**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

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###### **FORM10-Q**

###### ** **

**(MarkOne)**

 
| **ý** | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF  1934**                                                                                                                                                                                                                                                           |
|------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** | ** ** | **For the Quarterly Period Ended April 2, 2006**                                                                                                                                                                                                                                                                                                        |
| ** ** | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                   |
| **OR**     |
| ** ** | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                   |
| **o**      | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                                                                                           |
| ** ** | ** ** | **For the Transition Period From                          To                          ** |
| ** ** | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                   |

 

**COMMISSION FILE NUMBER: 000-22671**

 

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**QUICKLOGICCORPORATION**

(Exact name of registrant as specified in itscharter)

 

| **DELAWARE**                    | ** ** | **77-0188504**                        |
|---------------------------------|------------|---------------------------------------|
| (State or other jurisdiction of |       | (I.R.S. Employer Identification  No.) |
| incorporation or organization)  |       |                                  |

 

**1277 ORLEANS DRIVE SUNNYVALE, CA  94089**

(Address of principal executive offices, includingZip Code)

 

**(408) 990-4000**

(Registrant’s telephone number, includingarea code)

 

Indicate bycheck mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 duringthe preceding 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to suchrequirements for the past 90 days. Yes ý  No o

 

Indicate bycheck mark whether the registrant is a large accelerated filer, an acceleratedfiler, or a non-accelerated filer. See definition of “accelerated filer andlarge accelerated filer” in Rule 12b-2 of the Exchange Act.

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

 

Indicate bycheck mark whether the registrant is a shell company (as defined in Rule 12b-2of the Securities Exchange Act of 1934). Yes oNo ý

 

As of May 8,2006, 28,458,366 shares of the registrant’s common stock were outstanding.

 

 

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**QUICKLOGIC CORPORATION**

**FORM 10-Q**

**MARCH 31, 2006**

 
| ** **                                                                                                                           | ** ** | **Page**   |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|------------|
|                                                                                                                                 |       |       |
| Part I. Financial Information                                                                                                        |       | 3          |
| ** **                                                                                                                           | ** ** | ** ** |
| **Item 1. Financial Statements**                                                                                                     |       | 3          |
| Condensed Unaudited  Consolidated Statements of Operations for the three months ended  March 31, 2006 and 2005                  |       | 3          |
| Condensed Unaudited  Consolidated Balance Sheets as of March 31, 2006 and December 31,  2005                               |       | 4          |
| Condensed Unaudited  Consolidated Statements of Cash Flows for the three months ended  March 31, 2006 and 2005                  |       | 5          |
| Condensed Unaudited  Consolidated Statements of Comprehensive Income (Loss) for the three months  ended March 31, 2006 and 2005 |       | 6          |
| Notes to Condensed  Unaudited Consolidated Financial Statements                                                                      |       | 7          |
|                                                                                                                                 |       |       |
| **Item 2. Management’s Discussion and Analysis of Financial  Condition and Results of Operations**                              |       | 22         |
| ** **                                                                                                                           | ** ** | ** ** |
| **Item 3. Quantitative and Qualitative Disclosures about  Market Risk**                                                              |       | 32         |
| ** **                                                                                                                           | ** ** | ** ** |
| **Item 4. Controls and Procedures**                                                                                                  |       | 32         |
|                                                                                                                                 |       |       |
| Part II. Other Information                                                                                                           |       | 34         |
| ** **                                                                                                                           | ** ** | ** ** |
| **Item 1. Legal Proceedings**                                                                                                        |       | 34         |
| ** **                                                                                                                           | ** ** | ** ** |
| **Item 1A. Risk Factors**                                                                                                            |       | 34         |
| ** **                                                                                                                           | ** ** | ** ** |
| **Item 6. Exhibits**                                                                                                                 |       | 45         |
| ** **                                                                                                                           | ** ** | ** ** |
| Signatures                                                                                                                           |       | 46         |

 

2

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**PART I. Financial Information**

 

**Item 1. Financial Statements**

 

**QUICKLOGIC CORPORATION**

**CONDENSED UNAUDITED CONSOLIDATED STATEMENTSOF OPERATIONS**

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

 
| ** **                          | ** ** | **Three Months Ended  March 31,** | ** ** |
|-------------------------------------|------------|----------------------------------------|------------|
| ** **                          | ** ** | **2006**                               | ** ** | **2005** | ** ** |
|                                |       |                                   |       |   |   |
| Revenue                             |       | $                                      | 9,333      |   | $ | 12,527 |   |
| Cost of  revenue                    |       | 3,760                                  |       | 4,888 |   |
| Gross profit                        |       | 5,573                                  |       | 7,639 |   |
| Operating  expenses:                |       |                                   |       |   |   |
| Research and development            |       | 2,400                                  |       | 2,454 |   |
| Selling, general and administrative |       | 4,617                                  |       | 4,298 |   |
| Income  (loss) from operations      |       | (1,444                                 | )          | 887 |   |
| Interest  expense                   |       | (74                                    | )          | (53 | ) |
| Interest  income and other, net     |       | 292                                    |       | 80 |   |
| Income  (loss) before income taxes  |       | (1,226                                 | )          | 914 |   |
| Provision for  income taxes         |       | 2                                      |       | 50 |   |
| Net income  (loss)                  |       | $                                      | (1,228     | ) | $ | 864 |   |
|                                |       |                                   |       |   |   |
| Net income  (loss) per share:       |       |                                   |       |   |   |
| Basic                               |       | $                                      | (0.04      | ) | $ | 0.03 |   |
| Diluted                             |       | $                                      | (0.04      | ) | $ | 0.03 |   |
|                                |       |                                   |       |   |   |
| Weighted  average shares:           |       |                                   |       |   |   |
| Basic                               |       | 28,059                                 |       | 26,385 |   |
| Diluted                             |       | 28,059                                 |       | 27,413 |   |

 

See accompanying Notes to Condensed Unaudited Consolidated FinancialStatements.

 

3

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**QUICKLOGIC CORPORATION**

**CONDENSED UNAUDITED CONSOLIDATED BALANCESHEETS**

**(In thousands, except par value amount)**

 
| ** **                                                                                                                 | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                 |       |                     |       |                        |       |
|                                                                                                                       |       |                     |       |                        |       |
| Current assets:                                                                                                            |       |                     |       |                        |       |
| Cash and cash equivalents                                                                                                  |       | $                        | 30,186     |                        | $          | 28,283 |   |
| Short-term investment in Tower  Semiconductor Ltd.                                                                         |       | 1,145                    |       | 1,297                       |       |
| Accounts receivable, net of allowances for  doubtful accounts of $1,042 and $1,042, respectively                           |       | 4,114                    |       | 5,556                       |       |
| Inventory                                                                                                                  |       | 7,607                    |       | 7,830                       |       |
| Other current assets                                                                                                       |       | 1,369                    |       | 1,265                       |       |
| Total current assets                                                                                                       |       | 44,421                   |       | 44,231                      |       |
| Property and equipment, net                                                                                                |       | 6,353                    |       | 5,697                       |       |
| Investment in Tower Semiconductor Ltd.                                                                                     |       | 576                      |       | 653                         |       |
| Other assets                                                                                                               |       | 4,461                    |       | 4,415                       |       |
| TOTAL ASSETS                                                                                                               |       | $                        | 55,811     |                        | $          | 54,996 |   |
|                                                                                                                       |       |                     |       |                        |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                             |       |                     |       |                        |       |
|                                                                                                                       |       |                     |       |                        |       |
| Current liabilities:                                                                                                       |       |                     |       |                        |       |
| Trade payables                                                                                                             |       | $                        | 3,306      |                        | $          | 3,338 |   |
| Accrued liabilities                                                                                                        |       | 2,843                    |       | 3,434                       |       |
| Deferred income on shipments to  distributors                                                                              |       | 1,848                    |       | 1,626                       |       |
| Current portion of debt and capital lease  obligations                                                                     |       | 2,157                    |       | 1,790                       |       |
| Total current liabilities                                                                                                  |       | 10,154                   |       | 10,188                      |       |
|                                                                                                                       |       |                     |       |                        |       |
| Long-term liabilities:                                                                                                     |       |                     |       |                        |       |
| Debt and capital lease obligations, less  current portion                                                                  |       | 1,859                    |       | 1,163                       |       |
| Deferred royalty revenue                                                                                                   |       | 1,502                    |       | 1,408                       |       |
| Total long-term liabilities                                                                                                |       | 3,361                    |       | 2,571                       |       |
| Total liabilities                                                                                                          |       | 13,515                   |       | 12,759                      |       |
|                                                                                                                       |       |                     |       |                        |       |
| Commitments and contingencies (see Notes 14  and 15)                                                                       |       |                     |       |                        |       |
|                                                                                                                       |       |                     |       |                        |       |
| Stockholders’ equity:                                                                                                 |       |                     |       |                        |       |
| Common stock, $0.001 par value; 100,000  shares authorized; 28,281 and 27,896 shares issued and outstanding,  respectively |       | 28                       |       | 28                          |       |
| Additional paid-in capital                                                                                                 |       | 160,695                  |       | 159,179                     |       |
| Accumulated other comprehensive income                                                                                     |       | 148                      |       | 377                         |       |
| Accumulated deficit                                                                                                        |       | (118,575                 | )          | (117,347                    | )          |
| Total stockholders’ equity                                                                                            |       | 42,296                   |       | 42,237                      |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                            |       | $                        | 55,811     |                        | $          | 54,996 |   |

 

See accompanying Notes to Condensed Unaudited Consolidated FinancialStatements.

 

4

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**QUICKLOGIC CORPORATION**

**CONDENSED UNAUDITED CONSOLIDATED STATEMENTSOF CASH FLOWS**

**(In thousands)**

 
| ** **                                                                                | ** ** | **Three Months Ended  March 31,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                | ** ** | **2006**                               | ** ** | **2005** | ** ** |
| ** **                                                                                | ** ** | ** **                             | ** ** | ** ** | ** ** |
| Cash flows from operating activities:                                                     |       |                                   |       |   |   |
| Net income (loss)                                                                         |       | $                                      | (1,228     | ) | $ | 864 |   |
| Adjustments to reconcile net income (loss)  to net cash provided by operating activities: |       |                                   |       |   |   |
| Depreciation and amortization                                                             |       | 686                                    |       | 665 |   |
| Stock-based compensation                                                                  |       | 452                                    |       | — |   |
| Loss on disposal of property and equipment                                                |       | —                                 |       | 7 |   |
| Utilization of wafer credits from Tower  Semiconductor Ltd.                               |       | 25                                     |       | 94 |   |
| Inventory write-down                                                                      |       | 232                                    |       | 205 |   |
| Changes in assets and liabilities:                                                        |       |                                   |       |   |   |
| Accounts receivable, net of allowances for  doubtful accounts                             |       | 1,442                                  |       | (1,073 | ) |
| Inventory                                                                                 |       | (9                                     | )          | (940 | ) |
| Other assets                                                                              |       | (17                                    | )          | 256 |   |
| Trade payables                                                                            |       | (32                                    | )          | 260 |   |
| Accrued liabilities                                                                       |       | (591                                   | )          | 23 |   |
| Deferred income and royalty revenue                                                       |       | 316                                    |       | 221 |   |
| Net cash provided by operating activities                                                 |       | 1,276                                  |       | 582 |   |
|                                                                                      |       |                                   |       |   |   |
| Cash flows from investing activities:                                                     |       |                                   |       |   |   |
| Capital expenditures for property and  equipment                                          |       | (709                                   | )          | (407 | ) |
| Net cash used for investing activities                                                    |       | (709                                   | )          | (407 | ) |
|                                                                                      |       |                                   |       |   |   |
| Cash flows from financing activities:                                                     |       |                                   |       |   |   |
| Payment of debt and capital lease  obligations                                            |       | (660                                   | )          | (772 | ) |
| Proceeds from debt obligations                                                            |       | 932                                    |       | — |   |
| Proceeds from issuance of common stock                                                    |       | 1,064                                  |       | 281 |   |
| Net cash provided by (used for) financing  activities                                     |       | 1,336                                  |       | (491 | ) |
|                                                                                      |       |                                   |       |   |   |
| Net increase (decrease) in cash and cash  equivalents                                     |       | 1,903                                  |       | (316 | ) |
| Cash and cash equivalents at beginning of  period                                         |       | 28,283                                 |       | 24,914 |   |
| Cash and cash equivalents at end of period                                                |       | $                                      | 30,186     |   | $ | 24,598 |   |
|                                                                                      |       |                                   |       |   |   |
| Supplemental disclosures of cash flow  information:                                       |       |                                   |       |   |   |
| Interest paid                                                                             |       | $                                      | 58         |   | $ | 63 |   |
| Income taxes paid                                                                         |       | $                                      | 13         |   | $ | 16 |   |
| Supplemental schedule of non-cash  investing and financing activities:               |       |                                   |       |   |   |
| Capital lease obligation to finance capital  expenditures and related maintenance         |       | $                                      | 791        |   | $ | — |   |

 

See accompanying Notes to Condensed Unaudited Consolidated FinancialStatements.

 

5

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**QUICKLOGIC CORPORATION**

**CONDENSED UNAUDITED CONSOLIDATED STATEMENTSOF COMPREHENSIVE INCOME (LOSS)**

**(In thousands)**

 
| ** **                             | ** ** | **Three Months Ended  March 31,** | ** ** |
|----------------------------------------|------------|----------------------------------------|------------|
| ** **                             | ** ** | **2006**                               | ** ** | **2005** | ** ** |
| Net income  (loss)                     |       | $                                      | (1,228     | ) | $ | 864 |   |
| Other  comprehensive gain, net of tax: |       |                                   |       |   |   |
| Unrealized loss on investments         |       | (229                                   | )          | (592 | ) |
| Total  comprehensive income (loss)     |       | $                                      | (1,457     | ) | $ | 272 |   |

 

See accompanying Notes to Condensed Unaudited Consolidated FinancialStatements.

 

6

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**QUICKLOGIC CORPORATION**

**NOTES TO CONDENSED UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

 

**Note1—The Company and Basis of Presentation**

 

QuickLogicCorporation (“QuickLogic” or the “Company”), founded in 1988, is a Delawarecorporation. The Company operates in a single reportable industry segment whereit designs, develops, markets and supports advanced field programmable gatearrays (“FPGAs”), Embedded Standard Products (“ESPs”), associated softwaretools and programming hardware.

 

Theaccompanying interim financial statements are unaudited. In the opinion ofmanagement, these statements have been prepared in accordance with generallyaccepted accounting principles and include all adjustments, consisting only ofnormal recurring adjustments, necessary to provide a fair statement of resultsfor the interim periods presented. The Company recommends that these financialstatements be read in conjunction with the Company’s Form 10-K for theyear ended December 31, 2005. Operating results for the three months endedMarch 31, 2006 are not necessarily indicative of the results that may beexpected for the full year.

 

QuickLogic’s fiscal yearends on the Sunday closest to December 31.  QuickLogic’s fiscal firstquarters for 2006 and 2005 ended Sunday, April 2, 2006 and April 3,2005, respectively. For presentation purposes, the financial statementsand notes have been presented as ending on the last day of the nearest calendarmonth.

 

*Liquidity*

* *

The Companyanticipates that its existing cash resources will fund operations, financepurchases of capital equipment and provide adequate working capital for thenext twelve months. The Company’s liquidity is affected by many factorsincluding, among others, the level of revenue and gross profit, marketacceptance of existing and new products including EclipseTMII, QuickPCI®II andPolarProTM devices, the expected decline in pASIC® 1 and pASIC 2 revenueresulting from the end-of-life of these products, costs of securing access toand availability of adequate manufacturing capacity, inventory levels, waferpurchase commitments, customer credit terms, the amount and timing of researchand development expenditures, the timing of new product introductions,production volumes, product quality, sales and marketing efforts, the amountand financing arrangements for purchases of capital equipment, changes inoperating assets and liabilities, the ability to obtain or renew debt financingand to remain in compliance with the terms of credit facilities, the ability toraise funds from the sale of shares of Tower Semiconductor Ltd. (“Tower”) andequity in the Company, the issuance and exercise of stock options, the terms ofand participation in the Company’s employee stock purchase plan, and otherfactors related to the uncertainties of the industry and global economics.Accordingly, there can be no assurance that events in the future will notrequire the Company to seek additional capital or, if so required, that suchcapital will be available on terms acceptable to the Company.

 

*Principles of Consolidation*

 

The consolidatedfinancial statements include the accounts of QuickLogic Corporation and itswholly owned subsidiaries, QuickLogic International, Inc., QuickLogicCanada Company, QuickLogic Kabushiki Kaisha, QuickLogic Software (India)Private Ltd., and QuickLogic GmbH. The Company uses the U.S. dollar as itsfunctional currency. All significant intercompany accounts and transactions areeliminated in consolidation.

 

*Uses of Estimates*

 

Thepreparation of these financial statements in conformity with generally acceptedaccounting principles requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities, the disclosures ofcontingent assets and liabilities, and the reported amounts of revenue andexpenses during the period. Actual results could differ from those estimates,particularly in relation to revenue recognition, the allowance for doubtfulaccounts, sales returns, valuation of investments, valuation of long-livedassets, inventory valuation including identification of excess quantities andobsolescence, measurement of stock-based compensation awards, accounting forincome taxes and estimating accrued liabilities.

 

7

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**QUICKLOGIC CORPORATION**

**NOTES TO CONDENSED UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS –(Continued)**

 

**Note 2—SignificantAccounting Policies**

 

*Revenue Recognition*

 

The Companysupplies standard products which must be programmed before they can be used inan application. The Company’s products may be programmed by the Company,distributors, end customers or third parties. Once programmed, the Company’sparts cannot be erased and, therefore, programmed parts are only useful to aspecific customer.

 

The Companygenerally recognizes revenue as products are shipped if evidence of anarrangement exists, delivery has occurred, the sales price is fixed ordeterminable, collection of the resulting receivable is reasonably assured, andproduct returns are reasonably estimable.

 

Revenue isrecognized upon shipment of both programmed and unprogrammed parts to originalequipment manufacturer (“OEM”) customers, provided that legal title and risk ofownership have transferred.

 

The Companyalso sells to distributors under agreements that allow for price adjustmentsand, in the case of unprogrammed parts, certain rights of return on unsoldinventory.

 

Becauseprogrammed parts can only be used by a specific customer, it is the Company’spractice to agree upon any price adjustments with a distributor prior toshipment. Furthermore, distributors are not allowed any future priceadjustments and have no rights of return on programmed parts. Accordingly,revenue is recognized upon delivery to a distributor since title and risk ofownership have transferred to the distributor, the price is fixed, no right ofreturn exists, and collection of the resulting receivable is reasonablyassured.

 

Unprogrammedparts shipped to distributors may be used by multiple end customers anddistributors may have certain return and price adjustment privileges on unsoldinventory. Accordingly, revenue associated with unprogrammed parts is deferreduntil resale to the end customer.

 

Softwarerevenue from sales of design tools is recognized when persuasive evidence of anagreement exists, delivery of the software has occurred, no significant Companyobligations with regard to implementation or integration remain, the fee isfixed or determinable and collection is reasonably assured. Software revenueamounted to less than one percent of the Company’s revenue for the three monthsended March 31, 2006 and 2005.

