Tableof Contents

 

 

 

**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, DC 20549**

 

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**FORM 10-Q**

 

**(Mark one)**
| **x**                                                                                                                                                                                    | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934**  |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------|
| ** **                                                                                                                                                                               | ** ** | ** **                                                                                               |
| **For the quarterly period ended  June 30, 2008**                                                                                                                                   |
| ** **                                                                                                                                                                               | ** ** | ** **                                                                                               |
| **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 000-52014***                                                                                                                                                  |

 

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**Techwell, Inc.**

(Exact name of registrant asspecified in its charter)

 

| **Delaware**                                                     | ** ** | **77-0451738**                            |
|------------------------------------------------------------------|------------|-------------------------------------------|
| (State or other jurisdiction   of Incorporation or organization) |       | (I.R.S. Employer   Identification Number) |

 

| **408 E. Plumeria Drive  San Jose, California, 95134** |
|--------------------------------------------------------|
| (Address of principal executive office and  zip code)  |

 

| **(408) 435-3888**                                         |
|------------------------------------------------------------|
| (Registrant’s telephone number, including  area code) |

 

Indicate by check mark whether the Registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorterperiod that the registrant was required to file such reports), and (2) hasbeen subject to filing requirements for the past 90 days.     YES  x   NO  o

 

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, a non-accelerated filer, or a smaller reportingcompany. See the definitions of “large accelerated filer,” “accelerated filer’and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Checkone):

 

| Large Accelerated   filer  o |   | Accelerated filer  x |   | Non-Accelerated   filer  o |   | Smaller Reporting Company  o |
|----------------------------------------|--------|--------------------------------|--------|--------------------------------------|--------|----------------------------------------|
|                                   |   |                           |   | (Do not check if a smaller           |   |                                   |
|                                   |   |                           |   | reporting company)                   |   |                                   |

 

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act).

Yes o Nox

 

As of July 31, 2008, 21,175,365 shares of the Registrant’s commonstock, $0.001 par value, were outstanding.

 

 

 

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**TECHWELL, INC.**

** **

**INDEX**

 
|                      | ** **                                                                                                       | **Page** |
|----------------------|------------------------------------------------------------------------------------------------------------------|----------|
| PART I —   | FINANCIAL INFORMATION                                                                                            | 3        |
|                 |                                                                                                             |     |
| Item 1.              | Financial Statements (Unaudited):                                                                                | 3        |
|                 |                                                                                                             |     |
|                 | Condensed  Consolidated Balance Sheets at June 30, 2008 and December 31, 2007                          | 3        |
|                 |                                                                                                             |     |
|                 | Condensed  Consolidated Statements of Operations for the three and six months ended  June 30, 2008 and 2007 | 4        |
|                 |                                                                                                             |     |
|                 | Condensed  Consolidated Statements of Cash Flows for the six months ended June 30,  2008 and 2007           | 5        |
|                 |                                                                                                             |     |
|                 | Notes to Condensed Consolidated Financial Statements                                                             | 6        |
|                 |                                                                                                             |     |
| Item 2.              | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                      | 13       |
|                 |                                                                                                             |     |
| Item 3.              | Quantitative  and Qualitative Disclosures About Market Risk                                                      | 25       |
|                 |                                                                                                             |     |
| Item 4.              | Controls and  Procedures                                                                                         | 25       |
|                 |                                                                                                             |     |
| PART I I — | OTHER INFORMATION                                                                                                | 26       |
|                 |                                                                                                             |     |
| Item 1.              | Legal Proceedings                                                                                                | 26       |
|                 |                                                                                                             |     |
| Item 1A.             | Risk Factors                                                                                                     | 26       |
|                 |                                                                                                             |     |
| Item 2.              | Unregistered  Sales of Equity Securities and Use of Proceeds                                                     | 37       |
|                 |                                                                                                             |     |
| Item 3.              | Defaults Upon  Senior Securities                                                                                 | 37       |
|                 |                                                                                                             |     |
| Item 4.              | Submission of  Matters to a Vote of Security Holders                                                             | 37       |
|                 |                                                                                                             |     |
| Item 5.              | Other Information                                                                                                | 38       |
|                 |                                                                                                             |     |
| Item 6.              | Exhibits                                                                                                         | 38       |
|                 |                                                                                                             |     |
|                 | Signatures                                                                                                       | 39       |

 

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**PART I—FINANCIAL INFORMATION**

 

**Item 1. Financial Statements**

 

**TECHWELL, INC.CONDENSED CONSOLIDATED BALANCE SHEETS**

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

** **
| ** **                                                                                                                                                                                     | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                     | ** ** | **2008**          | ** ** | **2007**              | ** ** |
|                                                                                                                                                                                           |       |              |       |                  |       |
| **ASSETS**                                                                                                                                                                                     |       |              |       |                  |       |
| Current assets:                                                                                                                                                                                |       |              |       |                  |       |
| Cash and cash equivalents                                                                                                                                                                      |       | $                 | 39,225     |                  | $          | 27,177 |   |
| Short-term investments                                                                                                                                                                         |       | 18,682            |       | 33,384                |       |
| Total cash, cash equivalents and short-term  investments                                                                                                                                       |       | 57,907            |       | 60,561                |       |
| Accounts receivable                                                                                                                                                                            |       | 2,527             |       | 2,095                 |       |
| Inventory                                                                                                                                                                                      |       | 5,253             |       | 4,753                 |       |
| Deferred income tax assets                                                                                                                                                                     |       | 1,589             |       | 2,016                 |       |
| Prepaid expenses and other current assets                                                                                                                                                      |       | 1,497             |       | 1,456                 |       |
| Total current assets                                                                                                                                                                           |       | 68,773            |       | 70,881                |       |
| Property and equipment, net                                                                                                                                                                    |       | 1,315             |       | 1,471                 |       |
| Long-term investments                                                                                                                                                                          |       | 15,853            |       | 7,839                 |       |
| Deferred income tax assets                                                                                                                                                                     |       | 3,829             |       | 3,419                 |       |
| Other assets                                                                                                                                                                                   |       | 162               |       | 127                   |       |
| Total assets                                                                                                                                                                                   |       | $                 | 89,932     |                  | $          | 83,737 |   |
|                                                                                                                                                                                           |       |              |       |                  |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                  |       |              |       |                  |       |
| Current liabilities:                                                                                                                                                                           |       |              |       |                  |       |
| Accounts payable                                                                                                                                                                               |       | $                 | 2,472      |                  | $          | 2,973 |   |
| Accrued liabilities                                                                                                                                                                            |       | 2,442             |       | 2,534                 |       |
| Total current liabilities                                                                                                                                                                      |       | 4,914             |       | 5,507                 |       |
| Deferred rent                                                                                                                                                                                  |       | 143               |       | 165                   |       |
| Total liabilities                                                                                                                                                                              |       | 5,057             |       | 5,672                 |       |
|                                                                                                                                                                                           |       |              |       |                  |       |
| Commitments and contingencies                                                                                                                                                                  |       |              |       |                  |       |
|                                                                                                                                                                                           |       |              |       |                  |       |
| Stockholders’ equity:                                                                                                                                                                     |       |              |       |                  |       |
| Preferred stock, $0.001 par value;  10,000,000 shares authorized and no shares issued and outstanding                                                                                          |       | —            |       | —                |       |
| Common stock, $0.001 par value; 250,000,000  shares authorized; 21,140,182 shares and 20,889,349 shares issued and  outstanding at June 30, 2008 and December 31, 2007, respectively |       | 21                |       | 21                    |       |
| Additional paid-in capital                                                                                                                                                                     |       | 76,875            |       | 73,454                |       |
| Deferred stock-based compensation                                                                                                                                                              |       | (67               | )          | (160                  | )          |
| Accumulated other comprehensive gain (loss)                                                                                                                                                    |       | (373              | )          | 44                    |       |
| Retained earnings                                                                                                                                                                              |       | 8,419             |       | 4,706                 |       |
| Total stockholders’ equity                                                                                                                                                                |       | 84,875            |       | 78,065                |       |
| Total liabilities and stockholders’ equity                                                                                                                                                |       | $                 | 89,932     |                  | $          | 83,737 |   |

 

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

 

