of the warrant. The $717,000 estimated value of the warrant, was amortized over thefour-year period of the license agreement.

 

54

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***Stockoption plans***

 

***1993 Stock Option Plan***

 

TheCompany’s 1993 Stock Option Plan (the “1993 Option Plan”) was adopted by theBoard of Directors of the Company and approved by the stockholders of theCompany in July 1993. A total of 4,420,000 shares of common stock havebeen 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 fully exercisable on and afterthe date of grant, subject to the Company’s right to repurchase from anoptionee, at the optionee’s original per share exercise price, any unvestedshares which the optionee has purchased and holds in the event of thetermination 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.

 

InAugust 1998, substantially all options with an exercise price in excess of  $5.94 were cancelled and replaced with newoptions having an exercise price of $5.94, the market price on the date thatthe employees accepted the repricing.  Atotal of 924,164 shares were repriced.

 

AtDecember 31, 2001, shares available for grant under this plan were558,000.

 

***2000 Stock Option Plan***

 

TheCompany’s 2000 Nonstatutory Stock Option Plan (the “2000 Option Plan”) wasadopted by the Board of Directors of the Company in October 2000. A totalof 300,000 shares of preferred stock were initially reserved for issuance underthe 2000 Option Plan. The options to purchase preferred stock automaticallyconverted to options to purchase common stock however, upon the filing of anamendment of the certificate of incorporation of the Company with the Secretaryof State of Delaware to effect an increase in the number of authorized sharesof common stock to 55,000,000 in October 2000. A total of 1,550,000 shares ofcommon stock have been reserved for issuance under the 2000 Option Plan.  The 2000 Option Plan provides for grants ofoptions to employees or consultants. The 2000 Option Plan is currently being administered by the CompensationCommittee of the Board of Directors of the Company, which determines theoptionees and the terms of the options granted, including the exercise price,number of shares subject to the option plan and the exercisability thereof. The2000 Option plan was modified in 2001 to allow for exercisability of stockoptions ahead of vesting subject to selling restrictions.  The option price for shares granted underthe 2000 Option Plan is typically equal to the fair market value of the commonstock at the date of grant. Options expire ten years from the date of grant andan option shall generally terminate three months after termination ofemployment.  The 2000 Option Plan willterminate in October 2010, unless terminated sooner by the Board ofDirectors.

 

AtDecember 31, 2001, shares available for grant under this plan were 111,000.

 

55

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*1995Outside Directors Stock Option Plan*

 

TheCompany’s Outside Directors Stock Option Plan (the “Directors Plan”) wasadopted by the Company’s Board of Directors in October 1995, and was approvedby its stockholders in December 1995.  Atotal of 300,000 shares of Common Stock have been reserved for issuance underthe Directors Plan.  The Directors Planprovides for the grant of nonstatutory stock options to nonemployee directorsof the Company.  The Directors Planprovides that each new nonemployee director will automatically be granted anoption to purchase 20,000 shares on the date the optionee first becomes anonemployee director (the “Initial Grant”). Thereafter, on the date immediately following each annual stockholders’meeting, each nonemployee director who is reelected at the meeting to anadditional term shall be granted an additional option to purchase 4,800 sharesof Common Stock if, on such date, he or she shall have served on the Company’sBoard of Directors for at least six months (the “Annual Grant”).  The Initial Grant is exercisable in fourequal annual installments, and each Annual Grant shall become exercisable infull one year after the date of grant, subject to the director’s continuousservice.  The exercise price of allstock options granted under the Directors Plan is equal to the fair marketvalue of the Company’s Common Stock on the date of grant.  Options granted under the Directors Planhave a term of ten years.

 

AtDecember 31, 2001 shares available for grant under this plan were 97,000.

 

Thefollowing table summarizes the Company’s stock option activity for the yearsended December 31, 2001, 2000 and 1999. The weighted average exercise price for each category presented is alsoshown in the table below:

 
|                                |   | **Year Ended  December 31,** |   |
|-------------------------------------|--------|------------------------------|--------|
|                                |   | **2001**                     |   | **2000** |   | **1999** |   |
|                                |   | **Shares**                   |   | **Weighted  Average  Exercise  Price** |   | **Shares** |   | **Weighted  Average  Exercise  Price** |   | **Shares** |   | **Weighted  Average  Exercise  Price** |   |
| Outstanding at  beginning of period |   | 2,639,717                    |   | $ | 23.95 |   | 1,932,556 |   | $ | 11.22 |   | 2,226,265 |   | $ | 5.11 |   |
| Assumed                             |   | —                       |   |   |   | 168,472 |   | 11.38 |   | — |   |   |   |
| Granted                             |   | 1,976,090                    |   | 19.94 |   | 1,307,050 |   | 38.23 |   | 698,803 |   | 20.49 |   |
| Exercised                           |   | (568,892                     | )      | 9.93 |   | (484,863 | ) | 6.84 |   | (700,854 | ) | 2.87 |   |
| Canceled                            |   | (474,147                     | )      | 30.05 |   | (283,498 | ) | 24.96 |   | (291,658 | ) | 6.43 |   |
|                                |   |                         |   |   |   |   |   |   |   |   |   |   |   |
| Options  outstanding at period end  |   | 3,572,768                    |   | 23.16 |   | 2,639,717 |   | 23.95 |   | 1,932,556 |   | 11.22 |   |
|                                |   |                         |   |   |   |   |   |   |   |   |   |   |   |
| Options  exercisable at period end  |   | 3,572,768                    |   |   |   | 2,408,100 |   |   |   | 1,926,549 |   |   |   |
|                                     |        |                              |        |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