 

*Long-lived Assets*

 

The Companyreviews the recoverability of its long-lived assets, such as property andequipment, prepaid wafer credits and investments, annually and when events orchanges in circumstances occur that indicate that the carrying value of theasset or asset group may not be recoverable. The assessment of possibleimpairment is based on the Company’s ability to recover the carrying value ofthe asset or asset group from the expected future pretax cash flows,undiscounted and without interest charges, of the related operations. If thesecash flows are less than the carrying value of the asset or asset group, animpairment loss is recognized for the difference between estimated fair valueand carrying value, and the carrying value of the related assets is reduced bythis difference. The measurement of impairment requires management to estimatefuture cash flows and the fair value of long-lived assets.

 

*Comprehensive Income (Loss)*

 

Comprehensiveincome (loss) includes all changes in equity (net assets) during a period fromnon-owner sources. Comprehensive income (loss) for the Company has includedrealized and unrealized holding gains or losses on our holdings of Towerordinary shares. See Note 4.

 

*Stock-Based Compensation*

 

EffectiveJanuary 2, 2006, the Company adopted the provisions of Statement ofFinancial Accounting Standards (“SFAS”) No. 123 (revised 2004), *“Share-Based Payment,”* (“SFAS No.123(R)”) which requires the measurement and recognition of expense related tothe fair value of stock-based compensation awards. Accordingly, stock-basedcompensation is measured at the grant date, based on the fair value of theaward using the Black-Scholes option pricing model (“Black-Scholes”), and is recognizedas expense over the requisite service period of the award. Black-Scholesrequires the use of highly subjective, complex assumptions, including expectedterm and the price volatility of the Company’s stock. The Company elected touse the modified prospective transition method upon implementation and,therefore, has not restated its financial results for prior periods. TheCompany previously applied Accounting Principles Board (“APB”) OpinionNo. 25, *“Accounting for Stock Issued toEmployees”*

 

8

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**QUICKLOGIC CORPORATION**

**NOTES TO CONDENSED UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS –(Continued)**

 

(“APB 25”) and relatedinterpretations and provided the required pro forma disclosures of SFAS No.123, *“Accounting for Stock-BasedCompensation”* (“SFAS No. 123”). In March 2005, the SECissued Staff Accounting Bulletin No. 107 (“SAB 107”) relating to SFASNo. 123(R). The Company has applied the provisions of SAB 107 in itsadoption of SFAS No. 123(R). See Note 9.

 

*Foreign Currency Transactions*

 

All of theCompany’s sales and cost of manufacturing are transacted in U.S. dollars. TheCompany conducts a portion of its research and development activities in Canadaand India and has sales and marketing activities in various countries outsideof the United States. Most of these international expenses are incurred inlocal currency. Foreign currency transaction gains and losses are included ininterest income and other, net, as they occur. The effect of foreign currency exchangerate fluctuations has not been significant to date. Operating expensesdenominated in foreign currencies were approximately 23% and 26% of totaloperating expenses for the three months ended March 31, 2006 and 2005,respectively. The Company incurred a majority of these foreign currencyexpenses in Canada. The Company has not used derivative financial instrumentsto hedge its exposure to fluctuations in foreign currency.

 

*Concentration of Credit Risk*

 

Financialinstruments, which potentially subject the Company to concentrations of creditrisk, consist principally of cash and cash equivalents and accounts receivable.Cash and cash equivalents are maintained with high quality institutions. TheCompany’s accounts receivable are denominated in U.S. dollars and are derivedprimarily from sales to customers located in North America, Europe, and Asia.The Company performs ongoing credit evaluations of its customers and generallydoes not require collateral.

 

Onedistributor of the Company’s products accounted for 42% of the Company’saccounts receivable balance at March 31, 2006. Two distributors of theCompany’s products accounted for 25% and 13%, respectively, of the Company’saccounts receivable balance at December 31, 2005. One original equipment manufacturer(“OEM”) customer accounted for 18% of the Company’s accounts receivable balanceat December 31, 2005.

 

*Warranty Costs*

 

The Companygenerally warrants finished goods against defects in material and workmanshipunder normal use for twelve months from the date of shipment. The Companydoes not have significant product warranty related costs or liabilities. Theone-time-programmable nature of QuickLogic’s products minimizes warranty costs.

 

***Recently Issued Accounting Pronouncements***

** **

OnDecember 16, 2004, the Financial Accounting Standards Board, or FASB,issued Statement of Financial Accounting Standards No. 123(R), *“Share-Based Payment,”* which is a revisionof SFAS No. 123 and supersedes APB 25. SFAS No. 123(R) requires all share-based payments (“SBPs”)to employees, including grants of employee stock options, to be valued at fairvalue on the date of grant, and to be expensed over the requisite serviceperiod. Under SFAS No. 123(R), pro forma disclosure of the incomestatement effects of share-based payments is no longer an alternative. SFASNo. 123(R), as amended, is effective for all stock-based awardsgranted in fiscal years beginning after June 15, 2005. In addition, companiesmust also recognize compensation expense related to any awards that are notfully vested as of the effective date. Compensation expense for the unvestedawards will be measured based on the fair value of the awards previouslycalculated in developing the pro forma disclosures in accordance with theprovisions of SFAS No. 123. Effective January 2, 2006, the first dayof fiscal 2006, the Company adopted SFAS 123(R) on a modified prospectivebasis. As a result, the Company began to include stock-based compensationcharges in its results of operations beginning in the quarter ended March 31,2006. See Note 9.

 

In November2005, the FASB issued Staff Position (“FSP”) FAS123(R)-3, *“Transition Election to Accounting for the TaxEffects of Share-Based Payment Awards.”* This FSP requires an entityto follow either the transition guidance for the additional-paid-in-capitalpool as prescribed in SFAS No. 123(R), or the alternative transitionmethod as described in the FSP. An entity that adopts SFAS No. 123(R)using the modified prospective application may make a one-time election toadopt the transition method described in this FSP. An entity may take up to oneyear from the later of its initial adoption of SFAS No. 123(R) or theeffective date of this FSP to evaluate its available transition alternativesand make its one-time election. The Company continues to evaluate the impact thatthe adoption of this FSP could have on its consolidated financial statements.

 

9

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**QUICKLOGIC CORPORATION**

**NOTES TO CONDENSED UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS –(Continued)**

 

OnMarch 29, 2005, the SEC issued Staff Accounting Bulletin (“SAB”)No. 107, which provides guidance on the interaction between SFAS No.123(R), *“Shared-Based Payment,”*and certain SEC rules and regulations. SAB No. 107 provides guidance that may simplify some of the SFASNo. 123(R) implementation challenges and enhances the information thatinvestors receive. Effective January 2, 2006, the first day of fiscal2006, the Company adopted SFAS 123(R) on a modified prospective basis and appliedthe principles of SAB No. 107 in conjunction with the adoption of SFASNo. 123(R).

 

In February2006, the FASB issued SFAS No. 155, *“Accountingfor Certain Hybrid Instruments—An Amendment of FASB Statements No. 133 andNo. 144”*(“SFAS No. 155”). SFAS No. 155 permits fairvalue remeasurement for any hybrid financial instrument that contains anembedded derivative that otherwise would require bifurcation. It also clarifieswhich interest-only strips and principal-only strips are not subject to the requirementsof FASB Statement No. 133, and establishes a requirement to evaluateinterests in securitized financial assets to identify interests that arefreestanding derivatives or that are hybrid financial instruments that containan embedded derivative requiring bifurcation. Furthermore, SFAS No. 155clarifies that concentrations of credit risk in the form of subordination arenot embedded derivatives and it amends FASB Statement No. 140 to eliminatethe prohibition on a qualifying special purpose entity from holding aderivative financial instrument that pertains to a beneficial interest otherthan another derivative financial instrument. SFAS No. 155 is effectivefor all financial instruments acquired or issued after the beginning of thefirst fiscal year beginning after September 15, 2006. The Company’sadoption of the provisions of SFAS No. 155 is not expected to impact itsfinancial condition or results of operations.

 

OnMarch 13, 2006, the FASB issued SFAS No. 156, *“Accounting for Servicing of Financial Assets,”*(“SFAS No. 156”). SFAS No. 156 requires an entity to recognize aservicing asset or servicing liability each time it undertakes an obligation toservice a financial asset by entering into a servicing contract under specifiedcircumstances. SFAS No. 156 also requires all separately recognizedservicing assets and servicing liabilities to be initially measured at fairvalue, if practicable. SFAS No. 156 permits an entity to choosealternative measurement methods for each class of separately recognizedservicing assets and servicing liabilities. The Statement is an amendment ofSFAS No. 140, *“Accounting for Transfers andServicing of Financial Assets and Extinguishments of Liabilities-a replacementof FASB Statement No. 125.”* SFAS No. 156 is effective forservicing assets and liabilities acquired or issued after the beginning of anentity’s fiscal year that begins after September 15, 2006. The Company’sadoption of the provisions of SFAS No. 156 is not expected to impact itsfinancial condition or results of operations.

 

**Note 3—NetIncome (Loss) Per Share**

** **

Basic netincome (loss) per share is computed by dividing net income (loss) available tocommon stockholders by the weighted average number of common shares outstandingduring the period. Diluted net income (loss) per share is computed using theweighted average number of common shares outstanding during the period pluspotentially dilutive common shares outstanding during the period under thetreasury stock method. In computing diluted net income (loss) per share, theaverage stock price for the period is used in determining the number of sharesassumed to be purchased from the exercise of stock options. A reconciliation ofthe basic and diluted per share computations is as follows (in thousands, exceptper share amounts):

 
| ** **               | ** ** | **Three Months Ended March 31,** | ** ** |
|--------------------------|------------|---------------------------------------|------------|
| ** **               | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| ** **               | ** ** | **Net Loss**                          | ** ** | **Shares** | ** ** | **Per Share  Amount** | ** ** | **Net Income** | ** ** | **Shares** | ** ** | **Per Share  Amount** | ** ** |
| Basic                    |       | $                                     | (1,228     | ) | 28,059 |   | $ | (0.04 | ) | $ | 864 |   | 26,385 |   | $ | 0.03 |   |
| Effect of  stock options |       | —                                |       | — |   | — |   | — |   | 1,028 |   | — |   |
| Diluted                  |       | $                                     | (1,228     | ) | 28,059 |   | $ | (0.04 | ) | $ | 864 |   | 27,413 |   | $ | 0.03 |   |

 

For the threemonths ended March 31, 2006, potential common shares of 5,700,000, thenumber of vested options outstanding, were not included in the calculation ofdiluted net loss per share, as they were considered antidilutive due to the netloss the Company experienced during the period. For the three months endedMarch 31, 2005, approximately 5,017,000 shares of common stocksubject to outstanding options were antidilutive and,

 

10

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**QUICKLOGIC CORPORATION**

**NOTES TO CONDENSED UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS –(Continued)**

 

therefore, were not included inthe calculation of diluted net income per share, as the per share exerciseprice for such options exceeded the average trading price of the Company’scommon stock during the period.

 

**Note4—Investment in Tower Semiconductor Ltd.**

 

OnDecember 12, 2000, the Company entered into several agreements with Tower,as amended, under which the Company agreed to make a strategic investment inTower of up to $25 million as part of Tower’s plan to build and equip anew wafer fabrication facility. During 2001 and 2002, the Company paid a totalof $21.3 million to Tower to fulfill its investment requirements under theAgreement. In partial consideration for the investment, the Company received1,757,368 Tower ordinary shares with an original cost of $16.6 million.Due to write-downs in fiscal years 2001, 2002, 2004 and 2005 as a result of “otherthan temporary” declines in market value, the adjusted cost of the Company’sTower ordinary shares is $1.6 million, or $1.17 per share.  The Company sold a portion of the Towerordinary shares in fiscal 2003.

 

As ofMarch 31, 2006, the Company held 1,344,543 available for sale Towerordinary shares with an unrealized gain of $148,000 recorded in accumulatedother comprehensive income, representing the difference between the adjustedcost per share and $1.28 per share, their market value on the last trading dayof the reporting period. The Company plans to continue to hold 450,000 of theTower ordinary shares in order to receive competitive product pricing under theAgreement and has recorded these shares as a long-term investment on thebalance sheets. The remaining 894,543 shares are classified as a short-terminvestment on the balance sheets.

 

The Companyalso received $4.7 million in prepaid wafer credits in partialconsideration for the investment, $4.2 million of which remained availableas of March 31, 2006. The credits have no stated maturity and the Companyhas guaranteed capacity at Tower through at least 2010. These credits arerecorded within long-term other assets on the balance sheets and can be appliedtoward wafer purchases from Tower at 15% of the value of future purchases.

 

11

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**QUICKLOGIC CORPORATION**

**NOTES TO CONDENSED UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS –(Continued)**

 

**Note 5—BalanceSheet Components**

 
| ** **                                | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|-------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                                | ** ** | **(in thousands)**       | ** ** |
| Inventory:                                |       |                     |       |                        |       |
| Raw materials                             |       | $                        | 1,114      |                        | $          | 916 |   |
| Work-in-process                           |       | 6,084                    |       | 6,314                       |       |
| Finished goods                            |       | 409                      |       | 600                         |       |
|                                      |       | $                        | 7,607      |                        | $          | 7,830 |   |
|                                      |       |                     |       |                        |       |
| Other  current assets:                    |       |                     |       |                        |       |
| Prepaid expenses                          |       | $                        | 1,142      |                        | $          | 1,064 |   |
| Employee receivables                      |       | 30                       |       | 20                          |       |
| Other                                     |       | 197                      |       | 181                         |       |
|                                      |       | $                        | 1,369      |                        | $          | 1,265 |   |
|                                      |       |                     |       |                        |       |
| Property and  equipment:                  |       |                     |       |                        |       |
| Equipment                                 |       | $                        | 13,898     |                        | $          | 13,264 |   |
| Software                                  |       | 9,318                    |       | 8,610                       |       |
| Furniture and fixtures                    |       | 825                      |       | 825                         |       |
| Leasehold improvements                    |       | 802                      |       | 802                         |       |
|                                      |       | 24,843                   |       | 23,501                      |       |
| Accumulated depreciation and amortization |       | (18,490                  | )          | (17,804                     | )          |
|                                      |       | $                        | 6,353      |                        | $          | 5,697 |   |
|                                      |       |                     |       |                        |       |
| Other  assets:                            |       |                     |       |                        |       |
| Prepaid wafer credits                     |       | $                        | 4,202      |                        | $          | 4,227 |   |
| Other                                     |       | 259                      |       | 188                         |       |
|                                      |       | $                        | 4,461      |                        | $          | 4,415 |   |
|                                      |       |                     |       |                        |       |
| Accrued  liabilities:                     |       |                     |       |                        |       |
| Employee related accruals                 |       | $                        | 1,751      |                        | $          | 2,026 |   |
| Other                                     |       | 1,092                    |       | 1,408                       |       |
|                                      |       | $                        | 2,843      |                        | $          | 3,434 |   |

 

12

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**QUICKLOGIC CORPORATION**

**NOTES TO CONDENSED UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS –(Continued)**

 

**Note 6—Obligations**

 
| ** **                                             | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|--------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                                             | ** ** | **(in thousands)**       | ** ** |
|                                                   |       |                     |       |                        |       |
| Debt and  capital lease obligations:                   |       |                     |       |                        |       |
| Notes payable to bank                                  |       | $                        | 2,049      |                        | $          | 1,443 |   |
| Capital leases                                         |       | 1,967                    |       | 1,510                       |       |
|                                                   |       | 4,016                    |       | 2,953                       |       |
| Current portion of debt and capital lease  obligations |       | (2,157                   | )          | (1,790                      | )          |
|                                                   |       | $                        | 1,859      |                        | $          | 1,163 |   |

 

*Revolving Line of Credit and Notes Payable to Bank*

 

EffectiveJune 2005, the Company modified its Amended and Restated Loan and SecurityAgreement with Silicon Valley Bank. Terms of the modified agreement included an$8.0 million revolving line of credit available through June 2006 and anadditional $3.0 million of borrowing capacity under the equipment line ofcredit that is available to be drawn against through June 2006. Therevolving line of credit provides for formula advances based upon a percentageof eligible accounts receivable and for non-formula advances not to exceed $4.0million. Advances under the equipment line of credit must be repaid in either30 or 36 monthly equal installments, depending upon the nature of the itemsfinanced. Terms of the various advances under the modified agreement are asfollows (in thousands):

 
| ** **                 | ** ** | **Original  Balance** | ** ** | **Balance at  March 31,  2006** | ** ** | **Available  Credit** | ** ** | **Interest Rate** | ** ** | **Maturity Date**                                           | ** ** |
|----------------------------|------------|-----------------------|------------|--------------------------------------|------------|-----------------------|------------|-------------------|------------|-------------------------------------------------------------|------------|
| Revolving  Line of Credit: |       |                  |       |                                 |       |                  |       |              |       |                                                        |       |
| Formula advances           |       | n/a                   |       | $                                    | —     |                  | $          | 4,742             |       | Prime +  0.50%                                              |       | June 26, 2006 |   |
| Non-formula advances       |       | n/a                   |       | —                               |       | 3,258                 |       | Prime +  1.50%    |       | June 26, 2006                                          |       |
|                       |       |                  |       |                                 |       |                  |       |              |       |                                                        |       |
| Equipment  Line of Credit: |       |                  |       |                                 |       |                  |       |              |       |                                                        |       |
| Notes payable              |       | 2,136                 |       | 348                                  |       | n/a                   |       | Prime +  2.00%    |       | Multiple draws maturing on or before December 1, 2006  |       |
| Notes payable              |       | 859                   |       | 416                                  |       | n/a                   |       | Prime +  2.00%    |       | Multiple draws maturing on or before December 31, 2007 |       |
| Notes payable              |       | 550                   |       | 353                                  |       | n/a                   |       | Prime +  2.00%    |       | Multiple draws maturing on or before June 30, 2008     |       |
| Notes payable              |       | 932                   |       | 932                                  |       | n/a                   |       | Prime +  1.75%    |       | Multiple draws maturing on or before March 31, 2009         |       |
| Notes payable              |       | n/a                   |       | —                               |       | 2,068                 |       | Prime +1.75%      |       | 30 or 36 months from date of advance                        |       |
| Total                      |       |                  |       | $                                    | 2,049      |                  |       |              |       |                                                        |       |   |
|                            |            |                       |            |                                      |            |                       |            |                   |            |                                                             |            |  |  |

 

The bank has afirst priority security interest in substantially all of the Company’s tangibleand intangible assets to secure any outstanding amounts under the modifiedagreement. Under the terms of the modified agreement, the Company must maintaina minimum tangible net worth and adjusted quick ratio. The modified agreementalso has certain restrictions including, among others, on the incurrence ofother indebtedness, the maintenance of depository accounts, the disposition ofassets, mergers, acquisitions, investments, the granting of liens and thepayment of dividends. The Company was in compliance with the financialcovenants of the modified agreement as of March 31, 2006.