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**TECHWELL, INC.CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)****(In thousands, except pershare amounts)**

 
| ** **                                                      | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                      | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                                      | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                            |       |                             |       |                           |       |   |   |   |   |
| Revenues                                                        |       | $                                | 17,006     |                           | $          | 14,743 |   | $ | 32,613 |   | $ | 28,260 |   |
|                                                            |       |                             |       |                           |       |   |   |   |   |
| Cost of revenues                                                |       | 6,503                            |       | 5,989                          |       | 12,564 |   | 11,780 |   |
|                                                            |       |                             |       |                           |       |   |   |   |   |
| Gross profit                                                    |       | 10,503                           |       | 8,754                          |       | 20,049 |   | 16,480 |   |
|                                                            |       |                             |       |                           |       |   |   |   |   |
| Operating expenses:                                             |       |                             |       |                           |       |   |   |   |   |
| Research and development                                        |       | 4,208                            |       | 2,870                          |       | 7,757 |   | 5,085 |   |
| Selling, general and administrative                             |       | 3,765                            |       | 2,874                          |       | 7,457 |   | 5,632 |   |
| Total operating expenses                                        |       | 7,973                            |       | 5,744                          |       | 15,214 |   | 10,717 |   |
|                                                            |       |                             |       |                           |       |   |   |   |   |
| Income from operations                                          |       | 2,530                            |       | 3,010                          |       | 4,835 |   | 5,763 |   |
| Interest income                                                 |       | 540                              |       | 737                            |       | 1,295 |   | 1,416 |   |
|                                                            |       |                             |       |                           |       |   |   |   |   |
| Income before income taxes                                      |       | 3,070                            |       | 3,747                          |       | 6,130 |   | 7,179 |   |
| Income taxes                                                    |       | 1,228                            |       | 1,106                          |       | 2,417 |   | 2,074 |   |
|                                                            |       |                             |       |                           |       |   |   |   |   |
| Net income                                                      |       | $                                | 1,842      |                           | $          | 2,641 |   | $ | 3,713 |   | $ | 5,105 |   |
|                                                            |       |                             |       |                           |       |   |   |   |   |
| Basic net income per share                                      |       | $                                | 0.09       |                           | $          | 0.13 |   | $ | 0.18 |   | $ | 0.25 |   |
| Diluted net income per share                                    |       | $                                | 0.08       |                           | $          | 0.12 |   | $ | 0.17 |   | $ | 0.23 |   |
|                                                            |       |                             |       |                           |       |   |   |   |   |
| Weighed average shares used in computing  net income per share: |       |                             |       |                           |       |   |   |   |   |
| Basic                                                           |       | 21,065                           |       | 20,765                         |       | 20,995 |   | 20,701 |   |
| Diluted                                                         |       | 22,099                           |       | 21,826                         |       | 21,956 |   | 21,810 |   |

 

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

 

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**TECHWELL, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

**(In thousands)**

 
| ** **                                                                         | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                         | ** ** | **June 30,**              | ** ** |
| ** **                                                                         | ** ** | **2008**                       | ** ** | **2007** | ** ** |
| **Cash flows from operating activities:**                                          |       |                           |       |   |   |
| Net income                                                                         |       | $                              | 3,713      |   | $ | 5,105 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |       |                           |       |   |   |
| Depreciation and amortization                                                      |       | 363                            |       | 185 |   |
| Stock-based compensation                                                           |       | 3,585                          |       | 1,928 |   |
| Tax benefit from employee equity incentive  plan                                   |       | 191                            |       | 872 |   |
| Realized gain on investments                                                       |       | (18                            | )          | — |   |
| Deferred income tax                                                                |       | 17                             |       | — |   |
| Changes in assets and liabilities:                                                 |       |                           |       |   |   |
| Accounts receivable                                                                |       | (432                           | )          | 327 |   |
| Inventory                                                                          |       | (500                           | )          | (207 | ) |
| Prepaid expenses and other current assets                                          |       | (41                            | )          | (347 | ) |
| Other assets                                                                       |       | (33                            | )          | (75 | ) |
| Accounts payable                                                                   |       | (451                           | )          | (277 | ) |
| Accrued liabilities                                                                |       | 98                             |       | (1,182 | ) |
| Accrued taxes                                                                      |       | (205                           | )          | — |   |
| Deferred rent                                                                      |       | (22                            | )          | (11 | ) |
| Net cash provided by operating activities                                          |       | 6,265                          |       | 6,318 |   |
| **Cash flows from investing activities:**                                          |       |                           |       |   |   |
| Purchases of property and equipment                                                |       | (243                           | )          | (443 | ) |
| Purchases of investments                                                           |       | (30,992                        | )          | (42,872 | ) |
| Proceeds from maturities of investments                                            |       | 37,280                         |       | 36,458 |   |
| Net cash provided by (used in) investing  activities                               |       | 6,045                          |       | (6,857 | ) |
| **Cash flows from financing activities:**                                          |       |                           |       |   |   |
| Proceeds from exercise of stock options                                            |       | 334                            |       | 515 |   |
| Repurchase of common stock upon release of  restricted stock awards                |       | (596                           | )          | — |   |
| Net cash provided by (used in) financing  activities                               |       | (262                           | )          | 515 |   |
| Net increase (decrease) in cash and cash  equivalents                              |       | 12,048                         |       | (24 | ) |
| Cash and cash equivalents at beginning of  period                                  |       | 27,177                         |       | 13,201 |   |
| Cash and cash equivalents at end of period                                         |       | $                              | 39,225     |   | $ | 13,177 |   |
|                                                                               |       |                           |       |   |   |
| **Supplemental disclosure of non-cash  investing and financing activities:**       |       |                           |       |   |   |
| Accrued equipment purchase costs                                                   |       | $                              | 35         |   | $ | 120 |   |
| Gross issuance of restricted stock awards                                          |       | 2,558                          |       | — |   |
| Decrease in other comprehensive income                                             |       | (417                           | )          | (12 | ) |

 

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

 

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**TECHWELL, INC.NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

 

**Note 1. Background and Basis of Presentation**

 

***The Company***

 

Techwell, Inc.(“Techwell” or the “Company”) was incorporated in California on March 7, 1997and reincorporated in Delaware on March 30, 2006. The Company is a fablesssemiconductor company that designs, markets and sells mixed signal integratedcircuits for multiple video applications in the security surveillance,automotive, consumer and PC markets.

 

TheCompany’s headquarters is located in San Jose, California.  The Company’s international offices includebranch offices in South Korea and Taiwan and subsidiaries in China and Japan.These offices provide marketing support to customers. The South Korea and Japanoffices are also involved in product development.

 

***Basis of Presentation***

 

The accompanying condensed consolidated financial statements of theCompany have been prepared without audit in accordance with the rules andregulations of the Securities and Exchange Commission.  The consolidated balance sheet at December 31,2007 has been derived from the audited consolidated financial statements as ofand for the year then ended. Certain information and disclosuresnormally included in financial statements prepared in accordance withaccounting principles generally accepted in the United States of America havebeen condensed or omitted in accordance with these rules and regulations.The information in this report should be read in conjunction with the Company’sconsolidated financial statements and notes thereto included in its AnnualReport on Form 10-K for the year ended December 31, 2007.

 

In the opinion of management, the accompanying unaudited condensedconsolidated financial statements reflect all adjustments (consisting only ofnormal recurring adjustments) necessary to summarize fairly the Company’sfinancial position, results of operations and cash flows for the interimperiods presented. The operating results for the three and six months ended June 30,2008 are not necessarily indicative of the results that may be expected for theyear ending December 31, 2008 or for any other future period.

 

***Principles ofConsolidation and Year End***

*** ***

The condensed consolidated financial statements include the accounts ofthe Company and its subsidiaries. All significant intercompany transactions andbalances have been eliminated in consolidation. The Company reports its financialresults on a calendar fiscal year.

 

***Use of Estimates***

 

Thepreparation of financial statements in accordance with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities, the disclosure of contingent assets and liabilities at the date ofthe condensed consolidated financial statements and the reported amounts ofrevenues and expenses during the reporting period. Actual results could differfrom these estimates.

 

***Certain Significant Risks and Uncertainties***

*** ***

The Company operates in a dynamic hightechnology industry and changes in any of the following areas could have amaterial adverse effect on the Company’s financial position and results ofoperations: unpredictable volume and timing of customer orders, which are notfixed by contract; loss of one or more of its customers; decrease in theoverall average selling prices of its products; changes in the relative salesmix of its products; changes in its cost of finished goods; the quality andtimely service of third-party vendors that manufacture, assemble and test theCompany’s semiconductors; the Company’s customers’ sales outlook, purchasingpatterns and inventory adjustments based on demand and general economicconditions; product obsolescence and the Company’s ability to manage producttransitions; the Company’s ability to successfully develop, introduce and sellnew or enhanced products in a timely manner; and the timing of new productannouncements or introductions by the Company or by its competitors.

 

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***Fair Value of Financial Instruments***

 

The Company’s financial instruments consistprincipally of cash equivalents, short-term and long-term marketablesecurities. Marketable securities are comprised of available-for-salesecurities that are reported at fair value with the related unrealized gainsand losses included in accumulated other comprehensive income (loss), acomponent of shareholders’ equity, net of tax. Pursuant to Statement ofFinancial Accounting Standards No. 157, *Fair Value Measurement*, (“SFAS No. 157”), theCompany adopted the provisions of SFAS No. 157 effective January 1,2008, which defines fair value, establishes a framework for measuring fairvalue and expands disclosures about fair value measurements required underother accounting pronouncements.  SFAS No. 157clarifies that fair value is an exit price, representing the amount that wouldbe received to sell an asset or paid to transfer a liability in an orderlytransaction between market participants. SFAS No. 157 also requiresthat a fair value measurement reflect the assumptions market participants woulduse in pricing an asset or liability based on the best information available.Assumptions include the risks inherent in a particular valuation technique(such as a pricing model) and/or the risks inherent in the inputs to the model.

 

***Accumulated OtherComprehensive Loss***

 

Accumulated other comprehensive loss consists of net unrealized losseson available-for-sale investments. The change in unrealized losses oninvestments, net of tax, was an increase of $0.2 million in the three monthsended June 30, 2008 and an increase of $18,000 in the three months ended June 30,2007.  The change in unrealized losses oninvestments, net of tax, was an increase of $0.4 million in the six monthsended June 30, 2008 and an increase of $12,000 in the six months ended June 30,2007.