56

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Significantoption groups outstanding as of December 31, 2001 and the related weightedaverage exercise price and contractual life information, are as follows:

 
|                |                     | **Options  Outstanding** |      | **Options  Exercisable**                 |   |       |      |
|---------------------|--------------------------|--------------------------|-----------|------------------------------------------|--------|------------|-----------|
| **Exercise  Price** |                     | **Number**               |      | **Weighted  Average  Exercise****Price** |   | **Number** |      | **Weighted  Average  Exercise****Price** |   | **Weighted  Average  Contractual  Life (Years)** |   |
| $                   |   0.13 —$14.00 |                     | 778,754   |                                     | $      | 8.93       |      | 778,754 |   | $ | 8.93 |   | 7.0 |   |
| $                   | 14.44 —$17.28       |                     | 879,476   |                                     | 16.53  |       | 879,476   |   | 16.53 |   | 9.4 |   |
| $                   | 17.31 —$25.29       |                     | 758,154   |                                     | 21.74  |       | 758,154   |   | 21.74 |   | 8.5 |   |
| $                   | 25.64 —$41.00       |                     | 1,007,564 |                                     | 37.31  |       | 1,007,564 |   | 37.31 |   | 8.9 |   |
| $                   | 41.25 —$62.00       |                     | 148,820   |                                     | 48.20  |       | 148,820   |   | 48.20 |   | 8.4 |   |
|                |                     | 3,572,768                |      | 23.16                                    |   | 3,572,768  |      | 23.16 |   | 8.5 |   |
|                     |                          |                          |           |                                          |        |            |           |  |  |  |  |  |  |  |

 

Theweighted average grant date fair value of options granted during the yearsended December 31, 2001, 2000 and 1999 as defined by SFAS 123, were$16.20, $34.18 and $17.05 per share, respectively.

* *

*1995Employee Stock Purchase Plan*

 

TheCompany’s 1995 Employee Stock Purchase Plan (“ESPP”) was adopted by theCompany’s Board of Directors in October 1995, and approved by its stockholdersin December 1995.  The ESPP enablesemployees to purchase shares through payroll deductions at approximately 85% ofthe lesser of the fair value of Common Stock at the beginning of a 24-monthoffering period or the end of each six-month segment within such offeringperiod.  The ESPP is intended to qualifyas an “employee stock purchase plan” under Section 423 of the U.S. InternalRevenue Code.  During the years endedDecember 31, 2001 and 2000, 65,340 and 89,831 shares were purchased byemployees under the terms of the plan agreements at a weighted average price of$18.65 and $10.37 per share, respectively. At December 31, 2001, 156,387 shares were reserved and available forissuance under this plan.

 

Theweighted average grant date fair value of rights granted during the year endedDecember 31, 2001, 2000 and 1999 as defined by SFAS 123, was $11.72,$17.27 and $3.91 per share, respectively.

 

57

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***Fair Value Disclosures***

 

Hadcompensation cost for the Company’s option and stock purchase plans beendetermined based on the fair value at the grant dates, as prescribed in SFAS123, the Company’s net income (loss) and net income (loss) per share for eachof the three years ended December 31, 2001, would have been as follows (inthousands, except per share data):

 
|                          |   | **Year Ended  December 31** |    |
|-------------------------------|--------|-----------------------------|---------|
|                          |   | **2001**                    |    | **2000** |   | **1999** |   |
| Net income  (loss)            |   |                        |    |   |   |   |   |
| As reported                   |   | $                           | (36,065 | ) | $ | (20,608 | ) | $ | 6,659 |   |
| Pro forma                     |   | $                           | (57,150 | ) | $ | (33,851 | ) | $ | 1,212 |   |
|                          |   |                        |    |   |   |   |   |
| Net income  (loss) per share: |   |                        |    |   |   |   |   |
| As reported                   |   |                        |    |   |   |   |   |
| Basic                         |   | $                           | (2.07   | ) | $ | (1.37 | ) | $ | 0.61 |   |
| Diluted                       |   | $                           | (2.07   | ) | $ | (1.37 | ) | $ | 0.54 |   |
| Pro forma                     |   |                        |    |   |   |   |   |
| Basic                         |   | $                           | (3.27   | ) | $ | (2.25 | ) | $ | 0.11 |   |
| Diluted                       |   | $                           | (3.27   | ) | $ | (2.25 | ) | $ | 0.10 |   |

 

Thefair value of each option grant is estimated on the date of grant using theBlack Scholes model with the following assumptions used for options andpurchase grants during the applicable period.