 

13

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**QUICKLOGIC CORPORATION**

**NOTES TO CONDENSED UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS –(Continued)**

 

AtMarch 31, 2006, the prime rate under the credit facility was 7.75%. As ofMarch 31, 2006 and December 31, 2005, $864,000 and $387,000,respectively, of amounts outstanding under the equipment line of credit wereclassified as long-term obligations.

 

*Capital Lease*

 

In December2005, the Company leased design software and related maintenance under atwo-year capital lease at an imputed interest rate of 8.5% per annum. Terms ofthe agreement require the Company to make quarterly payments of approximately$204,000 through November 2007. Accordingly, the Company recorded a capitalasset for $1.2 million that is being depreciated over the term of theagreement, prepaid maintenance of $270,000 that is being amortized over theterm of the agreement and a capital lease obligation of $1.5 million. Asof March 31, 2006, $1.3 million was outstanding under the capitallease, $589,000 of which was classified as a long-term obligation.

 

In January2006, the Company leased design software tools and related maintenance under athree-year capital lease at an imputed interest rate of 9.0% per annum.  Terms of the agreement require the Company tomake semi-annual payments of approximately $148,000 through July 2008.Accordingly, the Company recorded a capital asset for $633,000 that is beingdepreciated over the term of the agreement, prepaid maintenance of $158,000that is being amortized over the term of the agreement and a capital leaseobligation of $791,000. As of March 31, 2006, $649,000 was outstandingunder the capital lease, $406,000 of which was classified as a long-termobligation.

 

**Note 7—DeferredRoyalty Revenue**

 

InOctober 2000, the Company entered into a technology license and wafersupply agreement with Aeroflex Incorporated (“Aeroflex”). Under the terms ofthe agreement, the Company received $750,000 of prepaid royalties. In addition,Aeroflex receives a prepaid royalty credit for a portion of the amounts paidfor wafers purchased from the Company under the agreement. These prepaidroyalties are recorded as a long-term liability and will be recognized asrevenue when Aeroflex sells products incorporating the licensed technology. Asof March 31, 2006 and December 31, 2005, the Company had recordedapproximately $1.5 million and $1.4 million, respectively, ofdeferred royalty revenue under this agreement. As of March 31, 2006, noroyalty revenue had been earned under the agreement.

 

**Note8—Employee Stock Plans**

 

*1989 Stock Option Plan*

 

The 1989 StockOption Plan (the “1989 Plan”) provided for the issuance of incentive andnonqualified options for the purchase of up to 4.6 million shares ofcommon stock. Options granted under the 1989 Plan have a term of up to10 years, and typically vest at a rate of 25% of the total grant per yearover a four-year period. In September 1999, the Company adopted the 1999Stock Plan and no further stock option grants were made under the 1989 Plan.

 

*1999 Stock Plan*

 

The 1999 StockPlan (the “1999 Plan”) was adopted by the board of directors in August 1999and was approved by the Company’s stockholders in September 1999. As ofMarch 31, 2006, approximately 13.8 million shares were reserved forissuance under the 1999 Plan. In addition, each January an annual increase isadded to the 1999 Plan equal to the lesser of (i) 5,000,000 shares,(ii) 5% of the Company’s outstanding shares on such date, or (iii) alesser amount determined by the board of directors. Options that are canceledunder the 1989 Plan also become available for grant under the 1999 Plan.Options granted under the 1999 Plan have a term of up to 10 years. Optionstypically vest at a rate of 25% one year after the vesting commencement date,and one forty-eighth for each month of service thereafter. However, the Companyhas implemented a different vesting schedule in the past and may implementdifferent vesting schedules in the future with respect to any new stock optiongrant.

 

14

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**QUICKLOGIC CORPORATION**

**NOTES TO CONDENSED UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS –(Continued)**

 

*Employee Stock Purchase Plan*

 

The 1999Employee Stock Purchase Plan (“ESPP”) was adopted by the board of directors inAugust 1999 and was approved by the Company’s stockholders inSeptember 1999. As of March 31, 2006, approximately 4.2 millionshares were reserved for issuance under the ESPP. In addition, each August anannual increase is added to the ESPP equal to the lesser of (i) 1,500,000shares, (ii) 4% of the Company’s outstanding shares on such date, or(iii) a lesser amount determined by the board of directors.

 

Through thepurchase period ending November 2005, the ESPP contained consecutive,overlapping, twenty-four month offering periods. Each offering period includedfour six-month purchase periods. The ESPP permitted participants to purchaseshares through payroll deductions at 85% of the lower of the fair market valueof the common stock at the beginning of an offering period or the end of apurchase period.

 

EffectiveNovember 2005, the board of directors amended the plan to provide for six-monthoffering periods.  The amended ESPPpermits participants to purchase shares through payroll deductions of up to 20%of an employee’s total compensation (maximum of 20,000 shares per offeringperiod) at either: (i) 85% of the fair market value of the common stock at theend of the offering period; or (ii) 85% of the lower of the fair market valueof the common stock at the beginning or the end of an offering period. Thedefault provision under the amended ESPP provides that shares will be purchasedat 85% of the fair market value of the common stock at the end of an offeringperiod. The board of directors has determined that purchases in the currentoffering period, ending in May 2006, will be made under the default provision.

 

**Note9—Stock-Based Compensation**

 

EffectiveJanuary 2, 2006, the Company adopted the provisions of SFAS No.123(R), using the modified prospective transition method, which requires themeasurement and recognition of expense related to the fair value of stock-basedcompensation awards made to employees and directors, over the requisite serviceperiod.

 

*Periods Prior to Adoption of SFAS No. 123(R)*

 

Prior to theadoption of SFAS No. 123(R), the Company applied APB 25 and relatedinterpretations and provided the required pro forma disclosures of SFAS No.123, as amended by SFAS No. 148, *“Accountingfor Stock-Based Compensation — Transition and Disclosures.”* The proforma information in the following table illustrates the effect on net incomeand net income per share for the three months ended March 31, 2005 as ifthe Company had applied the fair value recognition provisions of SFASNo. 123 (in thousands, except per share amounts):

 
| ** **                                                                                                                       | ** ** | **Three Months Ended  March 31, 2005** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| Net income – as reported                                                                                          |       | $                                           | 864        |   |
|                                                                                                                             |       |                                        |       |
| Less: Stock-based compensation expense  related to stock option plans determined under the fair value based method,  net of tax  |       | (870                                        | )          |
| Less: Stock-based compensation expense  related to the stock purchase plan determined under fair value based method,  net of tax |       | —                                      |       |
| Net loss – as adjusted                                                                                            |       | $                                           | (6         | ) |
|                                                                                                                             |       |                                        |       |
| Net income per share – as reported:                                                                                         |       |                                        |       |
| Basic                                                                                                                            |       | $                                           | 0.03       |   |
| Diluted                                                                                                                          |       | $                                           | 0.03       |   |
| Net loss per share – as adjusted:                                                                                           |       |                                        |       |
| Basic                                                                                                                            |       | $                                           | 0.00       |   |
| Diluted                                                                                                                          |       | $                                           | 0.00       |   |

 

15

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**QUICKLOGIC CORPORATION**

**NOTES TO CONDENSED UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS –(Continued)**

 

In the Company’spro forma information required under SFAS No. 123 for the periods prior tofiscal 2006, the Company used Black-Scholes to value stock-based compensationawards and accounted for forfeitures as they occurred.

 

*Impact of the Adoption of SFAS No. 123(R)*

 

The Companyadopted SFAS No. 123(R) using the modified prospective transitionmethod beginning January 2, 2006, the first day of the Company’s fiscalyear 2006. In accordance with the modified prospective transition method, theCompany’s consolidated financial statements for prior periods have not beenrestated to reflect, and do not include, the impact ofSFAS No. 123(R). Effective with the adoption of SFAS No. 123(R),stock-based compensation expense is recognized in the Company’s ConsolidatedStatements of Operations and includes (i) compensation expense forstock-based compensation awards granted prior to, but not yet vested as of January 1,2006, based on the grant-date fair value estimated in accordance with the proforma provisions of SFAS No. 123 and (ii) compensation expense forthe stock-based compensation awards granted or modified subsequent toJanuary 1, 2006, based on the grant-date fair value estimated inaccordance with the provisions of SFAS No. 123(R). The impact of SFASNo. 123(R) on the Company’s consolidated financial statements as of andfor the three months ended March 31, 2006 was as follows (in thousands,except per share amounts):

 
| ** **                           | ** ** | **Three Months Ended**  | ** ** |
|--------------------------------------|------------|-------------------------|------------|
| ** **                           | ** ** | **March 31, 2006** | ** ** |
| Cost of  revenue                     |       | $                       | 49         |   |
| Research and  development            |       | 146                     |       |
| Selling,  general and administrative |       | 257                     |       |
| Total costs  and expenses            |       | $                       | 452        |   |
|                                 |       |                    |       |
| Effect on  net loss per share:       |       |                    |       |
| Basic                                |       | $                       | (0.01      | ) |
| Diluted                              |       | $                       | (0.01      | ) |

 

Stock-based compensation expenserecorded in the three months ended March 31, 2006 had no effect on cash flows orthe provision for income taxes. 

 

As required bySFAS No. 123(R), the Company has made an estimate of expectedforfeitures and is recognizing compensation costs only for those equity awardsexpected to vest. The cumulative effect of forfeitures upon adoption ofSFAS No. 123(R) was not material.

 

The currentoffering period under the ESPP provides that shares will be purchased at 85% ofthe fair market value of the common stock at the end of the offering period.Accordingly, the fair value of stock-based compensation awards under the ESPPwas recognized based upon employee deductions and the purchase discount, ratherthan using a pricing model. In the three months ended March 31, 2006,stock-based compensation relating to the ESPP was $35,000.

 

*Valuation Assumptions*

 

SFAS No. 123(R) requirescompanies to estimate the fair value of stock-based compensation awards on thegrant date using an option pricing model. The value of the portion of the awardthat is ultimately expected to vest is recognized as expense over the requisiteservice periods in the Company’s Consolidated Statements of Operations. TheCompany measures the fair value of stock-based compensation awards usingBlack-Scholes. Black-Scholes, as well as other currently accepted optionvaluation models, was developed to estimate the fair value of freely tradable,fully transferable options without vesting restrictions. These assumptionsdiffer significantly from the characteristics of the Company’s stock-basedcompensation awards. Black-Scholes also requires the use of highly subjective,complex assumptions, including expected term and the price volatility of theCompany’s stock.

 

16

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**QUICKLOGIC CORPORATION**

**NOTES TO CONDENSED UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS –(Continued)**

 

The followingweighted average assumptions are included in the estimated fair valuecalculations for stock option grants:

 
| ** **                                    | ** ** | **Three Months Ended  March 31,** | ** ** |
|-----------------------------------------------|------------|----------------------------------------|------------|
| ** **                                    | ** ** | **2006**                               | ** ** | **2005** | ** ** |
| Expected  term (years)                        |       | 5.75                                   |       | 5.00 |   |
| Risk-free  interest rate                      |       | 4.75                                   | %          | 3.71 | % |
| Expected  volatility                          |       | 82                                     | %          | 88 | % |
| Estimated  pre-vesting annual forfeiture rate |       | 8.10                                   | %          | — |   |
| Dividend yield                                |       | —                                 |       | — |   |

 

Themethodologies for determining the above values were as follows:

 

•                  *Expected term:* The expected term represents the period thatthe Company’s stock-based awards are expected to be outstanding and isestimated based on historical experience.

•                  *Risk-free interest rate:* The risk-free interest rateassumption is based upon observed interest rate appropriate for the expectedterm of the Company’s employee stock options.

•                  *Expected volatility:* The Company determines expectedvolatility based on historical volatility of the Company’s common stock, andother factors.

•                  *Dividend yield:* The dividend yield assumption is based onthe Company’s intent not to issue a dividend under its dividend policy.

•                  *Estimated pre-vesting forfeitures:* When estimating pre-vestingforfeitures, the Company considers termination behavior based on actualhistorical information.

 

The weightedaverage estimated fair value for options granted during the three months endedMarch 31, 2006 and 2005 was $3.60 and $1.91 per option, respectively. Asof March 31, 2006, the fair value of unvested stock-based compensation awards,net of expected forfeitures, was $1.1 million which is expected to berecognized over the next four years.

 

*Stock-Based Compensation Award Activity*

 

The followingtable summarizes stock-based compensation award activity under the 1989 Planand the 1999 Plan, and the related weighted average exercise price, for thethree months ended March 31, 2006 and the year ended December 31,2005:

 
| ** **                         | ** ** | ** **                                | ** ** | **Options Outstanding**   | ** ** |
|------------------------------------|------------|-------------------------------------------|------------|--------------------------------|------------|
| ** **                         | ** ** | **Shares  Available for Grant** | ** ** | **Number of Shares** | ** ** | **Weighted Average  Exercise Price** | ** ** |
| ** **                         | ** ** | **(in thousands)**                   | ** ** | **(in thousands)**        | ** ** | ** ** | ** ** |
| Balance at  December 31, 2004 |       | 4,010                                     |       | 8,888                          |       | $ | 5.48 |   |
| Authorized                         |       | 1,316                                     |       | —                         |       | — |   |
| Granted                            |       | (207                                      | )          | 207                            |       | 3.77 |   |
| Forfeited or  expired              |       | 1,539                                     |       | (1,539                         | )          | 7.45 |   |
| Exercised                          |       | —                                    |       | (821                           | )          | 2.20 |   |
| Balance at  December 31, 2005 |       | 6,658                                     |       | 6,735                          |       | 5.37 |   |
| Authorized                         |       | 1,394                                     |       | —                         |       | — |   |
| Granted                            |       | (79                                       | )          | 79                             |       | 5.02 |   |
| Forfeited or  expired              |       | 63                                        |       | (63                            | )          | 3.65 |   |
| Exercised                          |       | —                                    |       | (385                           | )          | 2.76 |   |
| Balance at  March 31, 2006    |       | 8,036                                     |       | 6,366                          |       | $ | 5.55 |   |

 

As ofMarch 31, 2006 and December 31, 2005, options to purchase 5,700,000and 5,830,000 shares were vested, respectively.

 

17

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**QUICKLOGIC CORPORATION**

**NOTES TO CONDENSED UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS –(Continued)**

 

Significantexercise price ranges of options outstanding, related weighted average exerciseprices and contractual life information at March 31, 2006 was as follows:

 
| ** **                                                | ** **                    | **Options Outstanding**  | ** ** | **Options Exercisable**                             | ** ** |
|-----------------------------------------------------------|-------------------------------|--------------------------|------------|-----------------------------------------------------|------------|
| **Range of Exercise  Prices**                   | ** **                    | **Options  Outstanding** | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Aggregate  Intrinsic  Value** | ** ** | **Options  Vested and  Exercisable** | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
| ** **                                                | ** **                    | **(in thousands)**  | ** ** | **(in years)**                                      | ** ** | ** ** | ** ** | **(in  thousands)** | ** ** | **(in  thousands)** | ** ** | **(in years)** | ** ** | ** ** | ** ** | **(in  thousands)** | ** ** |
| $                                                         | 0.97 – $  2.75 |                     | 1,775      |                                                | 6.75       |   | $ | 2.11 |   | $ | 6,447 |   | 1,379 |   | 6.62 |   | $ | 2.10 |   | $ | 5,015 |   |
|   2.83 –     4.08 |                          | 1,661                    |       | 6.71                                                |       | 3.45 |   | 3,812 |   | 1,470 |   | 6.45 |   | 3.45 |   | 3,363 |   |
|   4.25 –     6.04 |                          | 1,720                    |       | 4.79                                                |       | 4.90 |   | 1,516 |   | 1,641 |   | 4.55 |   | 4.90 |   | 1,460 |   |
|   6.33 –   34.56            |                          | 1,210                    |       | 4.43                                                |       | 14.39 |   | — |   | 1,210 |   | 4.43 |   | 14.39 |   | — |   |
| $                                                         | 0.97 – $34.56            |                     | 6,366      |                                                | 5.77       |   | $ | 5.55 |   | $ | 11,775 |   | 5,700 |   | 5.51 |   | $ | 5.86 |   | $ | 9,838 |   |

 

The aggregateintrinsic value in the table above represents the total pretax intrinsic value,based on the Company’s closing stock price of $5.74 as of the end of theCompany’s current reporting period which would have been received by the optionholders had all option holders exercised their options as of that date. Thetotal number of shares of common stock underlying in-the-money optionsexercisable as of March 31, 2006 was 4,231,000.

 

The totalintrinsic value of options exercised during the three months endedMarch 31, 2006 was $820,000. Total cash received from employees as aresult of employee stock option exercises during the three months endedMarch 31, 2006 was approximately $1.1 million. The Company settlesemployee stock option exercises with newly issued common shares. In connectionwith these exercises, there was no tax benefit realized by the Company due tothe Company’s current loss position.

 

The status ofthe Company’s nonvested shares as of March 31, 2006 and changes during thethree months ended March 31, 2006 and the year ended December 31,2005 was as follows (in thousands, except per share amounts):

 
| ** **                           | ** ** | **Number of  Shares** | ** ** | **Weighted  Average Grant  Date Fair Value** | ** ** |
|--------------------------------------|------------|-----------------------|------------|----------------------------------------------|------------|
| Nonvested at  December 31, 2004 |       | 2,900                 |       | $                                            | 3.03       |   |
| Granted                              |       | 207                   |       | 3.77                                         |       |
| Vested                               |       | (1,870                | )          | 3.34                                         |       |
| Forfeited                            |       | (332                  | )          | 3.16                                         |       |
| Nonvested at  December 31, 2005 |       | 905                   |       | 2.52                                         |       |
| Granted                              |       | 79                    |       | 5.02                                         |       |
| Vested                               |       | (269                  | )          | 2.51                                         |       |
| Forfeited                            |       | (49                   | )          | 2.40                                         |       |
| Nonvested at  March 31, 2006    |       | 666                   |       | $                                            | 2.83       |   |

 

OnDecember 21, 2005, the Compensation Committee of the Company’s Board ofDirectors approved the vesting acceleration of unvested, “out-of-the-money”stock options awarded under its 1999 Stock Plan. The purpose of the acceleratedvesting was to reduce future compensation expense associated with theaccelerated stock options upon adoption of SFAS No.123(R) by approximately$380,000 and because the outstanding options were not fully achieving theiroriginal objective of incentive compensation and employee retention due toexercise prices which were in excess of current market value. A total of187,703 shares with exercise prices ranging from $4.08 to $8.70 wereaccelerated under the program. The accelerated stock options had a weightedaverage exercise price of $5.45. On average, the accelerated options wouldotherwise have completed vesting over 1.6 years from the date of acceleration.

 

**Note 10—ShelfRegistration Statement**

 

On July 12, 2005, the Companyfiled a shelf registration statement on Form S-3, which was declaredeffective on July 26, 2005 by the Securities and Exchange Commission.Under this filing, the Company has the

 

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**QUICKLOGIC CORPORATION**

**NOTES TO CONDENSED UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS –(Continued)**

 

ability to raise up to $30.0 million, in one or moretransactions, by selling common stock, preferred stock, depositary shares, andwarrants. As of March 31, 2006, the Company had not raised any funds inconnection with this filing.