 

**Note 2. ****Stock-BasedCompensation**

 

The Company has equity incentive plans (“Plans”) under which it maygrant stock options, restricted stock awards, stock units and stockappreciation rights to employees, consultants and directors. At June 30,2008, the total number of shares available for issuance under the Plans is1,768,977.  Stock options and awardsgranted under the Plans may have a contractual term up to ten years, generallyvest over four years at the rate of 25 percent on the one-year anniversaryof the vesting commencement date and ratably each month thereafter and areexercisable under conditions determined by the Board as permissible under theterms of the Plans. At June 30, 2008, 13,334 shares exercised prior tovesting are subject to repurchase by the Company.

 

Effective January 1,2006, the Company adopted Statement of Financial Accounting Standards No. 123(revised 2004), *Share-Based Payment*,(“SFAS No. 123(R)”) which requires the measurement and recognition ofcompensation expense for all share-based payment awards made to employees anddirectors, including employee stock options, based on estimated fair valuesrecognized over the requisite service period. Prior to the adoption of SFAS No. 123(R),the Company accounted for stock-based compensation awards issued to itsemployees using the intrinsic value measurement provisions of AccountingPrinciples Board Opinion No. 25 (“APB Opinion No. 25”), *Accounting for Stock Issued to Employees*.

 

The Company adopted SFAS No. 123(R) usingthe prospective transition method. Under this method, SFAS No. 123(R) isapplied to new awards and to awards modified, repurchased or cancelled afterthe adoption date of January 1, 2006. Compensation cost previouslyrecorded under APB Opinion No. 25 for awards outstanding at the adoptiondate, such as unvested options, continues to be recognized as the options vest.Accordingly, for the three and six months ended June 30, 2008 and 2007,stock-based compensation expense includes compensation cost related toestimated fair values of awards granted after the date of adoption of SFAS No. 123(R) andcompensation costs related to unvested awards at the date of adoption based onthe intrinsic values as previously recorded under APB Opinion No. 25.

 

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The following table summarizes thedistribution of stock-based compensation expense (in thousands):

 
| ** **                             | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                             | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                             | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| Cost of revenues                       |       | $                                | 131        |                           | $          | 71 |   | $ | 244 |   | $ | 116 |   |
| Research and development               |       | 859                              |       | 517                            |       | 1,552 |   | 835 |   |
| Selling, general and administrative    |       | 918                              |       | 591                            |       | 1,789 |   | 977 |   |
| Related tax effect                     |       | (683                             | )          | (283                           | )          | (1,281 | ) | (441 | ) |
| Total stock-based compensation expense |       | $                                | 1,225      |                           | $          | 896 |   | $ | 2,304 |   | $ | 1,487 |   |

 

Total compensation cost attributable to activities capitalized intoinventory was not significant in any period presented.  Stock-based compensation expense in the sixmonths ended June 30, 2008 and 2007 includes $9,000 and $2,000,respectively, for options granted to consultants.  Stock-based compensation expense in the threemonths ended June 30, 2008 and 2007 includes $4,000 and $2,000,respectively, for options granted to consultants.

 

SFAS No. 123(R) requires the cash flows resulting from thetax benefits for tax deductions resulting from the exercise of stock optionsaccounted for under SFAS No. 123(R) in excess of the compensationexpense recorded for these options (excess tax benefits) to be classified ascash from financing activities.  Excesstax benefits for options accounted for under APB Opinion No. 25 continueto be accounted for in cash from operating activities.

 

**Note 3. ****NetIncome per Share**

 

The Company calculates net income per share in accordance with SFAS No. 128,*Earnings Per Share.*  Under SFAS No. 128, basic net income pershare is calculated by dividing net income by the weighted average number ofcommon stock shares outstanding during the period excluding shares subject torepurchase. Diluted net income per share reflects the effects of potentiallydilutive securities, which consist of common stock options, restricted stockawards and common stock subject to repurchase.

 

A reconciliation of shares used in the calculation of basic and dilutednet income per share is as follows (in thousands):

 
| ** **                                              | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                              | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                              | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                    |       |                             |       |                           |       |   |   |   |   |
| Weighted average common shares outstanding              |       | 21,082                           |       | 20,810                         |       | 21,015 |   | 20,750 |   |
| Weighted average shares subject to  repurchase          |       | (17                              | )          | (45                            | )          | (20 | ) | (49 | ) |
| Shares used to calculate basic net income  per share    |       | 21,065                           |       | 20,765                         |       | 20,995 |   | 20,701 |   |
| Effect of dilutive securities:                          |       |                             |       |                           |       |   |   |   |   |
| Convertible preferred stock                             |       | —                           |       | —                         |       | — |   | — |   |
| Common stock options and restricted stock  awards       |       | 1,034                            |       | 1,061                          |       | 961 |   | 1,109 |   |
| Dilutive potential common stock                         |       | 1,034                            |       | 1,061                          |       | 961 |   | 1,109 |   |
| Shares used to calculate dilutive net  income per share |       | 22,099                           |       | 21,826                         |       | 21,956 |   | 21,810 |   |

 

# **Note 4.  Income Taxes**

# ** **

The Company accounts for income taxes under the provisions of SFAS No. 109,*Accounting for Income Taxes*. In applyingSFAS No. 109, the Company is required to estimate its current taxexpense together with assessing temporary differences resulting from differingtreatments of items for tax and accounting purposes. These differences resultin deferred tax assets and liabilities. Significant management judgment isrequired to assess the likelihood that its deferred tax assets will berecovered from future taxable income. As of June 30, 2008, the Company’stotal deferred tax assets were principally comprised of net operating losscarryforwards, research and other credit carryforwards, stock-basedcompensation and expense accruals.

 

The Company andits subsidiaries file income tax returns in the U.S. federal jurisdiction,various states and foreign jurisdictions.  The Company has not been underthe examination of U.S. federal, state or other foreign jurisdictions taxauthorities.

 

The Company’s effective tax rate is based on the estimated annualeffective tax rate in accordance with SFAS No. 109. In the three and sixmonths ended June 30, 2008 and 2007, the effective tax rate differed fromthe statutory federal income tax rate primarily because of the impact ofstock-based compensation,  research and developmentcredits and state income taxes.

 

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**Note 5.  FinancialInstruments**

 

The Company’s investments are considered available-for-sale andprimarily consist of corporate bonds, US government agency securities,commercial paper and auction rate securities, or ARS. These securities otherthan ARS are carried at fair market value based on market quotes. The ARSinvestments are intended to provide liquidity via an auction process thatresets the applicable interest rate at predetermined calendar intervals,allowing investors to either roll over their holdings or gain immediateliquidity by selling such interests at par. The recent uncertainties in thecredit markets have affected all of the Company’s holdings in ARS investmentsand auctions for the Company’s investments in these securities have failed tosettle on their respective settlement dates. Consequently, the investments arenot currently liquid and the Company will not be able to access these fundsuntil a future auction of these investments is successful or a buyer is foundoutside of the auction process. All of the ARS investments were investmentgrade quality and were in compliance with the Company’s investment policy atthe time of acquisition. The Company currently has the ability and intent tohold these ARS investments until a recovery of the auction process or untilmaturity. As of June 30, 2008, the entire ARS investment balance  isclassified as long-term investment on its condensed consolidated balance sheetbecause of the Company’s inability to determine when its investments in ARSwould settle.

 

Effective January 1, 2008, the Company adopted the provisions ofSFAS No. 157 *Fair Value Measurements*, whichdefines fair value, establishes a framework for measuring fair value andexpands disclosures about fair value measurements required under otheraccounting pronouncements.  SFAS No. 157clarifies that fair value is an exit price, representing the amount that wouldbe received to sell an asset or paid to transfer a liability in an orderlytransaction between market participants. SFAS No. 157 also requiresthat a fair value measurement reflect the assumptions market participants woulduse in pricing an asset or liability based on the best information available.Assumptions include the risks inherent in a particular valuation technique(such as a pricing model) and/or the risks inherent in the inputs to the model.The adoption of SFAS No. 157 on our assets and liabilities did not have asignificant impact on our financial statements.

 

SFAS No. 157 establishes a fair value hierarchy thatprioritizes the inputs to valuation techniques used to measure fair value. Thehierarchy gives the highest priority to unadjusted quoted prices in activemarkets for identical assets or liabilities (Level 1 measurements) and thelowest priority to unobservable inputs (Level 3 measurements). The threelevels of the fair value hierarchy under SFAS No. 157 are describedbelow:

 

Level 1: Quoted prices (unadjusted) in active markets that areaccessible at the measurement date for assets or liabilities. The fair valuehierarchy gives the highest priority to Level 1 inputs.

 

Level 2: Observable prices that are based on inputs not quoted onactive markets, but corroborated by market data.

 

Level 3: Unobservable inputs are used when little or no market data isavailable. The fair value hierarchy gives the lowest priority to Level 3inputs.

 

A financial instrument’s level within the fair value hierarchy is basedon the lowest level of any input that is significant to the fair valuemeasurement.

 

Typically the fair value of ARS investments approximates par value dueto the frequent resets through the auction process. While the Company continuesto earn interest on its ARS investments at the maximum contractual rate, theseinvestments are not currently trading and therefore do not currently have areadily determinable market value. Accordingly, the estimated fair value of ARSno longer approximates par value.