 
|                      |   | **Year Ended  December 31,** |   |
|---------------------------|--------|------------------------------|--------|
|                      |   | **2001**                     |   | **2000** |   | **1999** |   |
| Dividend rate             |   | 0.0                          | %      | 0.0 | % | 0.0 | % |
| Risk-free  interest rates |   | 3.9% to 4.9                  | %      | 5.2% to 6.7 | % | 4.6% to 6.2 | % |
| Volatility                |   | 90.0                         | %      | 91.0 | % | 93.0 | % |
| Expected life             |   |                         |   |   |   |   |   |
| Option plans              |   | 5 years                      |   | 5 years |   | 5 years |   |
| Purchase plan             |   | 0.5 years                    |   | 0.5 years |   | 0.5 years |   |

 

The proforma amounts reflect compensation expense related to stock options andpurchase rights granted during the years ended December 31, 2001, 2000 and1999.

 

58

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**NOTE 8 - EARNINGS PER SHARE:**

 

Areconciliation of the numerators and the denominators of the basic and dilutedper share computation are as follows (in thousands): 

 
|                             |   | **2001**                |    | **2000**                  |   | **1999**               |   |
|----------------------------------|--------|-------------------------|---------|---------------------------|--------|------------------------|--------|
|                             |   | **Income  (Numerator)** |    | **Shares  (Denominator)** |   | **Per  Share  Amount** |   | **Income  (Numerator)** |   | **Shares  (Denominator)** |   | **Per  Share  Amount** |   | **Income  (Numerator)** |   | **Shares  (Denominator)** |   | **Per  Share  Amount** |   |
| Basic EPS:                       |   |                    |    |                      |   |                   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income  (loss)               |   | $                       | (36,065 | )                         | 17,460 |                   | $      | (2.07 | ) | $ | (20,608 | ) | 15,070 |   | $ | (1.37 | ) | $ | 6,659 |   | 10,844 |   | $ | 0.61 |   |
|                             |   |                    |    |                      |   |                   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Effects of  dilutive securities: |   |                    |    |                      |   |                   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| stock   options                  |   | —                  |    | —                    |   |                   |   | — |   | — |   |   |   | — |   | 1,405 |   |   |   |
|                             |   |                    |    |                      |   |                   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Diluted EPS:                     |   |                    |    |                      |   |                   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income  (loss)               |   | $                       | (36,065 | )                         | 17,460 |                   | $      | (2.07 | ) | $ | (20,608 | ) | 15,070 |   | $ | (1.37 | ) | $ | 6,659 |   | 12,249 |   | $ | 0.54 |   |

 

Stock options anda warrant to purchase 3,648,000, 2,715,000 and 603,000 shares of common stockwere outstanding at December 31, 2001, 2000 and 1999 respectively, but were notincluded in the weighted average diluted earnings per share calculation as theywere antidilutive.

 

**NOTE 9 - INCOMETAXES:**

 

Thecomponents of income before income taxes are as follows: 

 
|    |   | **Year Ended  December 31,** |    |
|---------|--------|------------------------------|---------|
|    |   | **2001**                     |    | **2000** |   | **1999** |   |
|    |   | **(in  thousands)**          |    |
| U.S.    |   | $                            | (33,478 | ) | $ | (25,941 | ) | $ | 2,156 |   |
| Foreign |   | (1,322                       | )       | 7,303 |   | 5,678 |   |
|    |   | $                            | (34,800 | ) | $ | (18,638 | ) | $ | 7,834 |   |

 

Thecomponents of the provision for income taxes are as follows:

 
|          |   | **Year Ended  December 31,** |   |
|---------------|--------|------------------------------|--------|
|          |   | **2001**                     |   | **2000** |   | **1999** |   |
|          |   | **(in  thousands)**          |   |
| Current:      |   |                         |   |   |   |   |   |
| U.S.          |   | $                            | 927    |   | $ | 267 |   | $ | 50 |   |
| State         |   | 115                          |   | 827 |   | 454 |   |
| Foreign       |   | 223                          |   | 876 |   | 671 |   |
| Total current |   | 1,265                        |   | 1,970 |   | 1,175 |   |
| Deferred      |   | —                       |   | — |   | — |   |
| Total         |   | $                            | 1,265  |   | $ | 1,970 |   | $ | 1,175 |   |

 

59

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

 

***Tax provision difference***

 
|                                          |   | **Year Ended  December 31,** |    |
|-----------------------------------------------|--------|------------------------------|---------|
|                                          |   | **2001**                     |    | **2000** |   | **1999** |   |
|                                          |   | **(in  thousands)**          |    |
| Tax at U.S.  statutory rate                   |   | $                            | (11,832 | ) | $ | (6,337 | ) | $ | 2,663 |   |
| Utilization of  net operating loss carryovers |   | —                       |    | (2,075 | ) | (856 | ) |
| Foreign Earnings                              |   | (213                         | )       | (635 | ) | (1,612 | ) |
| State taxes net  of federal benefit           |   | 416                          |    | 443 |   | 302 |   |
| Other  differences not benefited              |   | 1,640                        |    | 433 |   | 513 |   |
| Permanent  differences                        |   | 16                           |    | (72 | ) | 85 |   |
| Alternative  minimum tax                      |   | 207                          |    | 122 |   | 50 |   |
| In-process  research and development          |   | —                       |    | 7,428 |   | — |   |
| Non-deductible  goodwill amortization         |   | 11,251                       |    | 2,663 |   | — |   |
| Other                                         |   | (221                         | )       | — |   | 30 |   |
|                                          |   | $                            | 1,264   |   | $ | 1,970 |   | $ | 1,175 |   |