 

**Note 11—RightsPlan**

 

In November 2001, the board ofdirectors adopted a Rights Agreement, which provides for a dividend of onePreferred Stock Purchase Right (each a “Right” and collectively, the “Rights”)for each share of common stock of the Company. Each Right will entitle stockholdersto buy one ten-thousandth of a share of Series A Junior ParticipatingPreferred Stock of QuickLogic at an exercise price of $32.50, subject toadjustment. The Rights will become exercisable only if a person or groupbecomes the beneficial owner of 15% or more of the common stock, or commences atender or exchange offer which would result in the offeror beneficially owning15% or more of the common stock, without the approval of the board ofdirectors. The Company is entitled to redeem the Rights at $0.001 per Right upto ten business days after the public announcement of a 15% holder. If notearlier terminated or redeemed, the Rights will expire on November 27,2011.

 

**Note 12—IncomeTaxes**

 

In the three months ended March 31, 2006 and 2005, the Company recordedincome tax expense of $2,000 and $50,000, respectively, which consisted primarily of income taxes onforeign operations.

 

Due to theuncertainties surrounding the realization of the deferred tax assets resultingfrom the Company’s accumulated deficit and net tax losses in previous years,the Company has provided a full valuation allowance against the associateddeferred tax assets. The Company will continue to assess the realizability ofthe deferred tax assets in future periods.

 

AtDecember 31, 2005, the Company had net operating loss carryforwards forfederal and state income tax purposes of approximately $72.0 million and$18.3 million, respectively. These carryforwards, if not utilized tooffset future taxable income and income taxes payable, will expire beginning in2006 for federal and state purposes.

 

Under the TaxReform Act of 1986, the amount of and the benefit from net operating lossesthat can be carried forward may be impaired in certain circumstances. Eventswhich may cause changes in the Company’s tax carryforwards include, but are notlimited to, a cumulative ownership change of more than 50% over a three-yearperiod. Since inception, the Company has had cumulative changes in ownershipwhich will limit the loss carryforward deduction under IRC Section 382.However, the Company believes that such limitations will not have a materialeffect on the future utilization of the losses.

 

**Note 13—InformationConcerning Product Lines, Geographic Information and Revenue Concentration**

 

The Company identifies its businesssegments based on business activities, management responsibility and geographiclocation. For all periods presented, the Company operated in a single businesssegment.

 

The following is a breakdown ofrevenue by product families (in thousands):

 
| ** **                          | ** ** | **Three Months Ended  March 31,** | ** ** |
|-------------------------------------|------------|-----------------------------------|------------|
| ** **                          | ** ** | **2006**                          | ** ** | **2005** | ** ** |
| Revenue by  product family(1):      |       |                              |       |   |   |
| Mature products                     |       | $                                 | 5,082      |   | $ | 8,548 |   |
| Embedded standard products          |       | 2,508                             |       | 2,387 |   |
| Advanced embedded standard products |       | 1,743                             |       | 1,592 |   |
| Total revenue                       |       | $                                 | 9,333      |   | $ | 12,527 |   |

 

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(1)          The matureproducts family includes pASIC 1, pASIC 2 and pASIC 3 products.The embedded standard products family includes QuickRAM, QuickPCI, QuickDSP,QuickFC, and V3 products. The advanced embedded standard products family includesEclipse, Eclipse II, QuickPCI II, PolarPro and QuickMIPS products, as well asprogramming hardware and software.

 

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**QUICKLOGIC CORPORATION**

**NOTES TO CONDENSED UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS –(Continued)**

 

The following is a breakdown ofrevenue by shipment destination (in thousands):

 
| ** **             | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------|------------|-----------------------------------|------------|
| ** **             | ** ** | **2006**                          | ** ** | **2005** | ** ** |
| Revenue by  geography: |       |                              |       |   |   |
| United States          |       | $                                 | 4,836      |   | $ | 5,881 |   |
| Europe                 |       | 2,033                             |       | 3,137 |   |
| Japan                  |       | 988                               |       | 2,083 |   |
| China                  |       | 605                               |       | 141 |   |
| Rest of North America  |       | 594                               |       | 714 |   |
| Rest of Asia Pacific   |       | 277                               |       | 571 |   |
| Total revenue          |       | $                                 | 9,333      |   | $ | 12,527 |   |

 

Twodistributors of the Company’s products accounted for 33% and 13% of revenue,respectively, in the three months ended March 31, 2006. Three distributorsof the Company’s products accounted for approximately 24%, 16% and 13% ofrevenue, respectively, in the three months ended March 31, 2005. Onedomestic OEM accounted for 12% and 11% of revenue for the three months endedMarch 31, 2006 and 2005, respectively.

 

As ofMarch 31, 2006 less than 10% of the Company’s long-lived assets, includingproperty and equipment and other assets, were located outside the UnitedStates.

 

**Note 14—Commitments**

 

Certain of theCompany’s wafer manufacturers require the Company to forecast wafer startsseveral months in advance. The Company is committed to take delivery of and payfor a portion of forecasted wafer volume. As of March 31, 2006 andDecember 31, 2005, the Company had $2.8 million and $2.7 million,respectively, of outstanding commitments for the purchase of wafer inventory.

 

The Companyleases, with an option to renew, its primary facility under a non-cancelableoperating lease that expires in 2009. In addition, the Company rents developmentfacilities in Canada and India as well as sales offices in Europe and Asia.Total rent expense, net of sublease income, for the three months endedMarch 31, 2006 and 2005 was approximately $235,000 and $260,000,respectively. The Company has subleased a portion of its primary facilities toa tenant until November 2007.

 

**Note 15—Litigation**

 

OnOctober 26, 2001, a putative securities class action was filed in the U.S.District Court for the Southern District of New York against certain investmentbanks that underwrote QuickLogic’s initial public offering, QuickLogic and someof QuickLogic’s officers and directors. The complaint alleges excessive andundisclosed commissions in connection with the allocation of shares of commonstock in QuickLogic’s initial and secondary public offerings and artificiallyhigh prices through “tie-in” arrangements which required the underwriters’customers to buy shares in the aftermarket at pre-determined prices inviolation of the federal securities laws. Plaintiffs seek an unspecified amountof damages on behalf of persons who purchased QuickLogic’s stock pursuant tothe registration statements between October 14, 1999 and December 6,2000. Various plaintiffs have filed similar actions asserting virtuallyidentical allegations against over 300 other public companies, theirunderwriters, and their officers and directors arising out of each company’spublic offering. These actions, including the action against QuickLogic, havebeen coordinated for pretrial purposes and captioned *In re Initial Public Offering Securities Litigation, 21 MC 92*.A stipulation of settlement for the claims against the issuer defendants,including the Company, has been signed and was submitted to the court. Underthe stipulation of settlement, the plaintiffs will dismiss and release allclaims against participating defendants in exchange for a contingent paymentguaranty by the insurance companies collectively responsible for insuring theissuers in all the related cases, and the assignment or surrender to theplaintiffs of certain claims the issuer defendants may have against theunderwriters. Under the guaranty, the insurers will be required to pay theamount, if any, by which $1.0 billion exceeds the aggregate amount ultimatelycollected by the plaintiffs from the underwriter defendants in all the cases.On February 15, 2005, the court preliminarily approved the settlementcontingent on specified modifications. The settlement is still subject to courtapproval and a number of other conditions. There is no guarantee that thesettlement will become effective.

 

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**QUICKLOGIC CORPORATION**

**NOTES TO CONDENSED UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS –(Continued)**

 

OnJuly 3, 2003, a putative securities class action was filed in the U.S.District Court for the Southern District of New York by shareholders of TowerSemiconductor Ltd. against Tower, several of its directors, and several of itsinvestors, including QuickLogic. QuickLogic was named solely as an allegedcontrol person. On August 19, 2004, the court dismissed the claims againstall defendants, including QuickLogic, with prejudice. On September 29,2004, one of the plaintiffs filed a notice of appeal from the judgment.

 

No estimatecan be made of the possible loss or possible range of loss associated with theresolution of these contingencies and, accordingly, the Company has notrecorded a liability.

 

From time totime, the Company is involved in legal actions arising in the ordinary courseof business, including but not limited to intellectual property infringementand collection matters.  Absolute assurance cannot be given that thirdparty assertions will be resolved without costly litigation in a manner that isnot adverse to the Company’s financial position, results of operations or cashflows or without requiring royalty payments in the future which may adverselyimpact gross profit.

 

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**Item 2.Management’s Discussion and Analysis of Financial Condition and Results ofOperations**

 

*The following Management’s Discussion and Analysis of FinancialCondition and Results of Operations, as well as information contained in “RiskFactors” in Part II, Item 1A and elsewhere in this Quarterly Report onForm 10-Q, contains “forward-looking statements” within the meaning ofSection 27A of the Securities Act of 1933 and Section 21E of theSecurities Exchange Act of 1934. We intend that these forward-lookingstatements be subject to the safe harbors created by those provisions.Forward-looking statements are generally written in the future tense and/or arepreceded by words such as “will,” “may,” “should,” “forecast,” “could,” “expect,”“suggest,” “believe,” “anticipate,” “intend,” “plan,” or other similar words.Forward-looking statements include statements regarding our revenuelevels, our gross profit and factors that affect gross profit, our levelof operating expenses, our research and development efforts, our liquidity, ourpartners and suppliers, industry trends and the commercial success of ourproducts. The following discussion should be read in conjunction with theattached condensed unaudited consolidated financial statements and notesthereto, and with our audited financial statements and notes thereto for the fiscalyear ended December 31, 2005, found in our Annual Report on Form 10-Kfiled with the Securities and Exchange Commission, or SEC, on March 17,2006.*

 

*The forward-looking statements contained in this Quarterly Reportinvolve a number of risks and uncertainties, many of which are outside of ourcontrol. Factors that could cause actual results to differ materially fromprojected results include, but are not limited to, risks associated with theexpected decline in revenue from our pASIC®**1 and pASIC 2 products, the commercial andtechnical success of our new products such as PolarProTM, EclipseTM II andQuickPCI® II, limited visibility into demand for our products, including demandfrom significant customers or for new products, our dependence upon single suppliersto fabricate and assemble our products, our relationship with and themanufacturing of our products by Tower Semiconductor Ltd., and the liquidityrequired to support our future operating and capital requirements. Although webelieve that the assumptions underlying the forward-looking statementscontained in this Quarterly Report are reasonable, any of the assumptions couldbe inaccurate, and therefore there can be no assurance that such statementswill be accurate. The risk, uncertainties and assumptions referred to abovethat could cause our results to differ materially from the results expressed orimplied by such forward looking statements include, but are not limited to,those discussed under the heading “Risk Factors” in Part II Item 1A heretoand the risks, uncertainties and assumptions discussed from time to time in ourother public filings and public announcements. All forward-looking statementsincluded in this document are based on information available to us as of thedate hereof.  In light of the significantuncertainties inherent in the forward-looking statements included herein, theinclusion of such information should not be regarded as a representation by usor any other person that the results or conditions described in such statementsor our objectives and plans will be achieved. Furthermore, past performance inoperations and share price is not necessarily indicative of future performance.We disclaim any intention or obligation to update or revise any forward-lookingstatements, whether as a result of new information, future events or otherwise.*

 

**Overview**

 

We operate ina single industry segment where we design and sell field programmable gatearrays, or FPGAs, embedded standard products, or ESPs, associated software andprogramming hardware. ESPs, products that combine standard functions andprogrammable logic in a single device, provide design engineers with theease-of-use, guaranteed functionality, high performance, low non-recurringengineering charges and immediate availability of application specific standardproducts, or ASSPs, combined with the flexibility and time-to-market advantagesof programmable logic. Our FPGA and ESP devices are standard products that canbe programmed to perform desired logic functions or combined with intellectualproperty to provide customers with desired solutions. We design these devicesbased on our proprietary ViaLink technology. We believe that the underlyingattributes of our ViaLink technology, including low power consumption, highreliability, design security and design efficiency enable us to differentiateour silicon solutions.

 

Our objectiveis to be the leading provider of the lowest-power programmable logic solutions.In addition to offering the lowest-power, full-featured FPGAs, our productsalso provide:

 

•                  *“Bulletproof” IP Security—*we believe ourproducts provide “bulletproof” programmable logic design security, since it isvirtually impossible to clone or reverse engineer designs implemented using ourViaLink technology;

•                  *Small Form Factor—*since our products donot require an additional device to store configuration data, we can providesingle chip full-featured solutions, in packages as small as 8x8 millimeters;

 

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•                  *Instant On—*our ViaLink based productsrequire no configuration bit stream and thus are live at power up. This iscritical in applications that need to be active as soon as power is supplied;and

•                  *High Reliability—*our ViaLink-based devicesare consistently more robust in harsh environments than SRAM-based FPGAproducts, since ViaLink-based products do not rely on an SRAM-cell that issusceptible to alpha particles, or brownouts, to define and maintain theirfunctionality.

 

Competitively,our products can offer significant power, performance and design securitybenefits when compared to traditional FPGAs; lower cost of ownership,time-to-market and increased system flexibility benefits when compared to theuse of application specific integrated circuits, or ASICs; and increased systemflexibility, product differentiation and design security benefits when comparedto application specific standard products, or ASSPs. We believe that developingproducts around our ViaLink technology will continue to allow us to provideproducts that address the design flexibility, system power, performance,intellectual property security and price points demanded by our target markets.

 

We believethat important industry trends in our target markets include lower powerconsumption, higher performance, shorter time-to-market, increased intellectualproperty security, higher ASIC development expenses and higher productdevelopment risks. We believe our products are designed to address many ofthese trends.

 

The market forprogrammable logic devices is expected to grow more quickly than thesemiconductor industry, and we believe the FPGA programmable logic market willgrow more quickly than the market for complex programmable logic devices, orCPLDs. One factor fueling this high growth is the migration from ASIC circuitdesigns to programmable logic circuit designs. System designers often chooseprogrammable logic solutions over ASIC solutions, due to the relatively lowdevelopment cost, low development risk, quick time-to-market and highadaptability or flexibility of programmable logic devices, and due to theability of programmable logic suppliers to reduce the unit costs of theirproducts over time.

 

Within theprogrammable logic device market, we believe that the market for low-powerembedded applications will be a relatively high-growth market. We anticipatethat original equipment manufacturers, or OEMs, will expand their offering ofconsumer or professional portable products. These new product offerings areexpected to include portable 3-D GPS products incorporating micro hard drivecapability, portable media players, personal video recorders or handheld POSterminals incorporating Wi-Fi and micro hard drive capabilities and cellulardata cards interfacing a processor and a cellular radio. This adoption of newfeatures by embedded system designers is increasing the use of low-powerprogrammable logic, since embedded processors often do not have the nativeability to interface to components such as Wi-Fi modules or micro hard diskdrives, which were designed to work in a personal computer environment. OurEclipse II, QuickPCI II and PolarPro products offer compelling advantages inthese programmable interconnect applications, where customers benefit fromtheir lowest power consumption, small form factor and high bandwidth.

 

In the fourthquarter of 2004, we completed the design of our Eclipse II andQuickPCI II products which provide a low-power solution for applicationsrequiring medium to small amounts of programmable logic. These devices offerthe lowest power consumption during all phases of operation – power-up,quiescent and dynamic operation – on the market today.

 

Our PolarProarchitecture and related products were announced in November 2005.  These products improve on our Eclipse II andQuickPCI II low-power leadership by providing lower power consumption and amore cost-effective architecture. Our PolarPro architecture combines theindustry’s lowest-power FPGA with embedded circuitry for implementinghigh-bandwidth bus-to-bus interfaces. All device circuitry is optimized for lowpower consumption through the new and innovative Very Low Power mode, or VLP,which provides an instant ability to lower power consumption when the devicefunction is not needed. When put in VLP mode, we believe that our PolarProproducts draw less than 10 micro amps of quiescent current. PolarProproducts also exhibit the FPGA industry’s lowest dynamic power consumption,with operational power consumption up to three times lower than competingalternatives. Based on our engineering analysis of portable media players, webelieve designers of handheld, battery-powered products using PolarPro productscan now extend battery life by as much as four times as compared to a standardproduct implementation, setting a new standard for low power consumptionthrough the use

 

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of our FPGAs. Our firstPolarPro product, the QL1P100, was released for production in the first quarterof 2006. We expect to sample additional PolarPro products during 2006.

 

We market arange of solutions to our customers, including:

 

•                  *complete solutions*incorporating ourdevices, intellectual property and software drivers. These complete solutionsare targeted at specific low-power application segments that have similarconnectivity and performance requirements. By providing solutions for customerswe increase their ability to meet the time-to-market pressures associated withtheir markets;

•                  *Embedded Standard Products*incorporating afixed function along with programmable logic in a low-power device. Ourcustomers build on this “known good starting point” to develop unique solutionsrequired for their products, which eliminates the need to acquire and assembleindustry standard IP, thus reducing design risk and improving time-to-market;and

•                  *FPGAs*which are general purpose FPGAs usedby customers who value the low power consumption, high IP security, instant onand reliability of our devices. These products give customers the ability tocreate a design specifically tailored for their needs.

 

Our newproducts are also being designed into applications in our traditional markets,such as data communications, instrumentation and test and military-aerospace,where customers value the low power consumption, instant-on, IP security,reliability and fast time-to-market of our products.

 

In addition toworking directly with our customers, we partner with other technology companiesto develop additional intellectual property, reference platforms and systemsoftware to provide application solutions. We work with processormanufacturers, such as Intel Corporation and Renesas Technology Corp., andcompanies that supply storage, networking or graphics components for embeddedsystems. The depth of these relationships varies depending on the partner andthe dynamics of the end market being targeted, but is typically a co-marketingprogram that incorporates engineering collaboration, such as reference designs,joint account calls and promotional activities.

 

Ourproprietary ViaLink programmable metal-to-metal technology is the core of ourFPGA products and the foundation of our ESP products. Our ViaLink technologyallows us to create devices smaller than competitors’ products on comparabletechnology, thereby minimizing silicon area and cost. In addition, our ViaLinktechnology has lower electrical resistance and capacitance than otherprogrammable technologies and, consequently, supports higher signal-speed andlow power consumption. Our user-programmable platform facilitates full utilizationof a device’s logic cells, clocks and input/output pins. These logic cells havebeen optimized to efficiently implement a wide range of logic functions at highspeed, thereby enabling greater usable device density and design flexibility.Our architecture uses our ViaLink technology to maximize interconnects at everyrouting wire intersection, which allows more paths between logic cells. As aconsequence, system designers are able to use our devices with smaller gatecounts to implement their designs than if they had used competing FPGAs. Theabundance of interconnect resources also provides a dense connection betweenthe ASSP and the FPGA portions of Embedded Standard Products.

 

Our ViaLinktechnology also provides our products with what we believe to be “bulletproof”intellectual property security, especially compared to SRAM-based FPGA or ASICsolutions, since it is virtually impossible to clone or reverse engineerdesigns implemented using our ViaLink technology. We believe intellectualproperty security is important to system designers who choose to implementproprietary algorithms or features in programmable logic.