 

Asof June 30, 2008, the Company had $6.7 million of auction rate securities,the fair value of which has been measured using Level 3 inputs. These ARS arecollateralized mostly with Student Loan Auction Rate Certificates. The monthlyauctions have historically provided a liquid market for these securities. TheARS in the Company’s portfolio had successful auctions until January 2008 andas such, their fair value would have been measured using Level 1 inputs at January 1,2008. However, since February 2008, there has not been a successfulauction in that there were insufficient buyers for these ARS, therefore theCompany has classified them  within Level3 category as of June 30, 2008.

 

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TheCompany has used a discounted cash flow model to determine the estimated fairvalue of its investment in ARS as of June 30, 2008. The assumptions usedin preparing the discounted cash flow model include estimates for interestrates, estimates for discount rates using yields of comparable tradedinstruments adjusted for illiquidity and other risk factors, amount of cashflows and expected holding periods of the ARS. These inputs reflect the Company’sown assumptions about the assumptions market participants would use in pricingthe ARS, including assumptions about risk, developed based on the bestinformation available in the circumstances. Based on this assessment offair value, as of June 30, 2008, the Company determined there was adecline in the fair value of its ARS investments of approximately $0.1 millionduring the three months ended June 30, 2008 and a total decline in fairvalue of $0.4 million for the six months ended June 30, 2008.  The declinein fair value was deemed temporary as the Company currently has the ability andintent to hold these ARS investments until a recovery of the auction process oruntil maturity. As of June 30, 2008, the Company  has classified the entire ARS investmentbalance  as long-term investments on itscondensed consolidated balance sheet because of the Company’s belief that itwill take longer than one year for its investments in ARS to settle.

 

Thefair value decline in ARS of approximately $0.4 million was recorded asan unrealized loss reported in a separate component of stockholders’ equity andincluded in accumulated other comprehensive loss as of June 30, 2008.Realized gains and losses are recorded based on the specific identificationmethod and are not significant in any period presented. The change inunrealized losses on ARS measured at fair value using significant unobservableinputs (Level 3), net of tax, in the three months ended June 30, 2008 wasan increase of $85,000 and in the six months ended June 30, 2008 was anincrease of $0.4 million.

 

Fair value measurements of financial assets carried at fair value as ofJune 30, 2008 are classified in the table below in one of the threecategories described above (in thousands):

 
| ** **                | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Total** | ** ** |
|---------------------------|------------|------------------|------------|------------------|------------|------------------|------------|-----------|------------|
| Money market funds        |       | $                | 30,151     |             | $          | —           |       | $         | —     |   | $ | 30,151 |   |
| Corporate bonds           |       | 10,988           |       | —           |       | —           |       | 10,988    |       |
| Municipal bonds           |       | 999              |       | —           |       | —           |       | 999       |       |
| Treasuries                |       | 12,873           |       | —           |       | —           |       | 12,873    |       |
| Commercial paper          |       | 8,939            |       | —           |       | —           |       | 8,939     |       |
| Auction rate securities   |       | —           |       | —           |       | 6,710            |       | 6,710     |       |
| Total                     |       | $                | 63,950     |             | $          | —           |       | $         | 6,710      |   | $ | 70,660 |   |
| Amount included in:       |       |             |       |             |       |             |       |      |       |
| Cash and cash equivalents |       | $                | 36,125     |             | $          | —           |       | $         | —     |   | $ | 36,125 |   |
| Short-term investments    |       | 18,682           |       | —           |       | —           |       | 18,682    |       |
| Long-term investments     |       | 9,143            |       | —           |       | 6,710            |       | 15,853    |       |
| Total                     |       | $                | 63,950     |             | $          | —           |       | $         | 6,710      |   | $ | 70,660 |   |

 

The following table provides a reconciliationof the beginning and ending balances for the assets measured at fair valueusing significant unobservable inputs (Level 3) (in thousands):

 
| ** **                                                                             | ** ** | **Total** | ** ** |
|----------------------------------------------------------------------------------------|------------|-----------|------------|
| Beginning balances as of January 1,  2008                                         |       | $         | —     |   |
| Total unrealized gains (loss) included in  accumulated other comprehensive gain (loss) |       | (305      | )          |
| Transfer into Level 3                                                                  |       | 7,100     |       |
| Ending balances as of March 31, 2008                                              |       | 6,795     |       |
| Total unrealized gains (loss) included in  accumulated other comprehensive gain (loss) |       | (85       | )          |
| Ending balances as of June 30, 2008                                               |       | $         | 6,710      |   |

 

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**Note 6.****Details of Certain Balance Sheet Components**

 

**Inventory**(inthousands):

 
| ** **      | ** ** | **June 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|-----------------|------------|-----------------------------|------------|---------------------------------|------------|
| Finished goods  |       | $                           | 3,037      |                            | $          | 3,194 |   |
| Work in process |       | 2,216                       |       | 1,559                           |       |
|            |       |                        |       |                            |       |
|            |       | $                           | 5,253      |                            | $          | 4,753 |   |

 

**Property and equipment, net**(in thousands):

 
| ** **                                     | ** ** | **June 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|------------------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| Equipment                                      |       | $                           | 1,855      |                            | $          | 1,727 |   |
| Software                                       |       | 596                         |       | 546                             |       |
| Furniture and fixtures                         |       | 287                         |       | 279                             |       |
| Leasehold improvements                         |       | 434                         |       | 414                             |       |
|                                           |       | 3,172                       |       | 2,966                           |       |
|                                           |       |                        |       |                            |       |
| Less accumulated depreciation and amortization |       | (1,857                      | )          | (1,495                          | )          |
|                                           |       |                        |       |                            |       |
|                                           |       | $                           | 1,315      |                            | $          | 1,471 |   |

 

**Accrued liabilities**(in thousands):

 
| ** **                           | ** ** | **June 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|--------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| Accrued compensation                 |       | $                           | 1,240      |                            | $          | 1,008 |   |
| Accrued inventory purchases          |       | 348                         |       | 461                             |       |
| Customer advances                    |       | 185                         |       | 280                             |       |
| Taxes payable                        |       | 25                          |       | 204                             |       |
| Accrued tape out expenses            |       | 117                         |       | 158                             |       |
| Legal and professional services fees |       | 109                         |       | 116                             |       |
| Exercise of unvested stock options   |       | 40                          |       | 62                              |       |
| Other                                |       | 378                         |       | 245                             |       |
|                                 |       |                        |       |                            |       |
|                                 |       | $                           | 2,442      |                            | $          | 2,534 |   |

 

**Note 7. Segment Information**

 

As defined by the requirements of SFAS No. 131, *Disclosure About Segments of an Enterprise andRelated Information,* the Company currently operates in onereportable segment, the designing, marketing and selling of mixed signalintegrated circuits for multiple video applications in the securitysurveillance, automotive and consumer markets. The Company’s chief operatingdecision maker is its chief executive officer.

 

The percentage of total revenues by geographic location are as follows:

 
| ** **    | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **    | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **    | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| Taiwan        |       | 31                               | %          | 45                             | %          | 33 | % | 44 | % |
| South Korea   |       | 28                               |       | 31                             |       | 29 |   | 32 |   |
| China         |       | 34                               |       | 19                             |       | 31 |   | 19 |   |
| Japan         |       | 5                                |       | 3                              |       | 5 |   | 3 |   |
| United States |       | 1                                |       | 1                              |       | 1 |   | 1 |   |
| Other         |       | 1                                |       | 1                              |       | 1 |   | 1 |   |
| Total         |       | 100                              | %          | 100                            | %          | 100 | % | 100 | % |

 

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Revenues byproduct line are as follows (in thousands):

 
| ** **               | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **               | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **               | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| Security Surveillance(1) |       | $                                | 12,855     |                           | $          | 9,095 |   | $ | 24,464 |   | $ | 18,003 |   |
| Video Decoders(2)        |       | 2,144                            |       | 3,883                          |       | 4,256 |   | 6,522 |   |
| LCD Display(3)           |       | 1,963                            |       | 1,527                          |       | 3,660 |   | 3,134 |   |
| Other(4)                 |       | 44                               |       | 238                            |       | 233 |   | 601 |   |
| Total                    |       | $                                | 17,006     |                           | $          | 14,743 |   | $ | 32,613 |   | $ | 28,260 |   |

 

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| (1)    | Consists of application  specific products designed for use in security surveillance systems.                                                                                                                                                                                                                                                     |
|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                              |
| (2)    | Consists of video  decoders designed for use in the security surveillance, automotive and consumer  markets. Revenues from video decoders used in security surveillance systems  and liquid crystal display, or LCD displays, are reported under the video  decoder product line and not the security surveillance or LCD display product  lines. |
|   |                                                                                                                                                                                                                                                                                                                                              |
| (3)    | Consists of application  specific products designed for use in LCD displays.                                                                                                                                                                                                                                                                      |
|   |                                                                                                                                                                                                                                                                                                                                              |
| (4)    | Consists of contract  development projects, early generation mixed signal semiconductors for  digital video applications and a PCI video decoder product.                                                                                                                                                                                         |

 

Thefollowing is a summary of long-lived assets by geographic region (inthousands):

 
| **Country**   | ** ** | **June 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|---------------|------------|-----------------------------|------------|---------------------------------|------------|
| United States |       | $                           | 1,093      |                            | $          | 1,187 |   |
| Taiwan        |       | 52                          |       | 67                              |       |
| South Korea   |       | 11                          |       | 39                              |       |
| China         |       | 40                          |       | 45                              |       |
| Japan         |       | 119                         |       | 133                             |       |
|          |       |                        |       |                            |       |
| Total         |       | $                           | 1,315      |                            | $          | 1,471 |   |