 

Deferredincome tax assets comprise the following: 

 
|                                                |   | **Year Ended  December 31,** |   |
|-----------------------------------------------------|--------|------------------------------|--------|
|                                                |   | **2001**                     |   | **2000** |   | **1999** |   |
|                                                |   | **(in  thousands)**          |   |
| Deferred tax  assets                                |   |                         |   |   |   |   |   |
| Federal and state  net operating loss carryforwards |   | $                            | 16,865 |   | $ | 18,605 |   | $ | 16,417 |   |
| Capitalized  research and development expenses      |   | —                       |   | 543 |   | 497 |   |
| Nondeductible  reserves and accruals                |   | 2,154                        |   | 1,841 |   | 1,653 |   |
| Total deferred  tax assets                          |   | 19,019                       |   | 20,989 |   | 18,567 |   |
| Deferred tax  liabilities                           |   |                         |   |   |   |   |   |
| Intangible  assets                                  |   | (4,858                       | )      | (8,468 | ) | — |   |
| Total deferred  tax assets                          |   | (4,858                       | )      | (8,468 | ) | — |   |
| Net deferred tax  assets                            |   | 14,161                       |   | 12,521 |   | 18,567 |   |
| Valuation  allowance                                |   | (14,161                      | )      | (12,521 | ) | (18,567 | ) |
|                                                |   | $                            | — |   | $ | — |   | $ | — |   |

 

As of December31, 2001, the Company had NOLs of approximately $48.0 million for federal taxreporting purposes. The federal NOLs expire on various dates between 2002 and2020.  Management has recorded a fullvaluation allowance against all U.S. deferred tax assets on the basis thatsignificant uncertainty exists regarding the realizability of the assets.

 

Pursuantto the Tax Reform Act of 1986, the amounts of and the benefit from NOLs thatcan be carried forward may be impaired or limited in certain circumstances,including a cumulative stock ownership change of more than 50% over athree-year period.  The Company’s IPOresulted in a cumulative change of ownership of greater than 50%.

 

60

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Accordingly,the Company’s NOLs incurred prior to the completion of the IPO that can beutilized to reduce future taxable income for federal tax purposes will belimited to approximately $3.0 million per year.

 

TheCompany’s Israeli subsidiary has been granted the status of an “ApprovedEnterprise” pursuant to the Israeli law for the Encouragement of CapitalInvestments, 1959, as amended.  TheCompany 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 $635,000 in fiscal 2000 and $1.6 million in fiscal 1999, and anincrease in net income per share of $0.45 and $0.13 in 2000 and 1999 respectively.There was no impact for tax holidays in 2001.

 

**NOTE 10 - SEGMENT REPORTING:**

 

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

 

Sales to customerslocated in:

 
|          |   | **Year Ended  December 31,** |    |
|---------------|--------|------------------------------|---------|
|          |   | **2001**                     |    | **2000** |   | **1999** |   |
|          |   | **(in  thousands)**          |    |
| United States |   | $                            | 7,767   |   | $ | 14,735 |   | $ | 12,671 |   |
| Pacific Rim   |   | 90,137                       |    | 51,985 |   | 41,870 |   |
| Europe        |   | 9,805                        |    | 12,951 |   | 7,133 |   |
|          |   | $                            | 107,709 |   | $ | 79,671 |   | $ | 61,674 |   |

 
|                  |   | **December  31,**   |    |
|-----------------------|--------|---------------------|---------|
|                  |   | **2001**            |    | **2000** |   |
|                  |   | **(in  thousands)** |    |
| Identifiable  assets: |   |                |    |   |   |
| U.S.                  |   | $                   | 299,026 |   | $ | 276,563 |   |
| Israel                |   | 32,318              |    | 82,903 |   |
| Total                 |   | $                   | 331,344 |   | $ | 359,466 |   |

 

61

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Significant customers areas follows:

 
|                                                                                              |   | **Year Ended  December 31,** |   |
|---------------------------------------------------------------------------------------------------|--------|------------------------------|--------|
|                                                                                              |   | **2001**                     |   | **2000** |   | **1999** |   |
| Customers  comprising 10% or more of the Company’s total revenues for the period  indicated: |   |                         |   |   |   |   |   |
| A                                                                                                 |   | 29                           | %      | 25 | % | 37 | % |
| B                                                                                                 |   | 12                           | %      | — |   | — |   |

 