 

We sellprogrammed and unprogrammed products through distributors and directly tosystem manufacturers. We recognize revenue at the time of shipment of productsdirectly to system manufacturers. However, we sell the majority of our productsthrough distributors who earn a negotiated margin on the sale of our products.We defer recognition of revenue from sales of unprogrammed products todistributors until after they have sold our products to systems manufacturers.We recognize revenue on programmed products at the time of shipment to ourdistributors. During the three months ended March 31, 2006 and 2005,respectively, approximately 51% and 68%, respectively, of the units shipped toour distributors were programmed by us and, accordingly, are not returnable.

 

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The percentage of sales derivedthrough distributors was 61% and 70% in the three months ended March 31,2006 and 2005, respectively.

 

Two distributorsof our products accounted for 33% and 13% of our revenue, respectively, in thethree months ended March 31, 2006. Three distributors of our productsaccounted for 24%, 16% and 13% of our revenue, respectively, in the threemonths ended March 31, 2005. One domestic manufacturer accounted for 12%and 11% of revenue for the three months ended March 31, 2006 and 2005,respectively. We anticipate that a limited number of distributors and customerswill continue to account for a significant portion of our revenue and thatindividual distributors could account for a larger portion of our revenue.

 

Ourinternational sales were 48% and 53% of our revenue in the three months endedMarch 31, 2006 and 2005, respectively. We expect that revenue from salesto international customers will continue to represent a significant portion ofour revenue. All of our sales originate in the United States and aredenominated in U.S. dollars.

 

We outsourcethe wafer manufacturing, assembly and test of all of our products. We currentlyrely upon Taiwan Semiconductor Manufacturing Company Ltd., or TSMC, CypressSemiconductor Corporation, Tower, Kawasaki Microelectronics, Inc. and SamsungSemiconductor, Inc. to manufacture our products, and we rely primarily uponAmkor Technology, Inc. to assemble, test and program our products. In 2001and 2002, we made a $21.3 million investment in Tower to obtain access tomanufacturing capacity for our new products. Our wafer suppliers’ lead times are often as long as three months andsometimes longer. In addition, Tower requires us to provide them with a monthlywafer start forecast. Under the terms of our agreement with them, we arelimited in the quantity that we can increase or decrease our wafer forecast andwe are committed to take delivery of and pay for a minimum portion of theforecasted wafer volume. Our long manufacturing cycle times conflict with ourcustomers’ desire for short delivery lead times and, as a result, we typicallypurchase wafers based on our internal forecasts of customer demand.

 

**CriticalAccounting Policies and Estimates**

 

The methods,estimates and judgments we use in applying our most critical accountingpolicies have a significant impact on the results we report in our financialstatements. The U.S. Securities and Exchange Commission, or SEC, has definedcritical accounting policies as those that are most important to the portrayalof our financial condition and results of operations and require us to make ourmost difficult and subjective judgments, often as a result of the need tomake estimates of matters that are inherently uncertain. Based on thisdefinition, our critical policies include revenue recognition including salesreturns and allowances, inventory valuation including identification of excessquantities and product obsolescence, allowance for doubtful accounts, valuationof investments, valuation of long-lived assets, measurement of stock-basedcompensation, accounting for income taxes, and estimating accrued liabilities.We believe that we apply judgments and estimates in a consistent manner andthat such consistent application results in financial statements and accompanyingnotes that fairly represent all periods presented. However, any factual errorsor errors in these judgments and estimates may have a material impact on ourstatement of operations and financial condition. For a discussion of criticalaccounting policies and estimates, please see Item 1A in our Annual Reporton Form 10-K for the fiscal year ended December 31, 2005 filed with theSEC on March 17, 2006 with the exception of stock-basedcompensation as discussed below.

 

*Stock-Based Compensation*

 

Effective January 2, 2006,we adopted the provisions of Statement of Financial Accounting Standards, or SFAS,No. 123 (revised 2004), *“Share-Based Payment,”*or SFAS No. 123(R), which requires the measurement and recognition of expenserelated to the fair value of stock-based compensation awards. Accordingly,stock-based compensation is measured at the grant date, based on the fair valueof the award using the Black-Scholes option pricing model, or Black-Scholes,and is recognized as expense over the requisite service period of the award.Black-Scholes requires the use of highly subjective, complex assumptions,including expected term and the price volatility of our stock. We elected touse the modified prospective transition method upon implementation and, therefore,have not restated our financial results for prior periods. As a result ofadopting SFAS No. 123(R), we recognized $452,000 of stock-based compensation expensein the first quarter of 2006. We previously applied Accounting Principles BoardOpinion No. 25, *“Accounting for Stock Issued to Employees”,*or APB 25, and restated interpretations and provided the required pro formadisclosures of SFAS No. 123, *“Accounting forStock-Based**compensation.”*

 

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**Results ofOperations**

 

The followingtable sets forth the percentage of revenue for certain items in our statementsof operations for the periods indicated:

 
| ** **                          | ** ** | **Three Months Ended  March 31,** | ** ** |
|-------------------------------------|------------|----------------------------------------|------------|
| ** **                          | ** ** | **2006**                               | ** ** | **2005** | ** ** |
| Revenue                             |       | 100.0                                  | %          | 100.0 | % |
| Cost of  revenue                    |       | 40.3                                   |       | 39.0 |   |
| Gross profit                        |       | 59.7                                   |       | 61.0 |   |
| Operating  expenses:                |       |                                   |       |   |   |
| Research and development            |       | 25.7                                   |       | 19.6 |   |
| Selling, general and administrative |       | 49.5                                   |       | 34.3 |   |
| Income  (loss) from operations      |       | (15.5                                  | )          | 7.1 |   |
| Interest  expense                   |       | (0.8                                   | )          | (0.4 | ) |
| Interest  income and other, net     |       | 3.1                                    |       | 0.6 |   |
| Income  (loss) before income taxes  |       | (13.2                                  | )          | 7.3 |   |
| Provision  for income taxes         |       | —                                 |       | 0.4 |   |
| Net income  (loss)                  |       | (13.2                                  | )%         | 6.9 | % |

 

**Three MonthsEnded March 31, 2006 and 2005**

 

*Revenue.*  Ourrevenue for the three months ended March 31, 2006 was $9.3 million,representing a decline of $3.2 million, or 25.5%, from revenue of$12.5 million in the three months ended March 31, 2005. Our Matureproduct family revenue declined by $3.5 million as a result of a $4.2 milliondecline in our pASIC 1 and pASIC 2 product revenue due to theirend-of-life, partially offset by a $700,000 increase in our pASIC 3 productrevenue, primarily due to higher demand and customers migrating designs frompASIC 2 products to pASIC 3 products. Our Advanced ESP product family revenue increased by approximately$200,000 due to an increase in sales of our new Eclipse II and QuickPCI IIproducts of approximately $900,000, partially offset by a decline in ourEclipse product revenue as a result of lower demand from a Japanese customerpurchasing product through a distributor. Our ESP product family revenue increased by approximately $100,000year-over-year.

 

Our revenuefor the three months ended March 31, 2006 was 9.5% lower sequentially,declining by approximately $980,000 to $9.3 million from$10.3 million in the three months ended December 31, 2005. Thissequential revenue decrease was primarily due to a $620,000 decline in Matureproduct family revenue, principally due to a $1.3 million reduction in pASIC 1and pASIC 2 revenue, due to the end-of-life of these products, which waspartially offset by a $660,000 increase in pASIC 3 revenue due to higher demandand the conversion of customer designs to the use of pASIC 3 from the use ofpASIC 2. ESP and Advanced ESP product family revenue declined by a combined$360,000 primarily due to customer demand and requested shipping dates.

 

Our foundryagreement with the supplier that fabricated our pASIC 1 and pASIC 2products expired at the end of 2005. We announced an end-of-life for theseproducts in 2004 and requested that our customers take delivery of lifetime buyorders before the end of 2005. These products contributed $2.3 million and$6.4 million of our revenue in the three months ended March 31, 2006and 2005, respectively. We currently believe that a majority of our customersthat use pASIC 1 and pASIC 2 products have either purchasedsufficient quantities of our product to satisfy their demand throughout theexpected life of their products or have converted to using other of ourproducts, such as pASIC 3, which is pin compatible with pASIC 2.While we may have limited future production capacity for these products, weexperienced a significant reduction in pASIC 1 and pASIC 2 revenueduring the fourth quarter of 2005 and the first quarter of 2006. Further,although we may record revenue from these products in the third quarter of2006, we anticipate that pASIC 1 and pASIC 2 products may contribute no revenuein the third quarter of 2006 and beyond.

 

In order tomaintain or grow our revenue from its current level after the end-of-lifeperiod for our pASIC 1 and pASIC 2 products, we are dependent uponincreased revenue from our existing products, especially our new PolarPro,Eclipse II and QuickPCI II products, and the development ofadditional new products.

 

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We continue to seek to expandour revenue, including the pursuit of high volume sales opportunities in the consumermarket segment, by providing low power solutions incorporating industrystandard interfaces such as PCI, SDIO or IDE. Our industry is characterized byintense price competition and by lower prices as order volumes increase. Whilewinning large volume sales opportunities will increase our revenue, we believe theseopportunities may decrease our average selling price and gross profit as apercentage of revenue.

 

*Gross Profit*.  Grossprofit was $5.6 million and $7.6 million in the three months endedMarch 31, 2006 and 2005, respectively, which represented 59.7% and 61.0%of revenue for those periods. The $2.1 million decline in gross profit wasprimarily due to a decline in revenue, which contributed approximately $2.2million to the decline, and lower absorbed overhead of approximately $380,000,primarily due to lower production volumes, which was partially offset by betterproduct mix, which improved gross profit by approximately $250,000, andimprovements in other production variances. Cost of revenue for the threemonths ended March 31, 2006, includes $49,000 related to the recognition ofstock-based compensation in accordance with SFAS No. 123(R). In the threemonths ended March 31, 2006, we provided inventory reserves primarily forexcess quantities in the amount of $232,000 and sold $323,000 of inventory thatwas previously reserved. In the three months ended March 31, 2005, weprovided inventory reserves primarily for excess quantities in the amount of$205,000 and sold $255,000 of inventory that was previously reserved.

 

*Research and Development Expense.*  Researchand development expense was $2.4 million and $2.5 million in thethree months ended March 31, 2006 and 2005, respectively, whichrepresented 25.7% and 19.6% of revenue for those periods. The decrease ofapproximately $50,000 was primarily due to lower headcount and relatedspending, partially offset by $146,000 related to the recognition ofstock-based compensation in accordance with SFAS No. 123(R). We believe thatcontinued or increased investments in product development and processtechnology are essential for us to remain competitive in the markets we serve.We expect that these development efforts will allow us to expand our productoffering, increase our revenue and provide additional value to our customersand stockholders.

 

*Selling, General and Administrative Expense.*  Selling,general and administrative expense was $4.6 million and $4.3 millionfor the three months ended March 31, 2006 and 2005, respectively, whichrepresented 49.5% and 34.3% of revenue for those periods. The $320,000 increasein selling, general and administrative expense was primarily the result of therecognition of stock-based compensation in accordance with SFAS No. 123(R) of$257,000 and a $140,000 recovery of an account receivable in the first quarterof 2005 that did not repeat in the first quarter of 2006.

 

*Interest Expense.*  Interestexpense increased to $74,000 for the three months ended March 31, 2006 ascompared to $53,000 for the three months ended March 31, 2005. This$21,000 increase was primarily due to higher interest rates and higher averageoutstanding debt and capital lease balances.

 

*Interest Income and Other, Net.*  Interestincome and other, net increased to $292,000 of income for the three monthsended March 31, 2006 as compared to $80,000 of income for the three monthsended March 31, 2005. The $212,000 increase in interest income and other,net is primarily due to increased interest income received as a result ofhigher invested cash balances and higher interest rates.

 

*Provision for Income Taxes.*  Forthe three months ended March 31, 2006 we incurred a net loss of$1.2 million and recorded a provision for income taxes of $2,000, which consisted of income taxes on foreignoperations. For the three months ended March 31, 2005, we recorded aprovision for income taxes of $50,000, whichconsisted of income taxes on foreign operations of $30,000 and federalalternate minimum income taxes of $20,000. Our ability to utilize ourincome tax loss carryforwards in future periods is uncertain and, accordingly,we recorded a full valuation allowance against the related tax benefit. We willcontinue to assess the realizability of the deferred tax assets in futureperiods.

 

*Stock-based Compensation.* Effective January 2, 2006,we adopted the provisions of Statement of Financial Accounting Standards (“SFAS”)No. 123 (revised 2004), *“Share-BasedPayment,”* or SFAS 123(R), which requires the measurement andrecognition of expense related to the fair value of stock-based compensationawards. Accordingly, stock-based compensation is measured at the grant date,based on the fair value of the award using the Black-Scholes option pricingmodel, and is recognized as expense over the requisite service period of theaward.  Black-Scholes requires the use ofhighly subjective, complex assumptions, including expected term and the price

 

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volatility of our stock. We elected to usethe modified prospective transition method as permitted by SFAS 123(R) and,therefore, we have not restated our financial results for prior periods. Wepreviously applied Accounting Principles Board, or APB, Opinion No. 25, *“Accounting for Stock Issued to Employees,”*or APB 25, and related interpretations and provided the required pro formadisclosures of SFAS No. 123, *“Accounting forStock-Based Compensation.”* In March 2005, the SEC issued StaffAccounting Bulletin No. 107, or SAB 107, relating to SFAS 123(R). Wehave applied the provisions of SAB 107 in our adoption of SFAS 123(R).

 

In the firstquarter of 2006 and 2005, stock-based compensation totaled $452,000 and zero,respectively, and was included in the statement of operations as follows (inthousands):

 
| ** **                           | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------|------------|----------------------------------------|------------|
| ** **                           | ** ** | **2006**                               | ** ** | **2005** | ** ** |
|                                 |       |                                   |       |   |   |
| Cost of  revenue                     |       | $                                      | 49         |   | $ | — |   |
| Research and  development            |       | 146                                    |       | — |   |
| Selling,  general and administrative |       | 257                                    |       | — |   |
| Total                                |       | $                                      | 452        |   | $ | — |   |

 

**Liquidityand Capital Resources**

 

We havefinanced our operating losses and capital investments through sales of commonstock, private equity investments, capital and operating leases, bank lines ofcredit and cash flow from operations. As of March 31, 2006, our principalsources of liquidity consisted of our cash and cash equivalents of$30.2 million, available credit under our revolving line of credit with SiliconValley Bank of approximately $8.0 million, available credit under ourequipment line of credit of approximately $2.1 million, and our investmentin Tower with a market value of approximately $1.7 million.

 

On July 12,2005, we filed a shelf registration statement on Form S-3 with the SEC, whichhas been declared effective. Under this filing, we may raise up to$30.0 million, in one or several transactions, by selling common stock,preferred stock, depositary shares, and warrants.

 

As ofMarch 31, 2006, our interest-bearing debt consisted of $2.0 millionoutstanding from Silicon Valley Bank and $2.0 million outstanding undercapital leases. As of March 31, 2006, our accumulated deficit was$118.6 million. Capital expenditures, which are largely driven by the developmentof new products and manufacturing levels, could be up to $4.0 million inthe next twelve months.

 

InJune 2005, we modified our Amended and Restated Loan and SecurityAgreement with Silicon Valley Bank. Terms of the modified agreement include an$8.0 million revolving line of credit available through June 2006 and anadditional $3.0 million of borrowing capacity under an equipment financingline of credit that is available to be drawn against through June 2006.The revolving line of credit provides for formula advances based upon apercentage of eligible accounts receivable and for non-formula advances not toexceed $4.0 million. As of March 31, 2006, we had no balancesoutstanding under the revolving line of credit and had available formula andnon-formula advances totaling $8.0 million. As of March 31, 2006, wehad $2.0 million outstanding under the current and previous equipmentlines of credit and $2.1 million available to be drawn against futureequipment purchases. Advances under the new equipment line of credit must berepaid in either 30 or 36 equal monthly installments, depending upon the natureof the items financed. The bank has a first priority security interest onsubstantially all of our tangible and intangible assets to secure any outstandingamounts under the modified agreement. Under the terms of the modifiedagreement, we must maintain a minimum tangible net worth and an adjusted quickratio. The modified agreement also has certain restrictions including, amongothers, on the incurrence of other indebtedness, the maintenance of depositoryaccounts, the disposition of assets, mergers, acquisitions, the granting ofliens and the payment of dividends. We were in compliance with all loancovenants as of March 31, 2006. We are currently negotiating the renewalof the credit facility, which expires on June 26, 2006.  We may not renew the facility or it may notremain available to us on acceptable terms.

 

As ofMarch 31, 2006, we had $1.3 million outstanding under a capital leaseobligation to finance electronic design automation software and relatedmaintenance. The capital lease obligation has an imputed interest rate of 8.5%per annum and is being repaid in quarterly amounts of $204,000 through November2007.

 

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As ofMarch 31, 2006, we also had $649,000 outstanding under a capital leaseobligation to finance design software tools and related maintenance. Thecapital lease obligation has an imputed interest rate of 9.0% per annum and isbeing repaid in semi-annual amounts of $148,000 through July 2008.

 

*Net cashfrom operating activities*

* *

Net cashprovided by operating activities was $1.3 million in the three monthsended March 31, 2006. The cash provided by operating activities resultedprimarily from a net loss of $1.2 million, adjusted for $1.4 millionof non-cash charges including depreciation and amortization of $686,000,stock-based compensation of $452,000 and reserves for excess inventory of$232,000. In addition, changes in working capital accounts provided cash in theamount of $1.1 million primarily as a result of a decrease of$1.4 million in accounts receivable, net of allowances for doubtfulaccounts, due to a reduction in revenue levels and the timing of shipments inthe period and a $316,000 increase in deferred income and royalty revenue dueprimarily to higher inventories at distributors on which revenue is deferred.These sources of cash were partially offset by a $591,000 decrease in accruedliabilities.

 

Net cashprovided by operating activities was $582,000 in the three months endedMarch 31, 2005.  The cash provided resulted primarily from net incomeof $864,000, adjusted for $971,000 of non-cash charges including depreciationand amortization of $665,000 and reserves for excess inventory of$205,000. In addition, changes in working capital accounts used cash inthe amount of $1.3 million primarily as a result of an increase of$1.1 million in accounts receivable, net of allowances for doubtfulaccounts, and a $940,000 increase in work-in-process and finished goodsinventory in anticipation of increased future sales, partially offset by a$260,000 increase in trade payables related to the increase in inventory, a$256,000 reduction in other current assets due to the amortization of prepaidexpenses and a $221,000 increase in deferred income and royalty revenue dueprimarily to higher inventories at distributors on which revenue is deferred.

 

*Net cash from investing activities*

 

Netcash used for investing activities for the three months ended March 31,2006 and 2005 was $709,000 and $407,000, respectively, as a result of capitalexpenditures made primarily to acquire equipment and software used in thedevelopment and production of our products.