 

The revenues and accounts receivable from customers representing 10% ormore of total revenues and accounts receivable are as follows:

 
| ** **   | ** ** | ** **                           | ** ** | **Revenues**                           | ** ** |
|--------------|------------|--------------------------------------|------------|----------------------------------------|------------|
| ** **   | ** ** | **Accounts Receivable at** | ** ** | **Three Months Ended ** | ** ** | **Six Months Ended ** | ** ** |
| ** **   | ** ** | **June 30,**                    | ** ** | **December 31,**                  | ** ** | **June 30,** | ** ** | **June 30,** | ** ** |
| **Customer** | ** ** | **2008**                             | ** ** | **2007**                               | ** ** | **2008** | ** ** | **2007** | ** ** | **2008** | ** ** | **2007** | ** ** |
| A            |       | *                                    | %          | 14                                     | %          | 31 | % | 16 | % | 29 | % | 16 | % |
| B            |       | 11                                   |       | 28                                     |       | * |   | 11 |   | * |   | * |   |
| C            |       | 20                                   |       | 19                                     |       | * |   | * |   | * |   | * |   |
| D            |       | 10                                   |       | *                                      |       | * |   | * |   | * |   | * |   |
| E            |       | 19                                   |       | *                                      |       | 10 |   | * |   | 11 |   | * |   |

 

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* less than 10%

 

# **Note 8. Related Party Transactions**

# ** **

One of the Company’s Board members is a partner in a law firm thatprovides legal services to the Company. The Company incurred fees of $5,000 and$6,000 from this law firm for legal services in the three months ended June 30,2008 and 2007, respectively. The Company incurred fees of $13,000 and $12,000from this law firm for legal services in the six months ended June 30,2008 and 2007, respectively. The amount payable to this law firm was $4,000 and$4,000 at June 30, 2008 and December 31, 2007, respectively. ThisBoard member also receives compensation in accordance with the Company’scompensation program for non-employee directors.

 

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**Note9.  Recent Accounting Pronouncements**

 

InSeptember 2006, the FASB issued SFAS No. 157,*Fair Value Measurements*, which definesfair value, establishes a framework for measuring fair value in generallyaccepted accounting principles, and expands disclosures about fair valuemeasurements. This statement applies to other accounting pronouncements thatrequire or permit fair value measurements, the FASB having previously concludedin those accounting pronouncements that fair value is the relevant measurementattribute. Accordingly, this Statement does not require any new fair valuemeasurements. SFAS No. 157 is effective for financial statements issuedfor fiscal years beginning after November 15, 2007. However, on February 12,2008, the FASB issued SFAS No. 157-2 which delays the effective date ofSFAS No. 157 for all nonfinancial assets and nonfinancial liabilities,except those that are recognized or disclosed at fair value in the financialstatements on a recurring basis (at least annually). SFAS No. 157-2partially defers the effective date of SFAS No. 157 to fiscal yearsbeginning after November 15, 2008, and interim periods within those fiscalyears for items within the scope of this FASB Staff Position. Effective January 1,2008, the Company adopted SFAS No. 157 for financial assets andliabilities recognized at fair value on a recurring basis except as it appliesto those nonfinancial assets and nonfinancial liabilities as noted in SFAS No. 157-2.The partial adoption of SFAS No. 157 did not have a material impact on theconsolidated financial positions, results of operations or cash flows.

 

InFebruary 2007, the FASB issued SFAS No. 159, *The FairValue Option for Financial Assets and Financial Liabilities – including anAmendment of FASB Statement No. 115*, to permit all entities tochoose to elect, at specified election dates, to measure eligible financialinstruments at fair value, to report unrealized gains and losses on items forwhich the fair value option has been elected in earnings at each subsequentreporting date, and recognize upfront costs and fees related to those items inearnings as incurred and not deferred. An entity is prohibited fromretrospectively applying SFAS No. 159, unless it chooses early adoption.SFAS No. 159 is effective as of the beginning of the first fiscal yearthat begins after November 15, 2007. Effective January 1, 2008, theCompany adopted SFAS No. 159. The adoption of SFAS No. 159 did nothave a material impact on the consolidated financial positions, results ofoperations or cash flows.

 

InJune 2007, the EITF reached a consensus on Issue No. 07-3, *Accounting for Nonrefundable Advance Payments forGoods or Services Received to Be Used in Future Research and DevelopmentActivities*. Nonrefundable advance payments for goods or servicesthat will be used or rendered for future research and development activitiesshould be deferred and capitalized. Such amounts should be recognized as anexpense as the related goods are delivered or the services are performed, orwhen the goods or services are no longer expected to be provided. This Issue iseffective for fiscal years beginning after December 15, 2007, and earlierapplication is not permitted. Effective January 1, 2008, the Companyadopted EITF No. 07-3. The adoption of EITF No. 07-03 did not have amaterial impact on the consolidated financial positions, results of operationsor cash flows.

 

**ITEM 2. Management’s Discussion and Analysisof Financial Condition and Results of Operations**

 

*The following discussion of our financialcondition and results of operations should be read in conjunction with thecondensed consolidated financial statements and notes to those statementsincluded elsewhere in this Quarterly Report on Form 10-Q for the three andsix  months ended June 30, 2008 andour audited consolidated financial statements for the year ended December 31,2007 included in our Annual Report on Form 10-K.*

 

*This Report contains forward-lookingstatements that involve risks and uncertainties. These statements relate tofuture periods, future events or our future operating or financial plans orperformance. These statements can often be identified by the use offorward-looking terminology such as “expects,” “believes,” “intends,”“anticipates,” “estimates,” “plans,” “may,” or “will,” or the negative of theseterms, and other similar expressions. These forward-looking statements includestatements as to the source of our revenues, our ability to generate revenues,our ability to sustain our growth rate and profitability, our expectationregarding the increase in certain expenses, our cash needs, our capitalrequirements, our market risk sensitivity, our business and product strategies,our anticipated effective tax rate, our intention to add integrated audiofunctionality to our video decoders, industry trends and our anticipation thatdevelopments in our technologies and new products will increase our targetmarket share.*

 

*These forward-looking statements reflect ourcurrent views with respect to future events are based on assumptions and aresubject to risks and uncertainties. These risks and uncertainties could causeactual results to differ materially from those projected and include, but arenot limited to, fluctuations in our revenue and operating*

 

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*results, the demand for digital videoapplications for the  securitysurveillance,  automotive and consumermarkets, our ability to compete, our dependence on key and highly skilledpersonnel, the ability to develop new products and to enhance our existingproducts, the continued seasonality of our business due to our target marketsand location of our customers, our ability to integrate businesses that we mayacquire, our ability to estimate and predict customer demand, economicvolatility in either domestic or foreign markets, the impact of any change inUnited States federal income tax laws and the loss of any beneficial taxtreatment that we currently enjoy, our reliance on independent foundries andsubcontractors for the manufacture, assembly and testing of our products, thelength of our sales cycle and reliance on distributors, our ability to protectour intellectual property, the cyclical nature of the semiconductor industry,our ability to raise capital, the potential volatility of our stock, theoutcome of future litigation and the risks set forth under PART II – OTHERINFORMATION,  Item 1A. “Risk Factors.”Given these risks and uncertainties, you should not place undue reliance onthese forward-looking statements. Except as required by federal securitieslaws, we undertake no obligation to update any forward-looking statements forany reason, even if new information becomes available or other events occur inthe future.*

 

*In this report all references to “Techwell,”“we,” “us” or “our” mean Techwell, Inc.*

 

*Techwell is our registered trademark. We alsorefer to trademarks of other corporations and organizations in thisForm 10-Q.*

 

***Overview***

 

 Weare a fabless semiconductor company that designs, markets and sells mixedsignal integrated circuits for multiple video applications in the securitysurveillance, automotive, consumer and PC markets. We target video applicationsbased on digital technologies that receive and process analog video signals.These video applications include security surveillance systems, in-car LCD displays,advanced TVs, multifunction LCD monitors, camcorders, DVD recorders and TVtuner cards. These applications receive analog video signals commonly generatedby surveillance cameras, by consumer electronics devices such as set-top boxes,DVD recorders, VCRs and camcorders, and to a lesser extent by over-the-air TVbroadcasts. We design application specific products that enable the conversionof analog video sources to digital form and perform advanced digital videoprocessing to facilitate the display, storage and transport of video content.We believe this product strategy allows us to better address varying customerrequirements, fully leverage our technology capabilities and achieve greatershare within our target markets. Our semiconductors are based on ourproprietary architecture and mixed signal technologies that we believe providehigh video quality under a wide range of signal conditions, enable high levelsof integration and are cost effective.

 

We commenced operations in 1997. From 1997 to 1999, we were primarilyinvolved in developing our technology. We shipped our first generation videodecoder in 1999. Since 1999, our business has experienced significant growthprimarily as a result of our ability to develop new products, obtain design winsand convert these design wins into revenues. We generated revenues from thesale of over 25 different products in the quarter ended June 30, 2008.