**NOTE 11– ACQUISITION AND DISPOSITION OF ASSETS:**

 

*SoftDVD Product Line:*InJune 1999, the Company sold to MGI Software of Canada the intellectual propertyrelated to its SoftDVD product line and transferred to MGI certain relatedsoftware development and support resources in exchange for cash, MGI commonstock and future royalties. The Company’s results for the second quarter of1999 include a $732,000 gain realized from this transaction which is reportedas part of interest and other income or expense. In connection with thistransaction, the Company also recorded a charge that reduced software,licensing and development revenue for the quarter by $517,000 for possibleissues related to receivables associated with the SoftDVD product line. The netimpact of the MGI transaction on the Company’s results was an after-tax gain of$172,000, or $0.01 per share on a diluted basis. This gain does not reflect thepotential future economic benefit that may be derived from this transaction andrealized in future periods in the form of royalties. The Company does notcurrently expect, however, that these royalties will have a material impact onquarterly revenues for the foreseeable future. In addition, the shares of MGIstock received by the Company as part of this transaction are subject to futureappreciation or depreciation. The Company’s software revenues have declinedsignificantly as a result of the sale of the SoftDVD product line.

 

*PixelCam:*On June 29, 2000, the Company acquired PixelCam, Inc. (“PixelCam”), amanufacturer of megapixel CMOS image sensors, in exchange for 370,832 shares ofZoran common stock and options to purchase 4,168 shares of Zoran common stockwith an aggregate value of $24.6 million. The common stock issued includes123,612 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 of acquisition.

 

62

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The acquisitionwas accounted for under the purchase method of accounting.  The Company had a valuation performed of thein-process research and development and the intangible assets acquired.  The allocation of the purchase price basedon independent appraisal and estimates of fair value and including acquisitioncosts of  $575,000, is as follows (inthousands):

 
| 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 forpurchased technology, covenant not to compete, acquired employees, patents andresidual goodwill, created as a result of the acquisition of PixelCam, isapproximately three 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 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.

 

63

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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 2,534,559 shares of Zoran common stock witha fair value of $154.4 million and options to purchase 168,472 shares of Zorancommon stock with a fair value of $9.2 million. The common stock issued wasvalued using the average of the market price per share of the Company’s commonstock on the date the proposed merger was announced and the three trading daysbefore and two trading days subsequent to the date of the announcement. Theoptions were valued using the Black-Scholes valuation mode. The results ofoperations of Nogatech are included in the Company’s financial statements fromthe date of acquisition.

 

The acquisitionwas accounted for under the purchase method of accounting.  The Company had a valuation performed of thein-process research and development and the intangible assets acquired.  The allocation of the purchase price basedon independent appraisal and estimates of fair value including acquisitioncosts 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.

 

64

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These projections were based on estimates of market size and growth,expected trends in technology, and the nature and expected timing of newproduct 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.

 

The Company has delayed thecompletion of the project due to uncertainty in the market concerningimplementation timing of this technology. Completion of this project remains asignificant risk to the Company due to the remaining effort to achievetechnical feasibility, rapidly changing customer markets and significantcompetitive threats from other companies. Failure to bring related products tomarket in a timely manner could adversely impact sales and profitability of theCompany in the future. Additionally, the value of the intangible assetsacquired may become impaired.

 

*Unaudited pro forma results*

 

The unaudited pro forma information below assumes that PixelCam andNogatech had been acquired at the beginning of each period presented andincludes the effect of amortization of goodwill and other identifiedintangibles from those dates. The impact of charges for in-process research anddevelopment has been excluded. This information is presented for informationalpurposes only and is not necessarily indicative of the results of futureoperations or results that would have been achieved had the acquisition takenplace at the beginning of any of the periods presented.

 
|                                     |   | **Twelve  Months Ended December 31,**         |    |
|------------------------------------------|--------|-----------------------------------------------|---------|
|                                     |   | **2000**                                      |    | **1999** |   |
|                                     |   | **(in  thousands, except per share amounts)** |    |
| Net revenues                             |   | $                                             | 88,136  |   | $ | 70,780 |   |
| Net loss                                 |   | $                                             | (43,666 | ) | $ | (40,713 | ) |
| Basic and  diluted loss per common share |   | $                                             | (2.43   | ) | $ | (2.97 | ) |

 

**NOTE 12- RELATED-PARTY TRANSACTIONS:**

 

In January 1996, the Company spun off its wholly-owned subsidiary, OrenSemiconductor, to the Company’s stockholders. Two of the Company’s directorsare also members of Oren’s board of directors. The Company has no ownershipinterest in Oren.

 

In March 1999, the Company entered into a technology license agreementwith Oren. Under the license arrangement Oren agreed to pay to the Companylicense and maintenance fees totaling $400,000 and royalties and maintenancefees

 

65

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based on related products sold by Oren. License fees of approximately$360,000 were recognized in the first quarter of 1999.

 

In April 1999, the Company loaned Oren $350,000. The loan plusinterest, computed at 7% per year, was repaid by Oren in July 1999. The Companyhas no commitments or plans to loan additional amounts to Oren.