 

*Net cash from financing activities*

 

Net cashprovided by financing activities was $1.3 million for the three monthsended March 31, 2006, resulting from $1.1 million in proceeds relatedto the issuance of common shares upon the exercise of stock options byemployees and $932,000 in proceeds from borrowings under our equipment line ofcredit, partially offset by scheduled repayments of $660,000 under the terms ofour debt and capital lease obligations.

 

Net cash usedfor financing activities was $491,000 for the three months ended March 31,2005. The use of funds was due to scheduled repayments of $772,000 underthe terms of our debt and capital lease obligations, partially offset by$281,000 of proceeds related to the issuance of common shares upon the exerciseof stock options by employees.

 

We requiresubstantial working capital to fund our business, particularly to finance ouroperations, the acquisition of property and equipment, the repayment of debtand for working capital requirements. Our future liquidity will depend on manyfactors such as these, as well as our level of revenue and gross profit, marketacceptance of our existing and new products, the decline in revenue from ourpASIC 1 and pASIC 2 products, wafer purchase commitments, the amountand timing of research and development expenditures, the timing of new productintroductions, production volumes, the quality of our products, sales andmarketing efforts, our ability to obtain debt financing and to remain incompliance with the terms of our credit facilities, our ability to raise fundsfrom the sale of Tower shares and equity in the Company, the exercise ofemployee stock options and participation in our employee stock purchase plan,and other factors related to the uncertainties of the industry and globaleconomics. However, we believe that our existing cash resources will besufficient to fund operations, capital expenditures of up to $4.0 million,and provide adequate working capital for at least the next twelve months. Asour liquidity is affected by many factors as mentioned above and as discussedin our “Risk Factors,” there can be no assurance that we will not seekadditional capital during the next twelve months or that such capital will beavailable on terms acceptable to

 

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us. After the nexttwelve months, our capital and operating requirements will depend on manyfactors, including our level of revenue and gross profit, the market acceptanceof our new products, the levels at which we maintain inventory and accounts receivable,costs of securing access to adequate manufacturing capacity, new productdevelopment efforts, capital expenditures and the level of our operatingexpenses.

 

**ContractualObligations and Commercial Commitments**

 

The followingtable summarizes our contractual obligations and commercial commitments as ofMarch 31, 2006 and the effect such obligations and commitments are expected tohave on our liquidity and cash flows in future periods (in thousands):

 
| ** **                                               | ** ** | **Payments Due by Period** | ** ** |
|----------------------------------------------------------|------------|----------------------------|------------|
| ** **                                               | ** ** | **Total**                  | ** ** | **Less than  1 Year** | ** ** | **1-3  Years** | ** ** | **3-5  Years** | ** ** | **More than  5 Years** | ** ** |
|                                                     |       |                       |       |   |   |   |   |   |   |   |   |
| *Contractual cash obligations:*                          |       |                       |       |   |   |   |   |   |   |   |   |
| Operating leases                                         |       | $                          | 2,319      |   | $ | 721 |   | $ | 1,489 |   | $ | 109 |   | $ | — |   |
| Wafer purchases (1)                                      |       | 2,791                      |       | 2,791 |   | — |   | — |   | — |   |
| Other purchase commitments                               |       | 2,822                      |       | 2,441 |   | 381 |   | — |   | — |   |
| *Total contractual cash obligations*                     |       | 7,932                      |       | 5,953 |   | 1,870 |   | 109 |   | — |   |
|                                                     |       |                       |       |   |   |   |   |   |   |   |   |
| *Other commercial commitments*(2):                       |       |                       |       |   |   |   |   |   |   |   |   |
| Notes payable to bank                                    |       | 2,049                      |       | 1,185 |   | 864 |   | — |   | — |   |
| Capital lease obligations                                |       | 1,967                      |       | 972 |   | 995 |   | — |   | — |   |
| *Total commercial commitments*                           |       | 4,016                      |       | 2,157 |   | 1,859 |   | — |   | — |   |
| Total contractual obligations and commercial commitments |       | $                          | 11,948     |   | $ | 8,110 |   | $ | 3,729 |   | $ | 109 |   | $ | — |   |

 

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(1)          Certain of our wafermanufacturers require us to forecast wafer starts several months in advance. Weare committed to take delivery of and pay for a portion of forecasted wafervolume. Wafer purchase commitments of $2.8 million include both firmpurchase commitments and a portion of our forecasted wafer starts as of March 31,2006.

 

(2)          Other commercialcommitments are included as liabilities on our balance sheet as of March 31,2006.

 

**Inflation**

** **

The impact ofinflation on our business has not been material for the periods presented.

 

**Off-BalanceSheet Arrangements**

** **

We do notmaintain any off-balance sheet partnerships, arrangements or otherrelationships with unconsolidated entities or others, often referred to asstructured finance or special purpose entities, which are established for thepurpose of facilitating off-balance sheet arrangements or other contractuallynarrow or limited purposes.

 

**RecentlyIssued Accounting Pronouncements**

** **

OnDecember 16, 2004, the Financial Accounting Standards Board, or FASB,issued SFAS No. 123(R), *“Share-BasedPayment,”*which is a revision of SFAS No. 123 and supersedesAPB 25. SFAS No. 123(R) requires all share-based payments toemployees, including grants of employee stock options, to be valued at fairvalue on the date of grant, and to be expensed over the requisite serviceperiod. Pro forma disclosure of the income statement effects of share-basedpayments is no longer an alternative. SFAS No. 123(R), as amended, iseffective for all stock-based awards granted in fiscal years beginning afterJune 15, 2005. In addition, companies must also recognize compensation expenserelated to any awards that are not fully vested as of the effective date.Compensation expense for the unvested awards will be measured based on the fairvalue of the awards previously calculated in developing the pro formadisclosures in accordance with the provisions of SFAS No. 123. EffectiveJanuary 2, 2006, the first day of our fiscal 2006, we adoptedSFAS 123(R) on a modified prospective basis. As a result, we began toinclude

 

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stock-based compensationcharges in our results of operations beginning in the quarter endedMarch 31, 2006. See Notes 2 and 9 to our Condensed UnauditedConsolidated Financial Statements.

 

In November2005, the FASB issued Staff Position, or FSP, FAS123(R)-3, *“Transition Election to Accounting for the TaxEffects of Share-Based Payment Awards.”* This FSP requires an entityto follow either the transition guidance for the additional-paid-in-capitalpool as prescribed in SFAS No. 123(R), or the alternative transitionmethod as described in the FSP. An entity that adopts SFAS No. 123(R)using the modified prospective application may make a one-time election toadopt the transition method described in this FSP. An entity may take up to oneyear from the later of its initial adoption of SFAS No. 123(R) or theeffective date of this FSP to evaluate its available transition alternativesand make its one-time election. We continue to evaluate the impact that theadoption of this FSP could have on our consolidated financial statements.

 

OnMarch 29, 2005, the SEC issued SAB No. 107, which provides guidanceon the interaction between SFAS No. 123(R), *“Shared-BasedPayment,”* and certain SEC rules and regulations.  SAB No. 107 provides guidance that maysimplify some of the SFAS No. 123(R) implementation challenges and enhancethe information that investors receive. Effective January 2, 2006, thefirst day of our fiscal 2006, we adopted SFAS 123(R) on a modified prospectivebasis and applied the principles of SAB No. 107 in conjunction with theadoption of SFAS No. 123(R).

 

In February2006, the FASB issued SFAS No. 155, *“Accountingfor Certain Hybrid Instruments—An Amendment of FASB Statements No. 133 andNo. 144,”* or SFASNo. 155. SFAS No. 155 permits fair value remeasurement for any hybridfinancial instrument that contains an embedded derivative that otherwise wouldrequire bifurcation. It also clarifies which interest-only strips andprincipal-only strips are not subject to the requirements of FASB StatementNo. 133, and establishes a requirement to evaluate interests insecuritized financial assets to identify interests that are freestandingderivatives or that are hybrid financial instruments that contain an embeddedderivative requiring bifurcation. Furthermore, SFAS No. 155 clarifies thatconcentrations of credit risk in the form of subordination are not embeddedderivatives and it amends FASB Statement No. 140 to eliminate theprohibition on a qualifying special purpose entity from holding a derivative financialinstrument that pertains to a beneficial interest other than another derivativefinancial instrument. SFAS No. 155 is effective for all financialinstruments acquired or issued after the beginning of the first fiscal yearbeginning after September 15, 2006. We do not expect the adoption of theprovisions of SFAS No. 155 to impact our financial condition or results ofoperations.

 

OnMarch 13, 2006, the FASB issued SFAS No. 156, *“Accounting for Servicing of Financial Assets,”*or SFAS No. 156. SFAS No. 156 requires an entity to recognize aservicing asset or servicing liability each time it undertakes an obligation toservice a financial asset by entering into a servicing contract under specifiedcircumstances. SFAS No. 156 also requires all separately recognizedservicing assets and servicing liabilities to be initially measured at fairvalue, if practicable. SFAS No. 156 permits an entity to choosealternative measurement methods for each class of separately recognizedservicing assets and servicing liabilities. The Statement is an amendment ofSFAS No. 140, *“Accounting for Transfers andServicing of Financial Assets and Extinguishments of Liabilities-a replacementof FASB Statement No. 125.”* SFAS No. 156 is effective forservicing assets and liabilities acquired or issued after the beginning of anentity’s fiscal year that begins after September 15, 2006. We do notexpect the adoption of the provisions of SFAS No. 156 to impact ourfinancial condition or results of operations.

 

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**Item3. Quantitative and Qualitative Disclosures about Market Risk**

** **

**InterestRate Risk**

** **

Our exposureto market rate risk for changes in interest rates relates primarily to ourinvestment portfolio and variable rate debt. We do not use derivative financialinstruments to manage our interest rate risk. We are adverse to principal lossand ensure the safety and preservation of invested funds by limiting default,market and reinvestment risk. Our investment portfolio is generally comprisedof investments that meet high credit quality standards. Since these securitiesare subject to interest rate risk, they could decline in value if interestrates fluctuate. Due to the short duration and conservative nature of ourinvestment portfolio, we do not anticipate any material loss with respect toour investment portfolio. A 10% move in interest rates as of March 31, 2006would have an immaterial effect on our financial position, results ofoperations and cash flows.

 

**ForeignCurrency Exchange Rate Risk**

 

All of oursales and cost of manufacturing are transacted in U.S. dollars. We conducted aportion of our research and development activities in Canada and India and havesales and marketing offices in several locations outside of the United States.We use the U.S. dollar as our functional currency. Most of the costs incurredat these international locations are in local currency. If these localcurrencies strengthen against the U.S. dollar, our payroll and other localexpenses will be higher than we currently anticipate. Since our sales aretransacted in U.S. dollars, this negative impact on expenses would not beoffset by any positive effect on revenue. Operating expenses denominated inforeign currencies were approximately 23% and 26% of total operating expensesfor the three months ended March 31, 2006 and 2005, respectively. Amajority of these foreign expenses were incurred in Canada. A currency exchangerate fluctuation of 10% would have caused our operating expenses to change byapproximately $180,000 in the three months ended March 31, 2006.

 

**EquityPrice Risk**

 

Our exposureto equity price risk for changes in market value relates primarily to ourinvestment in Tower Semiconductor Ltd., or Tower. Tower’s ordinary shares tradeon the Nasdaq National Market under the symbol “TSEM”.  Since these securities are publicly traded onthe open market, they are subject to market fluctuations.  Temporary market fluctuations are reflectedby increasing or decreasing the presented value of the related securities andrecording “other comprehensive income (loss)” in the equity section of thebalance sheet.  An “other than temporary”decline in market value is reflected by decreasing the adjusted cost of therelated securities and recording a charge to operating expenses on the incomestatement. We wrote down the value of the Tower shares due to an “other thantemporary” decline in their market value by $1.5 million,$1.5 million, $3.8 million and $6.8 million in fiscal 2005,2004, 2002 and 2001, respectively. The determination that the declinein market value was “other than temporary” included factors such as marketvalue and the period of time that the market value had been below the carryingvalue in each of the respective periods. A market value fluctuation of 10%would have caused us to reduce accumulated other comprehensive income byapproximately $170,000 in the three months ended March 31, 2006.

 

**Item 4. Controls and Procedures**

 

**Evaluationof Disclosure Controls and Procedures**

 

Our managementevaluated, with the participation of our Chief Executive Officer and ChiefFinancial Officer, the effectiveness of our disclosure controls and proceduresas of the end of the period covered by this Quarterly Report on Form 10-Q.Based upon that evaluation, our Chief Executive Officer and Chief FinancialOfficer concluded that our disclosure controls and procedures are effective toensure that information we are required to disclose in reports that we file orsubmit under the Securities Exchange Act of 1934, as amended, is(i) recorded, processed, summarized and reported within the time periodsspecified in Securities and Exchange Commission rules and forms, and(ii) accumulated and communicated to our management, including our ChiefExecutive Officer and Chief Financial Officer, as appropriate to allow timelydecisions regarding required disclosure. Based upon that evaluation, our Chief Executive Officer and ChiefFinancial Officer concluded that, while no cost-effective control system willpreclude all errors and irregularities, our current disclosure controls andprocedures are effective to provide reasonable assurance that the financialstatements and other disclosures in our SEC reports are reliable.

 

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**Changesin Internal Control Over Financial Reporting**

 

There were nochanges in our internal control over financial reporting that occurred duringthe period covered by this Quarterly Report on Form 10-Q that have materiallyaffected, or are reasonably likely to materially affect, our internal controlover financial reporting.

 

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**Part II.Other Information**

 

**Item1. Legal Proceedings**

 

OnOctober 26, 2001, a putative securities class action was filed in the U.S.District Court for the Southern District of New York against certain investmentbanks that underwrote QuickLogic’s initial public offering, QuickLogic and someof QuickLogic’s officers and directors. The complaint alleges excessive andundisclosed commissions in connection with the allocation of shares of commonstock in QuickLogic’s initial and secondary public offerings and artificiallyhigh prices through “tie-in” arrangements which required the underwriters’customers to buy shares in the aftermarket at pre-determined prices inviolation of the federal securities laws. Plaintiffs seek an unspecified amountof damages on behalf of persons who purchased QuickLogic’s stock pursuant tothe registration statements between October 14, 1999 and December 6,2000. Various plaintiffs have filed similar actions asserting virtuallyidentical allegations against over 300 other public companies, theirunderwriters, and their officers and directors arising out of each company’spublic offering. These actions, including the action against QuickLogic, havebeen coordinated for pretrial purposes and captioned *In re Initial Public Offering Securities Litigation, 21 MC 92*.A stipulation of settlement for the claims against the issuer defendants,including the Company, has been signed and was submitted to the court. Underthe stipulation of settlement, the plaintiffs will dismiss and release allclaims against participating defendants in exchange for a contingent paymentguaranty by the insurance companies collectively responsible for insuring theissuers in all the related cases, and the assignment or surrender to theplaintiffs of certain claims the issuer defendants may have against theunderwriters. Under the guaranty, the insurers will be required to pay theamount, if any, by which $1.0 billion exceeds the aggregate amount ultimatelycollected by the plaintiffs from the underwriter defendants in all the cases.On February 15, 2005, the court preliminarily approved the settlementcontingent on specified modifications. The settlement is still subject to courtapproval and a number of other conditions. There is no guarantee that thesettlement will become effective.

 

OnJuly 3, 2003, a putative securities class action was filed in the U.S.District Court for the Southern District of New York by shareholders of TowerSemiconductor Ltd. against Tower, several of its directors, and several of itsinvestors, including QuickLogic. QuickLogic was named solely as an allegedcontrol person. On August 19, 2004, the court dismissed the claims againstall defendants, including QuickLogic, with prejudice. On September 29,2004, one of the plaintiffs filed a notice of appeal from the judgment.

 

**Item1A. Risk Factors**

 

Thisdescription includes any material changes to the description of the riskfactors associated with our business previously disclosed in Item 1A of our2005 Annual Report on Form 10-K filed with the SEC on March 17, 2006.Because of the following risk factors, as well as other variables affecting ouroperating results, past financial performance may not be a reliable indicatorof future performance, and historical trends should not be used to anticipateresults or trends in future periods.

 

**Risk Factors**

 

# *We expect the announced end-of-life of ourpASIC 1 and pASIC 2 products will result in a decline in our revenue*

# * *

Our foundryagreement with the supplier that fabricates our pASIC 1 and pASIC 2products expired on December 31, 2005. We announced an end-of-life forthese products in 2004 and asked our customers to take delivery of lifetime buyorders before the end of 2005. As a result, we will experience a reduction inrevenue from these products. Revenue from these products was $6.4 million, $5.1million, $6.0 million and $3.5 million in the first, second, third andfourth quarters of 2005, respectively, and $2.3 million in the firstquarter of 2006. We believe that revenue from these products may contribute norevenue in the third quarter of 2006 and beyond. We believe that a majority ofour customers that use pASIC 1 and pASIC 2 products have purchasedenough pASIC 1 and pASIC 2 product to satisfy demand through theexpected life of their products rather than migrate to other QuickLogicproducts. While we may have limited fabrication capacity for these products in2006, we currently expect that the supplier will replace the equipment used tofabricate our devices with other equipment by the third quarter of 2006, whichwould end our ability to purchase additional wafers. Our operating results andliquidity will be adversely affected by the end-of-life of our pASIC 1 andpASIC 2 products. To mitigate the affects of the end-of-life of ourpASIC 1 and pASIC 2 products, we plan to: migrate customers to otherQuickLogic products; develop customer demand for new products, such asPolarPro, Eclipse II and QuickPCI II, which have strong customerdesign activity but limited revenue history; and increase revenue and grossprofit from our other products. The pASIC 1 and

 

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pASIC 2 revenue declinemay be more rapid than the revenue growth from our PolarPro, Eclipse II,QuickPCI II and other products. While we expect revenue growth fromPolarPro, Eclipse II, QuickPCI II, other products and new productswill offset the expected decline in pASIC 1 and pASIC 2 revenue,there is no assurance when this will occur, if at all.

 

# *If we fail to successfully develop, introduceand sell new products, we may be unable to compete effectively in the future*

# * *

We operate ina highly competitive, quickly changing environment marked by rapid obsolescenceof existing products. To compete successfully, we must obtain access toadvanced fabrication capacity and dedicate significant resources to specify,design, develop, manufacture and sell new or enhanced products and solutions thatprovide increasingly higher levels of performance, low power consumption, newfeatures, reliability and/or cost savings to our customers. We experience along delay between the time when we expend these product definition anddevelopment resources and invest in related long-lived assets, and the timewhen we begin to generate revenue, if any, from these expenditures.

 

We aremarketing our Eclipse II, QuickPCI II and PolarPro products to newcustomers and markets and expect a significant portion of our future revenuesto be generated from these new products. We believe our low-powerEclipse II, QuickPCI II and PolarPro products have a compellingadvantage in low-power applications, and that this business will providelong-term revenue growth for QuickLogic, but there is no assurance when thiswill occur, if at all. Some of these opportunities are in the rapidly changingconsumer market, which typically has shorter product life cycles, highervolumes and greater price pressure than our traditional business. In order toreact quickly to opportunities, we have made significant investments inEclipse II and QuickMIPS inventory. If we are unable to design, produceand sell new products and solutions that meet design specifications, addresscustomer requirements, and generate sufficient revenue and gross profit, ifmarket demand for our products fails to materialize, if we are unable to obtainadequate capacity, or if our customers do not successfully introduce productsincorporating our devices, our revenue and gross margin will be materiallyharmed and we may be required to write-off related inventory and long-livedassets or have other adverse effects on our business.