 

Wedesign, market and sell mixed signal semiconductor products that enable theconversion of analog video signals to digital form and perform advanced digitalvideo processing to facilitate the display, storage and transport of videocontent. Historically, we classified our initial products as general purposeproducts in that they serviced multiple markets. In the process of supplyingproducts to these markets we developed specific knowledge regarding therequirements for each market. We then determined that we would concentrate ourdevelopment efforts on video applications in the security surveillance, automotive,consumer and PC markets. Today, our application specific products includeproducts specifically designed for security surveillance systems, LCD displaysprimarily for the automotive market and video decoders used in consumer and PCproducts. We intend to continue to develop new generations of products for eachof these application specific product lines.

 

Our security surveillance products integrate important functionsrequired to display, store and transport analog video signals from securitysurveillance cameras.  In 2007, weintroduced our most integrated security surveillance product, which includesfour video decoders and a system controller and a multiplexer on a singlesemiconductor. As a result, this semiconductor is able to receive anddecode analog video signals from multiple cameras into a standard digitalformat.  In addition, we now integrate ona single semiconductor a multiplexer, a key technology required to combinemultiple video signals into a single video signal.  Wealso have developed a motion JPEG, or MJPEG, encoder/decoder, or CODEC, thatfacilitates the storage and playback of video from a hard disk drive andtransport of video over the Internet. We currently sell our securitysurveillance products to customers for 

 

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the following applications: embedded digital video recorders, or DVRs, PC-based DVRs, network videorecorders, or NVRs and multiplexers.

 

Our LCD display products integrate important functions required todisplay popular analog video, high definition video and PC graphics signals onan LCD display. These key functions include a video decoder, deinterlacer andscaler.  In addition, our newergeneration LCD display products integrate a timing controller to interfacedirectly with certain types of LCD display and image enhancement functionalityto improve overall video quality.  In January 2008,we announced the introduction of five new LCD display processors designed forthe automotive markets. These new products are designed to provide advancedimage processing, an integrated programmable timing controller and multipleanalog and digital video inputs.

 

Our video decoder products are high-performance mixed signalsemiconductors that decode analog TV broadcast signals, including NationalTelevision Systems Committee, or NTSC, phase alternation line, or PAL, andsequential color with memory, or SECAM, and popular analog video signals,including composite, S-Video, component and Syndicate of Radio and TelevisionManufacturers, or SCART, into a standard digital format. Our videodecoder products integrate proprietary sync processing, color demodulating anddigital 2D and 3D comb filtering, which are the key technologies required forhigh performance video decoding. We offer a broad range of video decoderproducts at various price points and with varying features. We currently sellour video decoder products to customers across the following digital videoapplications: advanced TV, multifunction LCD monitor, DVD recorder, camcorder,security surveillance systems and in-car LCD display.

 

Although our revenues have grown rapidly in a short period of time, wedo not expect to achieve similar growth rates in the future. We currentlyexpect to increase our expense levels in each of the next several quarters tosupport increased research and development and sales and marketing efforts.These expenditures may not result in increased revenues or profitability in thefuture. In addition, our ability to increase our revenues will depend onincreased demand for digital video applications in the security surveillance,automotive and consumer and PC markets. The growth of our target markets isuncertain. In addition, the timing of orders by and shipments to our customers,as well as general trends in our target markets, can cause our revenue growthto be inconsistent.

 

We undertake significant product development efforts well in advance ofa product’s release, and in advance of receiving purchase orders from ourcustomers. Our product development efforts, which are focused on developing newdesigns with broad demand and potential for future derivative products,typically take from six months to two years until production begins, dependingon the product’s complexity. If we secure a design win, the system designer islikely to continue to use the same or enhanced versions of our product across anumber of their models, which tends to extend the life cycles of our product.Conversely, if a competitor secures the design win, it may be difficult for usto sell into the customer’s application for an extended period. Our sales cycletypically ranges from six to 24 months. Due to the length of our productdevelopment and sales cycle, the majority of our revenues for any period isgenerally weighted toward products introduced for sale, meaning products forwhich we commenced placing orders with our manufacturing subcontractors, in theprior one or two years. As a result, our present revenues are not necessarilyrepresentative of future sales because our future sales are likely to becomprised of a different mix of products, some of which are now in thedevelopment stage.

 

As a fabless semiconductor company, we outsource all of ourmanufacturing, assembly and test functions to third-party vendors primarilylocated in Taiwan. This business model enables us to reduce our capitalexpenditures and fixed costs, while focusing our engineering and designresources on our core strength, the design of mixed signal semiconductors fordigital video applications.

 

We sell our products to a limited number of distributors that fulfillthird-party orders for our products. We also sell directly, using independentsales representatives, to original equipment manufacturers, or OEMs, such asSamsung and LG Electronics, which have historically been some of our largestcustomers, and to original design manufacturers, or ODMs.  In 2007, wederived approximately 77% of our revenues from products sold to distributorsand 23% from products sold to OEMs or ODMs. In the six months ended June 30,2008, we derived approximately 75% of our revenues from products sold todistributors and 25% from products sold to OEMs or ODMs. Our gross marginshave not historically been significantly different between sales todistributors and sales to OEMs or ODMs through orders procured by independentsales representatives. However, our operating profit on sales through ordersprocured by independent sales representatives can be less due to the payment ofcommissions to sales representatives, which we record as sales and marketingexpense.

 

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We received an aggregate of 83% and 80% of our revenues from our tenlargest customers in the three months ended June 30, 2008 and 2007,respectively.  In the three months ended June 30,2008, two of our customers accounted for 31% and 10% of our revenues, thelarger of which was a distributor.  Inthe three months ended June 30, 2007, two of our customers, all of whichare distributors, accounted for 16% and 11% of our revenues, respectively.  For the six months ended June 30, 2008,two of our customers accounted for 29% and 11% of our revenues, the larger ofwhich was a distributor.  For the sixmonths ended June 30, 2007, one of our customers, a distributor, accountedfor 16% of our revenues.

 

We derive substantially all of our revenues from sales to foreigncustomers, particularly in Asia, which sales accounted for approximately 98% ofour revenues in both the three and six months ended June 30, 2008 andapproximately 98% of our revenues for the three and six months ended June 30,2007. The table below indicates the percentage of total revenue by geographiclocation for the periods indicated:

 
| ** **    | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **    | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **    | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| Taiwan        |       | 31                               | %          | 45                             | %          | 33 | % | 44 | % |
| South Korea   |       | 28                               |       | 31                             |       | 29 |   | 32 |   |
| China         |       | 34                               |       | 19                             |       | 31 |   | 19 |   |
| Japan         |       | 5                                |       | 3                              |       | 5 |   | 3 |   |
| United States |       | 1                                |       | 1                              |       | 1 |   | 1 |   |
| Other         |       | 1                                |       | 1                              |       | 1 |   | 1 |   |
| Total         |       | 100                              | %          | 100                            | %          | 100 | % | 100 | % |

 

We believe that a substantial majority of our revenues will continue tocome from customers located in Asia, where most of the electronic devices thatuse our semiconductors are manufactured. As a result of this regionalcustomer concentration, we may be subject to economic, cultural and politicalevents and other developments that impact our customers in Asia. All of oursales currently are denominated in U.S. dollars. Therefore, an increase in thevalue of the U.S. dollar relative to foreign currencies could make our productsless competitive in international markets. Substantially all of our cost ofrevenues and a majority of our operating expenses are also denominated in U.S.dollars. As a consequence, we believe that our overall exposure toforeign exchange risk is low.

 

We have international branches in South Korea and Taiwan and we havesubsidiaries in China and Japan. At June 30, 2008, 60 of our 151 employeeswere located in our international offices. These offices provide marketingsupport to our customers. Our South Korea and Japan offices also performproduct development activities.

 

It is difficult for us to forecast the demand for our products, in partbecause of the highly complex supply chain between us and the end markets thatincorporate our products. Demand for new features changes rapidly. Distributorsand ODMs add an additional layer of complexity. We must, therefore, forecastdemand not only from our direct customers, but also from other participants inthis multi-level distribution channel. Because of our lengthy productdevelopment cycle, it is critical for us to anticipate changes in demand forour various product features and the applications they serve, to allowsufficient time for product design. Our failure to accurately forecast demandcan lead to product shortages that can impede production by our customers andharm our relationship with these customers. Conversely, our failure to forecastdeclining demand or shifts in product mix can result in excess or obsoleteinventory.

 

Generally, the average selling price of our products will decline overthe life of the product. Our experience to date is that the decline has not hada material effect on our gross margins, as price reductions have been mitigatedby lower per unit costs associated with both high unit volume and thetransition of our products to smaller process geometries. Our video decoder andLCD display products that are sold into consumer applications are subject tothe seasonality associated with the consumer market. As a result, revenues fromthese products are lower in the first calendar quarter of the year. Inaddition, a significant number of our semiconductors are sold to customerslocated in Asia, primarily to customers located in regions who observe theLunar New Year holiday. Typically, our customers are closed for a week or moreduring the extended holiday period, which negatively impacts our business. As aresult of seasonality associated with the consumer market and our customerconcentration in Asia, we expect our revenues to be lower in the first calendarquarter of each year compared to other quarters.

 

Our revenues increased by 15% for the three months ended June 30,2008 compared to the three months ended June 30, 2007 and our net incomedecreased to $1.8 million for the three months ended June 30, 2008 from 

 

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$2.6 million for the three months ended June 30, 2007 primarilydue to increased stock compensation and income tax expenses. Our revenuesincreased by 15% for the six months ended June 30, 2008 compared to the six months  ended June 30, 2007  and our net income decreased to $3.7 millionfor the six months  ended June 30,2008 from $5.1 million for the six months ended June 30, 2007 primarilydue to an increase in operating expenses and income tax expenses. We may not beable to maintain our recent growth and profitability and our limited operatinghistory makes the prediction of future operating results very difficult. Webelieve that period-to-period comparisons of operating results should not berelied upon as predictive of future performance.