 

66

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**ZORANCORPORATION**

**SELECTEDQUARTERLY FINANCIAL INFORMATION**

**(Unaudited)**

 
|                                                                                        |   | **Quarters  Ended**                        |   |
|---------------------------------------------------------------------------------------------|--------|--------------------------------------------|--------|
|                                                                                        |   | **Dec 31,  2001**                          |   | **Sept 30,  2001** |   | **June 30,  2001** |   | **March 31,  2001** |   | **Dec 31,  2000** |   | **Sept 30,  2000** |   | **June 30,  2000** |   | **March 31,  2000** |   |
|                                                                                        |   | **(in  thousands, except per share data)** |   |
| Revenues:                                                                                   |   |                                       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Product sales                                                                               |   | $                                          | 33,099 |   | $ | 28,976 |   | $ | 20,622 |   | $ | 17,315 |   | $ | 16,793 |   | $ | 20,378 |   | $ | 16,389 |   | $ | 14,222 |   |
| Software,  licensing and development                                                        |   | 2,669                                      |   | 1,448 |   | 1,302 |   | 2,278 |   | 2,361 |   | 3,636 |   | 2,472 |   | 3,420 |   |
| Total revenues                                                                              |   | 35,768                                     |   | 30,424 |   | 21,924 |   | 19,593 |   | 19,154 |   | 24,014 |   | 18,861 |   | 17,642 |   |
|                                                                                        |   |                                       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Cost and  expenses:                                                                         |   |                                       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Cost of product  sales                                                                      |   | 21,665                                     |   | 18,971 |   | 13,228 |   | 10,876 |   | 9,650 |   | 11,138 |   | 9,069 |   | 8,136 |   |
| Research and  development                                                                   |   | 6,110                                      |   | 5,210 |   | 5,922 |   | 5,968 |   | 6,112 |   | 5,271 |   | 3,976 |   | 3,269 |   |
| Selling, general  and administrative                                                        |   | 5,511                                      |   | 5,416 |   | 5,160 |   | 5,243 |   | 5,494 |   | 5,074 |   | 4,443 |   | 4,137 |   |
| Amortization of  goodwill and write-off of acquired in - process research & development |   | 10,808                                     |   | 10,808 |   | 10,809 |   | 10,808 |   | 23,497 |   | 1,503 |   | 6,769 |   | — |   |
| Total costs and  expenses                                                                   |   | 44,094                                     |   | 40,405 |   | 35,119 |   | 32,895 |   | 44,753 |   | 22,986 |   | 24,257 |   | 15,542 |   |
|                                                                                        |   |                                       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Operating income  (loss)                                                                    |   | (8,326                                     | )      | (9,981 | ) | (13,195 | ) | (13,302 | ) | (25,599 | ) | 1,028 |   | (5,396 | ) | 2,100 |   |
| Interest and  other income, net                                                             |   | 2,241                                      |   | 2,412 |   | 2,606 |   | 2,745 |   | 2,789 |   | 2,226 |   | 2,208 |   | 2,006 |   |
| Income (loss)  before taxes                                                                 |   | (6,085                                     | )      | (7,569 | ) | (10,589 | ) | (10,557 | ) | (22,810 | ) | 3,254 |   | (3,188 | ) | 4,106 |   |
| Provision for  income taxes                                                                 |   | 708                                        |   | 486 |   | 28 |   | 43 |   | 103 |   | 714 |   | 537 |   | 616 |   |
| Net income  (loss)                                                                          |   | $                                          | (6,793 | ) | $ | (8,055 | ) | $ | (10,617 | ) | $ | (10,600 | ) | $ | (22,913 | ) | $ | 2,540 |   | $ | (3,725 | ) | $ | 3,490 |   |
| Net income  (loss) per share:                                                               |   |                                       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                                                                       |   | $                                          | (0.38  | ) | $ | (0.46 | ) | $ | (0.62 | ) | $ | (0.61 | ) | $ | (1.35 | ) | $ | 0.17 |   | $ | (0.26 | ) | $ | 0.25 |   |
| Diluted                                                                                     |   | $                                          | (0.38  | ) | $ | (0.46 | ) | $ | (0.62 | ) | $ | (0.61 | ) | $ | (1.35 | ) | $ | 0.16 |   | $ | (0.26 | ) | $ | 0.23 |   |
| Shares used to  compute basic net income (loss) per share                                   |   | 17,689                                     |   | 17,502 |   | 17,263 |   | 17,314 |   | 16,950 |   | 14,564 |   | 14,113 |   | 13,988 |   |
| Shares used to  compute diluted net income (loss) per share                                 |   | 17,689                                     |   | 17,502 |   | 17,263 |   | 17,314 |   | 16,950 |   | 16,009 |   | 14,113 |   | 15,486 |   |

 

67

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

 

Not applicable.

 

68

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**PART III**

 

Certain informationrequired by Part III is omitted from this report in that the Company intends tofile its definitive proxy statement pursuant to Regulation 14A (the “ProxyStatement”) not later than 120 days after the end of the fiscal****yearcovered by this report and certain information therein is incorporated hereinby reference.