 

# *We may be unable to accurately estimatequarterly revenue, which could adversely affect the trading price of our stock*

# * *

We offer ourcustomers a short delivery lead-time and a majority of our shipments during aquarter are ordered by customers in that quarter. As a result, we often havelow visibility to the current quarter’s revenue, and our revenue levels canchange significantly in a short period of time. Furthermore, our ability torespond to increased demand is limited to inventory on hand or on order, thecapacity available at our contract manufacturers and our capacity to programproducts to customer specifications. In addition, a significant portion of ourrevenue is deferred until our distributors ship unprogrammed parts to endcustomers since the price is not fixed or determinable until that time.Therefore, we are highly dependent on the accuracy and timeliness of resale andinventory reports from our distributors. Inaccurate distributor resale orinventory reports, as well as unanticipated changes in distributor inventorylevels, could contribute to our difficulty in predicting and reporting ourquarterly revenue and results of operations. If we fail to accurately estimatecustomer demand, record revenue, or if our available capacity is less thanneeded to meet customer demand, our results of operations could be harmed andour stock price could materially fluctuate.

 

# *Our future results depend on our relationshipwith Tower*

# * *

We haveinvested approximately $21.3 million in Tower. In return for ourinvestment, we received equity, prepaid wafer credits and committed productioncapacity in Tower’s foundry facility. We believe that Tower’s long-termoperation of this fabrication facility depends on its ability to attractsufficient customer demand, to obtain additional financing, to increasecapacity, to obtain the release of grants and approvals for changes in grantprograms from the Israeli government’s Investment Center, and its ability toremain in compliance with the terms of its grant and credit agreements. Thecurrent political uncertainty and security situation in the Middle East whereTower’s fabrication facility is located, the cyclical nature of the market forfoundry manufacturing services, Tower’s financial condition, or other factorsmay adversely impact Tower’s business prospects and may discourage futureinvestments in Tower from outside sources. We may decide to invest additionalfunds in Tower, which could have an impact on our cash position and liquidity.If Tower is unable to obtain adequate financing and increase

 

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production output in a timelymanner, the value of our investment in Tower may decline significantly orpossibly become worthless, our wafer credit from Tower may decline in value orpossibly become worthless, and we would have to identify and qualify asubstitute supplier to manufacture our products. This could require significantdevelopment time, cause product shipment delays, impair long-lived assets andthe value of our wafer credits, damage our liquidity and severely harm ourbusiness. In addition, Tower solely manufactures our Eclipse II, PolarPro,certain QuickPCI II, QuickMIPS and other new products currently underdevelopment.

 

The value ofour investment in Tower and its corresponding wafer credits may also beadversely affected by a deterioration of conditions in the market for foundrymanufacturing services and the market for semiconductor products. AtMarch 31, 2006, the aggregated value of our Tower investment and wafercredits recorded on our balance sheets was $5.9 million. If the fair valueof our Tower investment or our wafer credits are deemed to be impaired, we willrecord charges to our statement of operations. For instance, the fair value ofour Tower investment was $2.26 per share at the end of 2004 as compared to$1.17 per share at the end of the second quarter of 2005. Since the value ofour Tower investment remained below $2.26 per share for a period of time, werecorded a $1.5 million write-down of marketable securities in the secondquarter of 2005.

 

# *We depend upon third parties to fabricate,assemble, test and program our products, and they may discontinue manufacturingour products, fail to give our products priority, be unable to successfullymanufacture our products to meet performance, volume or cost targets, orinaccurately report inventory to us*

# * *

We contractwith third parties to fabricate, assemble, test and program our devices. Ourdevices are generally fabricated, assembled and programmed by single suppliers,and the loss of a supplier, expiration of a supply agreement or the inabilityof our suppliers to manufacture our products to meet volume, performance andcost targets could have a material adverse effect on our business. Tower solelymanufactures our Eclipse II, PolarPro, certain QuickPCI II, QuickMIPS andother new products currently under development. Furthermore, a single supplierfabricates our pASIC 1 and pASIC 2 products under an agreement thatexpired in December 2005. While we may be able to purchase limitedpASIC 1 and pASIC 2 wafers in 2006, these products contributed 44% of2005 revenue and we anticipate that revenue from these products may be zero bythe third quarter of 2006. In addition, demand for assembly capacity at one ofour suppliers has increased. For this and other reasons, capacity available tous may be constrained. Programming capacity at our suppliers is also dependenton our investment in sufficient programming hardware to meet fluctuatingdemand. Our relationship with our suppliers could change as a result of amerger or acquisition. If for any reason these suppliers or any other vendorbecomes unable or unwilling to continue to provide services of acceptablequality, at acceptable costs and in a timely manner, our ability to operate ourbusiness or deliver our products to our customers could be severely impaired.We would have to identify and qualify substitute suppliers, which could be timeconsuming and difficult and could result in unforeseen operational problems, orwe could announce an end-of-life program for these products, as we did with ourpASIC 1 and pASIC 2 products. Alternate suppliers might not beavailable to fabricate, assemble, test and program our devices or, ifavailable, might be unwilling or unable to offer services on acceptable terms.

 

In addition,if competition for wafer manufacturing capacity increases, if we need tomigrate to more advanced wafer manufacturing technology, or if competition forbackend services increases, we may be required to pay or invest significantamounts to secure access to this capacity. The number of companies that providethese services is limited and some of them have limited operating histories andfinancial resources. In the event our current suppliers refuse or are unable tocontinue to provide these services to us, we may be unable to procure servicesfrom alternate suppliers in a timely manner, if at all. Furthermore, ifcustomer demand for our products increases, we may be unable to securesufficient additional capacity from our current suppliers on commerciallyreasonable terms, if at all. Moreover, our reliance on a limited number ofsuppliers subjects us to reduced control over delivery schedules, qualityassurance and costs. This lack of control may cause unforeseen productshortages or may increase our cost to manufacture and test our products, whichwould adversely affect our operating results and cash flows.

 

We record amajority of our inventory transactions based on information from oursubcontractors. If we do not receive prompt and accurate information from ourvendors, we could misstate inventory levels, incorrectly record gross profit,and be unable to meet our delivery commitments to customers or commit tomanufacturing inventory that is not required to meet customer deliverycommitments, which could materially harm our business.

 

# *Our customers may cancel or change theirproduct plans after we have expended substantial time and resources in thedesign of their products*

# * *

Our customersoften evaluate our products for six months or more before designing them intotheir systems, and they may not commence volume shipments for up to anadditional six to twelve months, if at all. During this lengthy sales cycle,our potential customers may cancel or change their product plans. In addition,customers may discontinue products incorporating our devices at any time orthey may choose to replace our products with lower cost semiconductors. Ifcustomers cancel, reduce or delay product orders from us or choose not torelease equipment that incorporates our products after we have spentsubstantial time and resources in assisting them with their product design, ourbusiness could be materially harmed.

 

# *We are expending substantial time and effortto develop solutions with partners that depend on the availability and successof technology owned by the partner*

# * *

Our approachto developing system solutions for potential customers involves embeddedprocessors or peripheral devices developed by other parties and specificindustry standards such as PCI, IDE and Secure Digital Input/Output, or SDIO.We have entered into informal partnerships with these other parties thatinvolve the development of solutions that interface with their devices. Theseinformal partnerships also may involve joint marketing campaigns and salescalls. For example, we have developed a system solution incorporating aspecific embedded processor, a micro hard disk drive and our Eclipse IIdevice that lowers the overall power consumption of a system and improvessystem performance. If our solution is not incorporated into customer products,if our partners discontinue production of their products, if our customers donot incorporate our solution into their product, or if the informal partnershipis significantly reduced or terminated, our revenue and gross margin will bematerially harmed and we may be required to write-off related long-livedassets.

 

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# *We will be unable to compete effectively ifwe fail to anticipate product opportunities based upon emerging technologiesand standards and fail to develop products that incorporate these technologiesand standards in a timely manner*

# * *

We spendsignificant time and money to design and develop products and customersolutions around an industry standard, such as Peripheral ComponentInterconnect, or PCI, and Integrated Drive Electronics, or IDE, or emergingtechnology, such as advanced process technology or lead-free packaging. Weintend to develop additional products and solutions and adopt new technology inthe future. If system manufacturers adopt alternative standards ortechnologies, if an industry standard or emerging technology that we havetargeted fails to achieve broad market acceptance, or if we are unable to bringthe technology or solutions to market in a timely manner, we may be unable togenerate significant revenue from our research and development efforts. As aresult, our business would be materially harmed and we may be required towrite-off related inventory and long-lived assets.

 

# *We may not have the liquidity to support ourfuture operations and capital requirements*

# * *

Our cash and cash equivalents balance at March 31, 2006 was$30.2 million. At March 31, 2006, our interest-bearing debt consistedof $2.0 million outstanding from Silicon Valley Bank and $2.0 millionoutstanding under capital leases. On June 27, 2005, we modified our creditfacility with Silicon Valley Bank. Terms of the modified agreement include an$8.0 million revolving line of credit available through June 2006 and$3.0 million of borrowing capacity under the equipment line of credit thatis available to be drawn through June 2006. We are currently negotiatingthe renewal of the credit facility, which expires on June 26, 2006. We may notrenew the facility or it may not remain available on acceptable terms. AtMarch 31, 2006, we had approximately $8.0 million available to borrowunder our revolving credit facility and approximately $2.1 millionavailable to borrow under our equipment line of credit.

 

At the end ofthe first quarter of 2006, we held 1,344,543 Tower ordinary shares availablefor sale valued at approximately $1.7 million based upon the marketclosing price of $1.28 per share on such date. Our ability to obtain capacityat competitive pricing from Tower is tied to our ownership of at least 450,000of these Tower shares.

 

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Capitalexpenditures, which are largely driven by development activities and theintroduction and initial manufacturing of new products, could be up to$4.0 million in the next twelve months. As of March 31, 2006, we hadcommitments to purchase $2.8 million of wafer inventory.

 

On July 12,2005, we filed a shelf registration statement on Form S-3 with the SEC, whichhas been declared effective. Under this filing, we may decide to raise up to$30.0 million, in one or several transactions, by selling common stock,preferred stock, depositary shares, and warrants.

 

As a result ofpotential investments, the expected fluctuation in revenue from ourpASIC 1 and pASIC 2 products, operating expenses, changes in workingcapital and interest and debt payments, we will need to generate higher revenueand gross profit, especially from our new Eclipse II, QuickPCI II andPolarPro products and products currently under development, to maintainpositive cash flow. Whether we can achieve cash flow levels sufficient tosupport our operations cannot be accurately predicted. Unless such cash flowlevels are achieved, we may borrow additional funds or sell debt or equitysecurities, or some combination thereof, to provide funding for our operations.If adequate funds are not available when needed, our financial condition andoperating results would be materially adversely affected and we may not be ableto operate our business without significant changes in our operations, or at all.

 

# *If we fail to adequately forecast demand forour products, we may incur product shortages or excess product inventory*

# * *

Our agreementswith third-party manufacturers require us to provide forecasts of ouranticipated manufacturing orders, and place binding manufacturing commitmentsin advance of receiving purchase orders from our customers. This may result inproduct shortages or excess product inventory because we are limited in ourability to increase or decrease our forecasts under such agreements. Othermanufacturers supply us product on a purchase order basis. The allocation ofcapacity is determined solely by our suppliers over which we have no directcontrol. Additionally, we provide programming equipment to our suppliers toprogram our products to customer specifications. The programming equipment ismanufactured to our specifications and has significant order lead-times.Obtaining additional supply in the face of product, programming equipment orcapacity shortages may be costly, or not possible, especially in the short termsince most of our products and programming equipment are supplied by a singlevendor. Our failure to adequately forecast demand for our products couldmaterially harm our business.

 

# *Fluctuations in our manufacturing processes andproduct yields and quality, especially for new products, may increase our costs*

# * *

Difficultiesencountered during the complex semiconductor manufacturing process can render asubstantial percentage of semiconductor wafers nonfunctional, and manufacturingfluctuations may change the performance distribution of manufactured products.We have, in the recent past, experienced manufacturing runs that have containedsubstantially reduced or no functioning devices, or that generated devices withbelow normal performance characteristics. In addition, manufacturing yieldproblems may take a significant period of time to analyze and correct. Ourreliance on third party suppliers may extend the period of time required toanalyze and correct these problems. Once corrected, our customers may berequired to redesign or requalify their products. As a result, we may incursubstantially higher manufacturing costs, inventory shortages or reducedcustomer demand.

 

Yieldfluctuations frequently occur in connection with the manufacture of newlyintroduced products, with changes in product architecture, with manufacturingat new facilities or on new manufacturing processes. Newly introduced productsand products that incorporate new intellectual property, such as our Eclipse IIand PolarPro products, are often more complex and more difficult to produce,increasing the risk of manufacturing-related defects. New manufacturingfacilities or processes, such as at Tower, are often more complex and take aperiod of time to achieve expected quality levels and product costs. While wetest our products, including our software development tools, they may stillcontain errors or defects that are found after we have commenced commercialproduction, that occur due to manufacturing variations or as new intellectualproperty is incorporated into our products. If our products contain undetectedor unresolved defects, we may lose market share, experience delays in or lossof market acceptance, reserve or scrap inventory, or be required to issue a productrecall. In addition, we would be at risk of product liability litigation ifdefects in our products were discovered. Although we attempt to limit ourliability to end users through disclaimers of special, consequential andindirect damages and similar provisions, we cannot assure you that suchlimitations of liability will be legally enforceable.

 

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# *We have significant customers and limitedvisibility into the long-term demand for our products from these customers*

# * *

A few of ourend customers can represent a significant portion of our total revenue in agiven reporting period and the likelihood of this occurring will increase inthe future as we target high-volume consumer applications. As in the past, futuredemand from these customers may fluctuate significantly. These customerstypically order products with short requested delivery lead times, and do notprovide a firm commitment to purchase product past the period covered bypurchase orders. In addition, our manufacturing lead times are longer than thedelivery lead times requested by these customers, and we make significantinventory purchases in anticipation of future demand. For example, a U.S.-basedinstrumentation and test customer accounted for 13% of revenue infiscal 2005. If revenue from any significant customer were to declinesubstantially, we may be unable to offset this decline with increased revenuefrom other customers and we may purchase excess inventory. These factors couldseverely harm our business.

 

In addition,we may make a significant investment in long-lived assets for the production ofour products based upon historical and expected demand. If demand for or grossmargin generated from our products does not meet our expectations or if we areunable to collect amounts due from significant customers, we may be required towrite-off inventory, provide for uncollectible accounts receivable or incurcharges against long-lived assets, which would materially harm our business.

 

# *We have a history of losses and cannot assureyou that we will again be profitable in the future*

# * *

We incurredsignificant losses in 2004, 2003 and 2002. Our accumulated deficit as ofMarch 31, 2006 was $118.6 million. Although we recorded net income of$2.4 million for the year ended December 31, 2005, we recorded a netloss of $1.2 million in the first quarter of 2006 and we may not return toprofitability in any future periods. Our profitability for the year endedDecember 31, 2005 and in certain years prior to 2001 cannot be relied uponas any indication of our future operating results or prospects.

 

# *We depend upon third party distributors tomarket and sell our products, and they may discontinue sale of our products,fail to give our products priority or be unable to successfully market, selland support our products*

# * *

We contractwith third-party distributors to market and sell a significant portion of ourproducts. We typically have only a few distributors serving each geographicmarket, and, in the future, we may have a single distributor covering ageographic market. Although we have contracts with our distributors, ouragreements with them may be terminated on short notice by either party and, ifterminated, we may be unable to recruit additional or replacement distributors.Additionally, distributors that we have contracted with may acquire, beacquired or merge with other distributors which may result in the terminationof our contract or less effort being placed on the marketing, sale and supportof our products. As a result, our future performance will depend in part on ourability to retain our existing distributors and attract new distributors thatwill be able to effectively market, sell and support our products. The loss ofone or more of our principal distributors, or our inability to attract newdistributors, could materially harm our business.

 

Many of ourdistributors, including our principal distributors, market and sell productsfor other companies, and many of these products may compete directly or indirectlywith our products. We generally are not one of the principal suppliers ofproducts to our distributors. If our distributors give higher priority orgreater attention to the products of other companies, including products thatcompete with our products, our business would be materially harmed.

 

Individualdistributors and original equipment manufacturers often represent a significantportion of our accounts receivable. If we are unable to collect funds due fromthese distributors and customers, our financial results may be materiallyharmed.

 

# *Our future operating results are likely tofluctuate and therefore may fail to meet expectations, which could cause ourstock price to decline*

# * *

Our operatingresults have varied widely in the past and are likely to do so in the future.In addition, our past operating results may not be an indicator of futureoperating results. Our future operating results will depend on many factors andmay fail to meet our expectations for a number of reasons, including those setforth in these risk factors. Any failure to meet expectations could cause ourstock price to significantly fluctuate or decline.

 

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Factors that could cause our operating results to fluctuate include:

 

•                  theeffect of end-of-life programs;

 

•                  asignificant change in sales to or the collectibility of accounts receivablefrom our largest customers;

 

•                  successfuldevelopment and market acceptance of our products and system solutionsincorporating our products;

 

•                  ourability to accurately forecast product volumes and mix, and to respond to rapidchanges in customer demand;

 

•                  changesin sales volume, product mix, average selling prices or production variancesthat affect gross profit;

 

•                  ourability to adjust our manufacturing capacity and costs in response to economicand competitive pressures;

 

•                  ourreliance on subcontract manufacturers for product capacity, yield and quality;

 

•                  ourcompetitors’ product portfolio and product pricing policies;

 

•                  timelyimplementation of efficient manufacturing technologies;

 

•                  changesin accounting and corporate governance rules;

 

•                  theissuance of stock options, or changes in the terms of our employee stockpurchase plan;

 

•                  mergersor acquisitions;

 

•                  impactof import and export laws and regulations;

 

•                  thecyclical nature of the semiconductor industry and general economic, market,political and social conditions in the countries where we sell our products andthe related effect on our customers, distributors and suppliers; and

 

•                  ourability to obtain capital, debt financing and insurance on commerciallyreasonable terms.

 

Althoughcertain of these factors are out of our immediate control, unless we cananticipate and be prepared with contingency plans that respond to thesefactors, our business may be materially harmed.

 

# *We may encounter periods of industry-widesemiconductor oversupply, resulting in pricing pressure, as well asundersupply, resulting in a risk that we could be unable to fulfill ourcustomers’ requirements*

# * *

Thesemiconductor industry has historically been characterized by wide fluctuationsin the demand for, and supply of, its products. These fluctuations haveresulted in circumstances when supply of and demand for semiconductors havebeen widely out of balance. An industry-wide semiconductor oversupply couldresult in severe downward pricing pressure from customers. In a market withundersupply of manufacturing capacity, we would have to compete with largerfoundry and assembly customers for limited manufacturing resources. In such anenvironment, we may be unable to have our products manufactured in a timelymanner, at a cost that generates adequate gross profit, or in sufficientquantities. Since we outsource all of our manufacturing and generally have a single-sourceof wafer supply, test, assembly and programming for our products, we areparticularly vulnerable to such supply shortages and capacity limitations. As aresult, we may be unable to fulfill orders and may lose customers. Any futureindustry-wide oversupply or undersupply of semiconductors could materially harmour business.