 

***Critical Accounting Policies***

 

Our discussion and analysis of our financial condition and results ofoperations are based upon our condensed consolidated financial statements,which have been prepared in accordance with accounting principles generallyaccepted in the United States. The preparation of these financial statementsrequires us to make estimates and judgments that affect the reported amount ofassets, liabilities, revenues and expenses and related disclosure of contingentassets and liabilities. We evaluate our estimates on an on-going basis,including those related to inventory valuations, income taxes, warrantyobligations, stock-based compensation and valuation of investments of whichsome of these investments such as auction rate securities do not haveobservable market quotes. We base our estimates on historical experience and onvarious other assumptions that we believe to be reasonable under thecircumstances, the results of which form the basis for making the judgments wemake about the carrying values of assets and liabilities that are not readilyapparent from other sources. Because these estimates can vary depending on thesituation, actual results may differ from the estimates.

 

We believe the following critical accounting policies affect our moresignificant judgments used in the preparation of our condensed consolidatedfinancial statements.

 

*Revenue Recognition.  *Revenues from product sales are recognized upon shipment, provided that titleand risk of loss has passed to the customer, persuasive evidence of anarrangement exists, the price is fixed or determinable and collectibility isprobable. We do not allow for price protection or stock rotation rights withany of our distributors. If we change our practice and allow stock rotation orprice protection in the future, we would have to evaluate the consequences onthe timing of our revenue recognition, which could lead to the deferral of therevenues subject to such uncertainties unless reasonable estimates can be madeat the time of shipment.

 

*Warranty.  *We offer an 18 month product replacement warranty against any defectiveproduct. We accrue for estimated returns of defective products at the timerevenue is recognized, based on the rate of return from our historicalexperience. As a consequence of standardized manufacturing processes andproduct testing procedures, returns of defective product are infrequent and thequantities have not been significant. Accordingly, historical warranty costshave not been significant in the fiscal periods presented. If our futureexperience with warranty costs differs significantly from our historicalexperience, we would need to exercise increased judgment in determining theappropriate warranty accrual.

 

*Fair Value Measurements.*  Effective January 1, 2008, we adoptedthe provisions of Statement of Financial Accounting Standards No. 157(SFAS No. 157) *Fair Value Measurements*,which defines fair value, establishes a framework for measuring fair value andexpands disclosures about fair value measurements required under otheraccounting pronouncements.  SFAS No. 157clarifies that fair value is an exit price, representing the amount that wouldbe received to sell an asset or paid to transfer a liability in an orderlytransaction between market participants. SFAS No. 157 also requiresthat a fair value measurement reflect the assumptions market participants woulduse in pricing an asset or liability based on the best information available.Assumptions include the risks inherent in a particular valuation technique(such as a pricing model) and/or the risks inherent in the inputs to the model.The adoption of SFAS No. 157 on our assets and liabilities did not have asignificant impact on our financial statements.

 

*Inventory Valuation.  *Inventory is valued at the lower of cost or market, computed on a first-in,first-out basis. We evaluate inventory for excess and obsolescence andwrite-off units that are unlikely to be sold based upon a six months’ demandforecast. This evaluation may take into account matters including expecteddemand, anticipated sales price, product obsolescence and other factors. Ifactual future demand for our products is less than currently forecasted,additional inventory adjustments may be required. Once a reserve isestablished, it is maintained until the product to which it relates is sold orscrapped. If a unit that has been written down or off is subsequently sold, thecost associated with the revenue from this unit is reduced to the extent of thewrite-off, resulting in an increase in gross profit.

 

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*Accounting for Income Taxes.  *We account for income taxes under the provisions of Statement of FinancialStandards, or SFAS No. 109,*  Accounting for Income Taxes*. Inapplying SFAS No. 109, we are required to estimate our current tax expensetogether with assessing temporary differences resulting from differingtreatments of items for tax and accounting purposes. These differences resultin deferred tax assets and liabilities. We must assess the likelihood that ourdeferred tax assets will be recovered from future taxable income and to theextent we believe that recovery is not likely, we must establish a valuationallowance. Significant management judgment is required to assess the likelihoodthat our deferred tax assets will be recovered from future taxable income. At June 30,2008, our total deferred tax assets were principally comprised of net operatingloss carryforwards, research and other credit carryforwards, stock-basedcompensation expenses and expense accruals.

 

As required under the provisions of SFAS No. 109, we assess therecoverability of our deferred tax assets. To assess the likelihood that the deferred tax assets will be recoveredfrom taxable income, we applied the guidance provided in SFAS No. 109 andconsidered both positive evidence that indicates a valuation allowance is notneeded and negative evidence that indicates a valuation allowance is needed. Asof June 30, 2008, we believe that our continued and predictable strongearnings provides ample evidence that no valuation allowance is required atthis time.

 

We file income taxreturns in the U.S. federal jurisdiction, various states and foreignjurisdictions.  We have not been under the examination of U.S. federal,state or other foreign jurisdictions.

 

On January 1,2007, we adopted the provisions of Financial Accounting Standards Board Interpretation No. 48, *Accountingfor Uncertainty in Income Taxes,* or FIN No. 48.  FIN No. 48clarifies the accounting for uncertainty in income taxes recognized inan enterprise’s financial statements in accordance with SFAS No. 109*.*  As a result of the implementation of FIN No. 48,we recognized no material adjustment to the January 1, 2007 balance ofretained earnings.  As of June 30,2008, we have unrecognized tax benefits of approximately $0.2 million but donot expect our unrecognized tax benefits to change significantly over the next12 months. We recognize interest related to unrecognized tax benefits inour income tax expense and penalties related to unrecognized tax benefits inour operating expenses. For the three and six months ended June 30, 2008,we did not recognize any interest or penalties related to unrecognized taxbenefits.

 

*Stock-Based Compensation.  *Effective January 1, 2006, we adopted SFAS No. 123 (revised 2004),*Share-Based Payment*, or SFAS No. 123(R),which requires that we measure compensation expense for all share-based paymentawards made to employees and directors, including employee stock options, basedon estimated fair values and recognize that expense over the required serviceperiod. Prior to our adoption of SFAS No. 123(R), we accounted forstock-based compensation awards issued to our employees using the intrinsicvalue measurement provisions of Accounting Principles Board Opinion No. 25,*Accounting for Stock Issued to Employees*,or Opinion No. 25.

 

We adopted SFAS No. 123(R) using the prospective transitionmethod. Under this method, SFAS No. 123(R) is applied to new awardsand to awards modified, repurchased or cancelled after January 1, 2006.Compensation cost previously recorded under Opinion No. 25 for unvestedoptions will continue to be recognized as the required services are rendered.Accordingly, for the three and six months ended June 30, 2008 and 2007,stock based compensation expense includes compensation costs related toestimated fair values of awards granted after the date of adoption of SFAS No. 123(R) andcompensation costs related to unvested awards at the date of adoption based onthe intrinsic values as previously recorded under Opinion No. 25.

 

For options granted after January 1, 2006, and valued inaccordance with SFAS No. 123(R), we use the straight-line method forexpense attribution. For options granted prior to January 1, 2006, we usethe multiple grant approach for expense attribution, which results insubstantially higher amounts of amortization in earlier years as opposed to thestraight-line method, which results in equal amortization over the vestingperiod of the options.

 

The fair value of options granted after January 1, 2006 isestimated on the grant date using the Black-Scholes option valuation model.Since our stock has been actively traded for only a short period of time forthe periods through 2007, we used the simplified calculation of expected termdescribed in Staff Accounting Bulletin No. 107 and volatility was based onan average of the historical volatilities of the common stock of severalentities with characteristics similar to us. For the three and six months endedJune 30, 2008, we performed a review of our assumptions using additionalhistorical data available to us. In the expected term assumption calculation,we started with our additional historical data as suggested by Staff AccountingBulletin No. 107 and adjusted the historical data for any changes infuture expectations. Since we do not have any publicly traded options, we relyexclusively on historical volatility in the expected volatility assumptioncalculation. The risk-free rate is based on the U.S. Treasury 

 

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yield curve in effect at the time of grant for periods correspondingwith the expected term of the option. The estimated forfeiture rate is based onour historical forfeiture experience and is estimated at 10% for all periodspresented.

 

Thefollowing assumptions are used to value stock options granted in the periodspresented:

 
| ** **              | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **              | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **              | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| Expected term in years  |       | 4.28                             |       | 6.08                           |       | 4.28 |   | 6.08 |   |
| Risk-free interest rate |       | 2.86                             | %          | 4.65                           | %          | 2.57% – 2.86 | % | 4.60% - 4.65 | % |
| Expected volatility     |       | 51.0                             | %          | 68.4                           | %          | 51.0% - 64.0 | % | 68.4% - 70.6 | % |
| Dividend yield          |       | 0                                | %          | 0                              | %          | 0 | % | 0 | % |

 

Compensation expense for restricted stockawards is determined using the fair value of Techwell’s stock on the date ofthe grant and is recognized on a straight-line basis over the service period.