 

# **Item 10.        Directors and Executive Officers of theRegistrant.**

 

The informationrequired by this Item is incorporated by reference to information set forth inthe Proxy Statement under the heading “Proposal No. 1 — Election of Directors”and in Part I of this Report under the heading “Executive Officers of theRegistrant.”

 

The informationrequired by this Item with respect to compliance with Section 16(a) of theSecurities Exchange Act of 1934 is incorporated by reference to information setforth in the Proxy Statement under the heading “Section 16(a) BeneficialOwnership Reporting Compliance.”

 

# **Item 11.        Executive Compensation.**

 

The informationrequired by this Item is incorporated by reference to information set forth inthe Proxy Statement under the heading “Executive Compensation.”

 

# **Item 12.        Security Ownership of Certain BeneficialOwners and Management.**

 

The informationrequired by this Item is incorporated by reference to information set forth inthe Proxy Statement under the heading “Principal Stockholders and ShareOwnership by Management.”

 

# **Item 13.        Certain Relationships and RelatedTransactions.**

 

The informationrequired by this Item is incorporated by reference to information set forth inthe Proxy Statement under the heading “Certain Transactions.”

 

69

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**PART IV**

# ** **

# **Item 14.        Exhibits, Financial Statement Schedulesand Reports 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 41of 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, 2001: |                                                                                                                                                                                                                                    |
|   |                                                             |                                                                                                                                                                                                                                    |   |
|   |                                                             | None                                                                                                                                                                                                                                    |   |

 

70

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**SIGNATURES**

 

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, theregistrant has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.

 
| Dated:  April 1, 2002 | ZORAN CORPORATION |
|----------------------------|-------------------|
|                       |              |   |
|                       |              |   |
|                       | By:               | /s/ Levy  Gerzberg |
|                       |              | Levy Gerzberg,  President and   Chief Executive Officer |

 

Pursuant to therequirements of the Security Exchange Act of 1934, this report has been signedby the following persons on behalf of the registrant and in the capacities andon the dates indicated.

 
| **Signature**          |   | **Title**                                           |   | **Date**      |
|------------------------|--------|-----------------------------------------------------|--------|---------------|
|                   |   |                                                |   |          |
| /s/ Levy Gerzberg      |   | President, Chief Executive Officer and Director     |   | April 1, 2002 |
| Levy Gerzberg          |   | (Principal Executive Officer)                       |   |          |
|                   |   |                                                |   |          |
| /s/ Karl Schneider     |   | Vice President, Finance and Chief Financial Officer |   | April 1, 2002 |
| Karl Schneider         |   | (Principal Financial and Accounting Officer)        |   |          |
|                   |   |                                                |   |          |
| /s/ Uzia Galil         |   | Chairman of the Board of Directors                  |   | April 1, 2002 |
| Uzia Galil             |   |                                                |   |          |
|                   |   |                                                |   |          |
| /s/ James D. Meindl    |   | Director                                            |   | April 1, 2002 |
| James D. Meindl        |   |                                                |   |          |
|                   |   |                                                |   |          |
| /s/ Arthur B. Stabenow |   | Director                                            |   | April 1, 2002 |
| Arthur B. Stabenow     |   |                                                |   |          |
|                   |   |                                                |   |          |
| /s/ Philip M. Young    |   | Director                                            |   | April 1, 2002 |
| Philip M. Young        |   |                                                |   |          |

 