 

# *Customers may cancel or defer significantpurchase orders or our distributors may return our products, which would causeour inventory levels to increase and our revenue to decline*

# * *

Ourdistributors or customers may cancel purchase orders at any time with little orno penalty. Contractually, our distributors are generally permitted to returnunprogrammed products worth up to 10%, by value, of the products

 

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they purchase from us. If ourdistributors or customers cancel or defer significant purchase orders or returnour products, our accounts receivable collections would decrease andinventories would increase, which would materially harm our business.

 

# *Problems associated with internationalbusiness operations could affect our ability to manufacture and sell ourproducts*

# * *

Most of ourproducts are manufactured outside of the United States at manufacturingfacilities operated by our suppliers in Taiwan, South Korea, the Philippines,Israel and Malaysia. We expect to manufacture a majority of our new productsand the products that we currently have under development in Israel and toassemble these products in South Korea, the Philippines, Malaysia, Wales orChina. As a result, these manufacturing operations and new productintroductions are subject to risks of political instability, including the riskof conflict between Taiwan and the People’s Republic of China, between SouthKorea and North Korea, and conflicts involving Israel or Malaysia.

 

A significantportion of our total revenue comes from sales to customers located outside theUnited States. We anticipate that sales to customers located outside the UnitedStates will continue to represent a significant portion of our total revenue infuture periods. In addition, most of our domestic customers sell their productsoutside of North America, thereby indirectly exposing us to risks associatedwith foreign commerce and economic instability. In addition to overseas salesoffices, we have significant research and development activities in Canada andIndia. Accordingly, our operations and revenue are subject to a number of risksassociated with foreign commerce, including the following:

 

•                  managingforeign distributors;

 

•                  collectingamounts due;

 

•                  staffingand managing foreign offices;

 

•                  politicaland economic instability;

 

•                  foreigncurrency exchange fluctuations;

 

•                  changesin tax laws, import and export regulations, tariffs and freight rates;

 

•                  timingand availability of export licenses;

 

•                  supplyingproducts that meet local environmental regulations; and

 

•                  inadequateprotection of intellectual property rights.

 

In the past,we have denominated sales of our products to foreign countries exclusively inU.S. dollars. As a result, any increase in the value of the U.S. dollarrelative to the local currency of a foreign country will increase the price ofour products in that country so that our products become relatively moreexpensive to customers in the local currency of that foreign country. As aresult, sales of our products in that foreign country may decline. To theextent any such risks materialize, our business could be materially harmed.

 

In addition,we incur costs in foreign countries that may be difficult to reduce quicklybecause of employee-related laws and practices in those foreign countries.

 

# *Many system manufacturers may be unwilling toswitch to our products because of their familiarity with the products offeredby our direct competitors, such as Xilinx and Altera, which dominate theprogrammable logic market*

# * *

Thesemiconductor industry is intensely competitive and characterized by:

 

•                  erosionof selling prices over product lives;

 

•                  rapidtechnological change;

 

•                  shortproduct life cycles; and

 

•                  strongdomestic and foreign competition.

 

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If we are notable to compete successfully in this environment, our business will bematerially harmed.

 

Many of ourcompetitors have substantially greater financial, technical, manufacturing,marketing, sales, distribution, name recognition and other resources than wedo. In addition, many of our competitors have well-established relationshipswith our current and potential customers and have extensive knowledge of systemapplications. In the past, we have lost potential customers to competitors forvarious reasons, including, but not limited to, re-programmability and lowerprice. Our current direct competitors include suppliers of complex programmablelogic devices and field programmable gate arrays, such as Xilinx, Inc., AlteraCorporation, Actel Corporation, and Lattice Semiconductor Corporation. Xilinxand Altera together have a majority share of the programmable logic market.Many system manufacturers may be unwilling or unable to switch to our productsdue to their familiarity with competitors’ products or other inhibitingfactors.

 

We also facecompetition from companies that offer ASICs, which may be purchased for a lowerprice at higher volumes and typically have greater logic capacity, additionalfeatures and higher performance than those of our products. We may also facecompetition from suppliers of embedded microprocessors, such as FreescaleSemiconductor, Inc., or from suppliers of products based on new or emergingtechnologies. Our inability to successfully compete in any of the followingareas could materially harm our business:

 

•                  thedevelopment of new products and advanced manufacturing technologies;

 

•                  thequality, performance characteristics, price and availability of devices,programming hardware and software development tools;

 

•                  theability to engage with companies that provide synergistic products andservices;

 

•                  theincorporation of industry standards in our products;

 

•                  thediversity of product offerings available to customers; or

 

•                  thequality and cost effectiveness of design, development, manufacturing andmarketing efforts.

 

# *We may be unable to successfully grow ourbusiness if we fail to compete effectively with others to attract and retainkey personnel*

# * *

We believe ourfuture success will depend upon our ability to attract and retain engineers andother highly competent personnel. Our employees are at-will and not subject toemployment contracts. Hiring and retaining qualified sales, technical andfinancial personnel is difficult due to the limited number of qualifiedprofessionals, economic conditions and the size of our company. Competition forthese types of employees is intense. In addition, new hires frequently requireextensive training before they achieve desired levels of productivity. We havein the past experienced difficulty in recruiting and retaining qualified seniormanagement, sales, finance and technical personnel. Failure to attract, hire,train and retain personnel could materially harm our business.

 

# *We may be unable to adequately protect ourintellectual property rights, and may face significant expenses as a result offuture litigation*

# * *

Protection ofintellectual property rights is crucial to our business, since that is how wekeep others from copying the innovations that are central to our existing andfuture products. From time to time, we receive letters alleging patentinfringement or inviting us to license other parties’ patents. We evaluatethese requests on a case-by-case basis. These situations may lead to litigationif we reject the offer to obtain the license.

 

We have in thepast and are currently involved in litigation relating to alleged infringementby us of others’ patents or other intellectual property rights. This kind oflitigation is expensive and consumes large amounts of management’s time andattention. Additionally, matters that we initially consider not material to ourbusiness could become costly. For example, we incurred substantial costsassociated with the litigation and settlement of our dispute with Actel, whichmaterially harmed our business. In addition, if the letters we sometimesreceive alleging patent infringement or other similar matters result inlitigation that we lose, a court could order us to pay substantial damagesand/or royalties, and prohibit us from making, using, selling or importingessential technologies. For these and other reasons, this kind of litigationcould materially harm our business.

 

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Also, althoughwe may seek to obtain a license under a third party’s intellectual propertyrights in order to bring an end to certain claims or actions asserted againstus, we may not be able to obtain such a license on reasonable terms, or at all.We have entered into technology license agreements with third parties whichgive those parties the right to use patents and other technology developed byus, and which give us the right to use patents and other technology developedby them. We anticipate that we will continue to enter into these kinds oflicensing arrangements in the future; however, it is possible that desirablelicenses will not be available to us on commercially reasonable terms. If welose existing licenses to key technology, or are unable to enter into newlicenses that we deem important, it could materially harm our business.

 

Because it iscritical to our success that we continue to prevent competitors from copyingour innovations, we intend to continue to seek patent and trade secretprotection for our products. The process of seeking patent protection can belong and expensive, and we cannot be certain that any currently pending orfuture applications will actually result in issued patents, or that, even ifpatents are issued, they will be of sufficient scope or strength to providemeaningful protection or any commercial advantage to us. Furthermore, othersmay develop technologies that are similar or superior to our technology ordesign around the patents we own. We also rely on trade secret protection forour technology, in part through confidentiality agreements with our employees,consultants and other third parties. However, these parties may breach theseagreements, and we may not have adequate remedies for any breach. In any case,others may come to know about or determine our trade secrets through a varietyof methods. In addition, the laws of certain territories in which we develop,manufacture or sell our products may not protect our intellectual propertyrights to the same extent as the laws of the United States.

 

# *We may engage in manufacturing, distributionor technology agreements that involve numerous risks, including the use ofcash, diversion of resources and significant write-offs*

# * *

We haveentered into and, in the future, intend to enter into agreements that haveinvolved numerous risks, including the use of significant amounts of our cash;diversion of resources from other development projects or market opportunities;our ability to incorporate licensed technology in our products; our ability tointroduce related products in a cost-effective and timely manner; our abilityto collect amounts due under these contracts; and market acceptance of relatedproducts. For instance, we have licensed certain microprocessor technology fromMIPS Technologies and obtained other elements of our products from third-partycompanies. In the fourth quarter of 2004, we determined that the expectedrevenue and gross profit from these products would not be sufficient to recoverthe full carrying value of the related third party elements and otherlong-lived assets, and we recorded a $3.2 million long-lived assetimpairment charge. If we fail to recover the cost of these or other assets fromthe cash flow generated by the related products, our assets will becomeimpaired and our financial results would be harmed.

 

# *Our business is subject to the risks ofearthquakes, other catastrophic events and business interruptions for which wemay maintain limited insurance*

# * *

Our operationsand the operations of our suppliers are vulnerable to interruption by fire,earthquake, power loss, flood, terrorist acts and other catastrophic eventsbeyond our control. In particular, our headquarters is located near earthquakefault lines in the San Francisco Bay area. In addition, we rely on solesuppliers to manufacture our products and would not be able to qualify analternate supplier of our products for several quarters. Our suppliers oftenhold significant quantities of our inventory which, in the event of a disaster,could be destroyed. In addition, our business processes and systems arevulnerable to computer viruses, break-ins, and similar disruptions fromunauthorized tampering. Any catastrophic event, such as an earthquake or othernatural disaster, the failure of our computer systems, war or acts ofterrorism, could significantly impair our ability to maintain our records, payour suppliers, or design, manufacture or ship our products. The occurrence ofany of these events could also affect our customers, distributors and suppliersand produce similar disruptive effects upon their business. If there is anearthquake or other catastrophic event near our headquarters, our customers’facilities, our distributors’ facilities or our suppliers’ facilities, ourbusiness could be seriously harmed.

 

We do not havea detailed disaster recovery plan. In addition, we do not maintain sufficientbusiness interruption and other insurance policies to compensate us for alllosses that may occur. Any losses or damages incurred by us as a result of acatastrophic event or any other significant uninsured loss could have amaterial adverse effect on our business.

 

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# *Our principal stockholders have significantvoting power and may vote for actions that may not be in the best interests ofour other stockholders*

# * *

Our officers,directors and principal stockholders together control a significant portion ofour outstanding common stock. As a result, these stockholders, if they acttogether, will be able to significantly influence our operations, affairs andall matters requiring stockholder approval, including the election of directorsand approval of significant corporate transactions. This concentration ofownership may have the effect of delaying or preventing a change in control andmight affect the market price of our common stock. This concentration ofownership may not be in the best interest of our other stockholders.

 

# *Our Shareholder Rights Plan, Certificate ofIncorporation, Bylaws and Delaware law contain provisions that could discouragea takeover that is beneficial to stockholders*

# * *

OurShareholder Rights Plan as well as provisions of our Certificate ofIncorporation, our Bylaws and Delaware law could make it difficult for a thirdparty to acquire us, even if doing so would be beneficial to our stockholders.

 

# *The market price of our common stock mayfluctuate significantly and could lead to securities litigation*

# * *

Stock pricesfor many companies in the technology and emerging growth sectors haveexperienced wide fluctuations that have often been unrelated to the operatingperformance of such companies. In the past, securities class action litigationhas often been brought against a company following periods of volatility in themarket price of its securities. In the future, we may be the target of similarlitigation. Securities litigation could result in substantial costs and divertmanagement’s attention and resources.

 

# *Changes to existing accounting pronouncementsor taxation rules or practices may cause adverse revenue fluctuations, affectour reported results of operations or how we conduct our business*

# * *

GenerallyAccepted Accounting Principles, or GAAP, are promulgated by, and are subject tothe interpretation of, FASB and the SEC. New accounting pronouncements ortaxation rules and varying interpretations of accounting pronouncements ortaxation practice have occurred and may occur in the future. Any future changesin accounting pronouncements or taxation rules or practices may have asignificant effect on how we report our results and may even affect ourreporting of transactions completed before the change is effective. This changeto existing rules, future changes, if any, or the questioning of currentpractices may adversely affect our reported financial results or the way weconduct our business.

 

For example,FASB has issued SFAS No. 123(R), *“Share-BasedPayment,”* which we adopted in the first quarter of 2006. SFAS No.123(R) requires us to measure compensation costs for all stock-basedcompensation awards (including our stock options and our employee stockpurchase plan, as currently constructed) at fair value and record compensationexpense equal to that value. If this accounting pronouncement had been ineffect during fiscal 2005, we estimate that we would have reported asignificantly lower net income.

 

# *Compliance with changing regulations relatedto corporate governance and public disclosure may result in additional expenses*

# * *

Changing laws,regulations and standards relating to corporate governance and publicdisclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations andthe Nasdaq National Market rules, are creating uncertainty for companies suchas ours. These new or changed laws, regulations and standards are subject tovarying interpretations in many cases due to their lack of specificity, and asa result, their application in practice may evolve over time as new guidance isprovided by regulatory and governing bodies, which could result in continuinguncertainty regarding compliance matters and higher costs necessitated byongoing revisions to disclosure and governance practices. We are committed tomaintaining high standards of corporate governance and public disclosure. As aresult, we intend to invest resources to comply with evolving laws, regulationsand standards, and this investment may result in increased general andadministrative expenses and a diversion of management time and attention fromprofit-generating activities. If our efforts to comply with new or changedlaws, regulations and standards differ from the activities intended byregulatory or governing bodies due to ambiguities related to practice, ourreputation may be harmed and the market price of our common stock could beaffected.

 

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# *While we believe that we currently haveadequate internal control procedures in place, we are still exposed topotential risks from recent legislation requiring companies to evaluatecontrols under Section 404 of the Sarbanes-Oxley Act of 2002*

 

Our managementis responsible for establishing and maintaining adequate internal control overfinancial reporting.  Internal controlover financial reporting cannot provide absolute assurance of achievingfinancial reporting objectives because of its inherent limitations. Internalcontrol over financial reporting is a process that involves human diligence andcompliance and is subject to lapses in judgment and breakdowns resulting from humanfailures. Internal control over financial reporting also can be circumvented bycollusion or improper management override. Because of such limitations, thereis a risk that material misstatements may not be prevented or detected on atimely basis by internal control over financial reporting. However, theseinherent limitations are known features of the financial reporting process.Therefore, it is possible to design into the process safeguards to reduce,though not eliminate, this risk. 

# * *

As of December 2005,we have evaluated our internal control systems in order to allow management toreport on, and our independent registered public accounting firm to attest to,our internal controls over financial reporting, as required by Section 404of the Sarbanes-Oxley Act. We performed the system and process evaluation andtesting required in an effort to comply with the management certification andindependent registered public accounting firm attestation requirements ofSection 404. As a result, we incurred additional expenses and a diversionof management’s time. While we believe that our internal control procedures areadequate and we intend to continue to fully comply with the requirementsrelating to internal control and all other aspects of Section 404, our controlsnecessary for continued compliance with the Act may not operate effectively atall times and may result in a material control disclosure. The identificationof a material weakness in internal controls over financial reporting, if any,could indicate a lack of proper controls to generate accurate financialstatements. Furthermore, we cannot be certain as to the outcome of futureevaluations, testing and remediation actions or the impact of the same on ouroperations. If we are not able to remain in compliance with the requirements ofSection 404, we might be subject to sanctions or investigation by regulatoryauthorities, such as the SEC or the Nasdaq National Market. Any such actioncould adversely affect our financial results and the market price of our commonstock.

 

# *We have implemented import and export controlprocedures to comply with United States regulations but we are still exposed topotential risks from import and export activity*

# * *

Our products,technology and software are subject to import and export control laws andregulations which, in some instances, may impose restrictions on businessactivities, or otherwise require licenses or other authorizations from agenciessuch as the U.S. Department of State, U.S. Department of Commerce and U.S.Department of the Treasury. We have import and export licensing and complianceprocedures in place for purposes of conducting our business consistent withU.S. and applicable international laws and regulations, and we periodicallyreview these procedures to maintain compliance with the requirements relatingto import and export regulations. If we are not able to remain in compliancewith import and export regulations, we might be subject to investigation,sanctions or penalties by regulatory authorities. Such penalties can includecivil, criminal or administrative remedies (such as loss of export privileges).We cannot be certain as to the outcome of an evaluation, investigation, inquiryor other action or the impact of these items on our operations. Any such actioncould adversely affect our financial results and the market price of our commonstock.

 

**Item 6. Exhibits**

 

a.     Exhibits

 

The followingExhibits are filed with this report:

 
| **Exhibit  Number** | ** ** | **Description** |
|---------------------|------------|-----------------|
| 3                   | .1(1)      |            | Amended and Restated  Certificate of Incorporation of Registrant. |
| 3                   | .2(2)      |            | Bylaws of Registrant. |
| 31                  | .1         |            | CEO Certification pursuant  to Section 302 of the Sarbanes-Oxley Act of 2002. |
| 31                  | .2         |            | CFO Certification pursuant  to Section 302 of the Sarbanes-Oxley Act of 2002. |
| 32                  |       |            | CEO and CFO Certifications  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002. |

 

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(1)                      Incorporated by reference to the Company’sRegistration Statement on Form S-1 declared effective October 14, 1999(Commission File No. 333-28833).

(2)                      Incorporated by reference to the Company’sCurrent Report on Form 8-K (Item 5.03) filed May 2, 2005.

 

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**Signatures**

 

Pursuant tothe requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
| ** **          | **QUICKLOGIC CORPORATION**                                                                                                            |
|---------------------|---------------------------------------------------------------------------------------------------------------------------------------|
|                |                                                                                                                                  |
|                | /s/ CARL M. MILLS                                                                                                                     |
| Date: May  12, 2006 | Carl M. Mills                                                                                                                         |
| * *            | *Vice President, Finance and Chief Financial  Officer**(as Principal Accounting and Financial  Officer and on behalf of**Registrant)* |

 

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**EXHIBIT INDEX**

 
| **Exhibit  Number** | ** ** | **Description** |
|---------------------|------------|-----------------|
| 3                   | .1(1)      |            | Amended and  Restated Certificate of Incorporation of Registrant. |
| 3                   | .2(2)      |            | Bylaws of  Registrant. |
| 31                  | .1         |            | CEO  Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| 31                  | .2         |            | CFO  Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| 32                  |       |            | CEO and CFO  Certifications pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

 

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(1)                      Incorporated by reference to the Company’sRegistration Statement on Form S-1 declared effective October 14, 1999(Commission File No. 333-28833).

(2)                      Incorporated by reference to the Company’sCurrent Report on Form 8-K (Item 5.03) filed May 2, 2005.

 

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