71

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EXHIBIT INDEX

Exhibit Title

 
| Exhibit  Number |   |                                                                                                                                                                                                                                                                                                                           |
|-----------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1(11)         |   | Form of Restated Certificate of Incorporation of the  Registrant.                                                                                                                                                                                                                                                              |
|            |   |                                                                                                                                                                                                                                                                                                                           |
| 3.2(1)          |   | Amended Bylaws of the Registrant.                                                                                                                                                                                                                                                                                              |
|            |   |                                                                                                                                                                                                                                                                                                                           |
| 4.1(2)          |   | Amended and Restated Stock Rights Agreement dated  July 30, 1993 among the Registrant and certain of its stockholders, as  amended.                                                                                                                                                                                            |
|            |   |                                                                                                                                                                                                                                                                                                                           |
| *10.1(11)       |   | 1993 Stock Option Plan, as amended.                                                                                                                                                                                                                                                                                            |
|            |   |                                                                                                                                                                                                                                                                                                                           |
| *10.2(9)        |   | 1995 Outside Directors Stock Option Plan.                                                                                                                                                                                                                                                                                      |
|            |   |                                                                                                                                                                                                                                                                                                                           |
| *10.3(12)       |   | Amended and Restated 1995 Employee Stock Purchase  Plan.                                                                                                                                                                                                                                                                       |
|            |   |                                                                                                                                                                                                                                                                                                                           |
| *10.4(2)        |   | Form of Indemnity Agreement for officers and  directors.                                                                                                                                                                                                                                                                       |
|            |   |                                                                                                                                                                                                                                                                                                                           |
| †10.5(2)   |   | Agreement dated June 28, 1991 between the Registrant  and Fujifilm Microdevices Co., Ltd. (“Fujifilm”), as amended.                                                                                                                                                                                                  |
|            |   |                                                                                                                                                                                                                                                                                                                           |
| †10.6(2)   |   | Agreement dated July 27, 1992 between the Registrant  and Fujifilm.                                                                                                                                                                                                                                                            |
|            |   |                                                                                                                                                                                                                                                                                                                           |
| 10.7(2)         |   | Letter Agreement dated December 16, 1991 between the  Registrant and Dolby Laboratories Licensing Corporation, as amended.                                                                                                                                                                                                     |
|            |   |                                                                                                                                                                                                                                                                                                                           |
| 10.11(2)        |   | 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(2)  |   | License Agreement for ZR33891 Digital Filter  Processor dated June 8, 1995 between the Registrant and Atmel Corporation  (“Atmel”).                                                                                                                                                                                  |
|            |   |                                                                                                                                                                                                                                                                                                                           |
| †10.13(2)  |   | License Agreement for ZR34325 Vector Signal  Processor dated June 8, 1995 between the Registrant and Atmel.                                                                                                                                                                                                                    |
|            |   |                                                                                                                                                                                                                                                                                                                           |
| †10.14(2)  |   | 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(2)  |   | Cooperation and Project Funding Agreement dated June  9, 1992 between ZML and BIRDF.                                                                                                                                                                                                                                           |
|            |   |                                                                                                                                                                                                                                                                                                                           |
| 10.16(2)        |   | 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(2)        |   | 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(2)        |   | 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.                                                                                                                                                                         |

 

72

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| 10.29(4)  |   | Summary of Discussion dated April 23, 1996 between  ZML and Matam regarding Lease Agreement dated October 1, 1992 between ZML and  Matam.                   |
|-----------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------|
|      |   |                                                                                                                                                        |
| 10.30(5)  |   | 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(6)  |   | Sub-Sublease dated April 1, 1997 between the  Registrant and Integrated Silicon Solutions, Inc.                                                        |
|      |   |                                                                                                                                                        |
| *10.34(7) |   | Confidential Separation Agreement dated  August 4, 1997 between the Registrant and George T. Haber.                                                    |
|      |   |                                                                                                                                                        |
| 10.35(8)  |   | Agreement for Purchase and Sale of Assets between  the Registrant and MGI Software Corp. dated June 15, 1999                                                |
|      |   |                                                                                                                                                        |
| 10.36(10) |   | 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(11) |   | Addendum to sub-sublease dated April 1, 1997 between  the Registrant Integrated Silicon Solution, Inc.                                                      |
|      |   |                                                                                                                                                        |
| 10.38(12) |   | Form of Amendment of Nonstatutory Stock Option  Agreement for Outside Directors.                                                                            |
|      |   |                                                                                                                                                        |
| 21.1      |   | List of subsidiaries of the Registrant.                                                                                                                     |
|      |   |                                                                                                                                                        |
| 23.1      |   | Consent of PricewaterhouseCoopers LLP.                                                                                                                      |

 

----

| *      |   | 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 Exhibit 3.3 to  Registrant’s Form 10-Q Quarterly Report for the quarter ended September 30,  1998.                                       |
|   |   |                                                                                                                                                                       |
| (2)    |   | Incorporated by reference to identically numbered  exhibit to the 1995 Registration Statement.                                                                             |
|   |   |                                                                                                                                                                       |
| (3)    |   | Incorporated by reference to identically numbered  exhibit to Registrant’s Form 10-K Annual Report for the year ended December  31, 1995.                             |
|   |   |                                                                                                                                                                       |
| (4)    |   | 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”). |
|   |   |                                                                                                                                                                       |
| (5)    |   | Incorporated by reference to Exhibit 10.2 to the  June 1996 Form 10-Q.                                                                                                     |
|   |   |                                                                                                                                                                       |
| (6)    |   | Incorporated by reference to identically numbered  exhibit to Registrant’s Form 10-Q Quarterly Report for the quarter ended  March 31, 1997.                     |
|   |   |                                                                                                                                                                       |
| (7)    |   | Incorporated by reference to Exhibit 10.34 to  Registrant’s Form 10-K Annual Report for the year ended December 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.                           |

 

73

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| (9)    |   | Incorporated by reference to identically numbered  exhibit to Registrant’s Form 10-Q Quarterly Report for the quarter ended September  30, 2000. |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                  |
| (10)   |   | Incorporated by reference to identically numbered  exhibit to Registrant’s Form 10-K Annual Report for the year ended December  31, 1999.        |
|   |   |                                                                                                                                                  |
| (11)   |   | Incorporated by reference to identically numbered  exhibit to Registrant’s Form 10-K Annual Report for the year ended December  31, 2000         |
|   |   |                                                                                                                                                  |
| (12)   |   | Incorporated by reference to identically numbered  exhibit to Registrant’s Form 10-Q Quarterly Report for the quarter ended June  30, 2001.      |

 

74

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