 

Stock-based compensation expense is allocated among cost of revenues,research and development expenses and selling, general and administrativeexpenses, respectively, based upon the employee’s job function. We expect tocontinue to recognize substantial amounts of stock-based compensation expenserelating to our employee stock options in future periods primarily as a resultof our adoption of SFAS No. 123(R).

 

***Results ofOperations***

*** ***

The following table is derived from our selected financial data andsets forth our historical operating results as a percentage of revenues for theperiods indicated:

 
| ** **                                                         | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                         | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| **Consolidated Statement of Operations Data:** | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| Revenues                                                           |       | 100.0                            | %          | 100.0                          | %          | 100.0 | % | 100.0 | % |
| Cost of revenues*                                                  |       | 38.2                             |       | 40.6                           |       | 38.5 |   | 41.7 |   |
| Gross margin                                                       |       | 61.8                             |       | 59.4                           |       | 61.5 |   | 58.3 |   |
|                                                               |       |                             |       |                           |       |   |   |   |   |
| Operating expenses:                                                |       |                             |       |                           |       |   |   |   |   |
| Research and development*                                          |       | 24.7                             |       | 19.5                           |       | 23.8 |   | 18.0 |   |
| Selling, general and administrative*                               |       | 22.2                             |       | 19.5                           |       | 22.9 |   | 19.9 |   |
|                                                               |       |                             |       |                           |       |   |   |   |   |
| Total operating expenses                                           |       | 46.9                             |       | 39.0                           |       | 46.7 |   | 37.9 |   |
|                                                               |       |                             |       |                           |       |   |   |   |   |
| Income from operations                                             |       | 14.9                             |       | 20.4                           |       | 14.8 |   | 20.4 |   |
| Interest income                                                    |       | 3.2                              |       | 5.0                            |       | 4.0 |   | 5.0 |   |
|                                                               |       |                             |       |                           |       |   |   |   |   |
| Income before income taxes                                         |       | 18.1                             |       | 25.4                           |       | 18.8 |   | 25.4 |   |
| Income taxes                                                       |       | 7.2                              |       | 7.5                            |       | 7.4 |   | 7.3 |   |
| Net Income                                                         |       | 10.9                             | %          | 17.9                           | %          | 11.4 | % | 18.1 | % |

 

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(*)  Percentages includestock-based compensation.

 

The table below indicates the percentage of stock-based compensationattributed to each item as a percentage of revenues for the periods indicated:

 
| ** **                          | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                          | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                          | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                |       |                             |       |                           |       |   |   |   |   |
| Cost of revenues                    |       | 0.8                              | %          | 0.5                            | %          | 0.7 | % | 0.4 | % |
| Research and development            |       | 5.1                              |       | 3.5                            |       | 4.8 |   | 3.0 |   |
| Selling, general and administrative |       | 5.4                              |       | 4.0                            |       | 5.5 |   | 3.5 |   |

 

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***Revenues by product line are as follows (inthousands):***

 
| ** **               | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **               | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **               | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| Security Surveillance(1) |       | $                                | 12,855     |                           | $          | 9,095 |   | $ | 24,464 |   | $ | 18,003 |   |
| Video Decoders(2)        |       | 2,144                            |       | 3,883                          |       | 4,256 |   | 6,522 |   |
| LCD Display(3)           |       | 1,963                            |       | 1,527                          |       | 3,660 |   | 3,134 |   |
| Other(4)                 |       | 44                               |       | 238                            |       | 233 |   | 601 |   |
| Total                    |       | $                                | 17,006     |                           | $          | 14,743 |   | $ | 32,613 |   | $ | 28,260 |   |

 

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| (1)    | Consists of application  specific products designed for use in security surveillance systems.                                                                                                                                                                                                                            |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                     |
| (2)    | Consists of our video  decoders designed for use in the security surveillance, automotive and consumer  markets. Revenues from video decoders used in security surveillance systems  and LCD displays are reported under the video decoder product line and not  the security surveillance or LCD display product lines. |
|   |                                                                                                                                                                                                                                                                                                                     |
| (3)    | Consists of application  specific products designed for use in LCD displays.                                                                                                                                                                                                                                             |
|   |                                                                                                                                                                                                                                                                                                                     |
| (4)    | Consists of early  generation mixed signal semiconductors for digital video applications and PCI  video decoder products.                                                                                                                                                                                                |

 

**Comparisons of the Three Months Ended June 30,2008 and 2007**

 

*Revenues.*    Ourrevenues consist of sales of our mixed signal integrated circuits for digitalvideo applications. We have three principal product lines: securitysurveillance, LCD display and video decoder. All of our sales are denominatedin U.S. dollars.

 

Revenueswere $17.0 million for the three months ended June 30, 2008 and $14.7million for the three months ended June 30, 2007, an increase of 15%.Revenues from our security surveillance products increased approximately $3.8million, or 41%, in the three months ended June 30, 2008 compared to thethree months ended June 30, 2007, primarily as a result of the increase insales of our integrated four-in-one-video decoder products. Revenuesfrom of our LCD display products increased slightly by approximately $0.4million, or 29%, in the three months ended June 30, 2008 compared to thethree months ended June 30, 2007, primarily as aresult of continuing demand in the automotive market for vehicles with anin-car LCD display that utilizes our product. Revenues from video decoderproducts decreased approximately $1.7 million, or 45%, in the three monthsended June 30, 2008 compared to the three months ended June 30,2008,primarily as a result of a general decrease in demand from our targetmarkets for products utilizing video decoders such as multi-function monitorsand DVD recorders. Other revenues decreased $0.2 million, or 82%, in thethree months ended June 30, 2008 compared with the three monthsended June 30, 2007, primarily as a result of decreased sales of our PCIvideo decoder products.

 

*Gross Profit and Gross Margin.*  Gross profit is thedifference between revenues and cost of revenues, and gross margin representsgross profit as a percentage of revenues. Cost of revenues, also known as costof goods sold, consists primarily of cost of processed silicon wafers, costsassociated with assembly, test and shipping of our production semiconductors,cost of personnel and related expenses associated with supporting ouroutsourced manufacturing activities and write-downs for excess and obsoleteinventory.

 

Gross profit was $10.5 million for thethree months ended June 30, 2008 and $8.8 million for the three monthsended June 30, 2007, an increase of 20%. Gross margin was 62% for the three months ended June 30, 2008increasing from 59% for the three months ended June 30, 2007. The increase in gross profit was primarilydue to an increase in revenue of $2.3 million or 15%. The increase in grossmargin was primarily a result of reducedmaterial costs partiallyattributable to volume purchase discounts and the transition of our products to lower process geometries in thesecond quarter of 2008 compared to the second quarter of 2007.

 

We incurredstock-based compensation included in cost of revenues associated withoutsourced manufacturing support and quality assurance personnel of $0.1million for both the three months ended June 30, 2008 and 2007,respectively.

 

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*Research and Development.*    Researchand development expenses consist primarily of compensation and associated costsof employees engaged in research and development, contractor costs, tape-outcosts, development testing and evaluation costs, occupancy costs anddepreciation expense. Before releasing new products, we incur charges for masksets, prototype wafers and mask set revisions, which we refer to as tape-outcosts. Tape-out costs attributable to new product development may causeour research and development expenses to fluctuate because they are notincurred uniformly every quarter. We expect our research and developmentcosts to increase in absolute dollars in 2008 as we increase our investment indeveloping new products.

 

Researchand development expenses were $4.2 million, or 25% of revenues, for the threemonths ended June 30, 2008 and $2.9 million or 20% of revenues for thethree months ended June 30, 2007, an increase of 47%.  This increase was primarily due to increasedcompensation-related expenses of approximately $0.8 million in salary andbenefits associated with new hires in the U.S. and the opening of our Japanoffice in the second quarter of  2007 tosupport product development efforts, and an increase of $0.3 million ofstock-based compensation expense.

 

We incurredstock-based compensation expense associated with research and developmentpersonnel of $0.9 million and $0.5 million in the three months ended June 30,2008 and 2007, respectively.

 

*Selling, General and Administrative.*    Selling, general and administrative expenses consistprimarily of compensation and associated costs for marketing, selling andadministrative personnel, sales commissions to independent salesrepresentatives, contractor compensation, public relations, promotional andother marketing expenses, insurance and fees paid for professional services,travel, depreciation expenses and occupancy costs. Costs associated with auditand tax services, corporate governance and compliance and financial reportingare also included in selling, general and administrative expenses.

 

Selling, general and administrative expenses were$3.8 million, or 22% of revenues, for the three months ended June 30, 2008and $2.9 million, or 20% of revenues, for the three months ended June 30,2007, an increase in absolute dollars of 31%. The increase in expense wasprimarily due to increasedsalary-related expenses of approximately $0.4 million associated with new hiresto support the expansion of our subsidiary in China and the opening of ourJapan office in the second quarter of 2007, and $0.3 million instock-based compensation expenses. We expect selling, general andadministrative expenses to continue to increase in the future in support of ouranticipated growth as we hire additionalpersonnel, expand our sales and marketing efforts and pay increased salescommissions based on a projected increase in sales volume. Administrativeexpenses will also increase to cover additional costs associated withoperating as a public company, such as growthin our information technology infrastructure.

 

We incurredstock-based compensation expense associated with selling, general andadministrative personnel of $0.9 million and $0.6 million in the threemonths ended June 30, 2008 and 2007, respectively.

 

*InterestIncome.*    Interest income was $0.5million for the three months ended June 30, 2008 and $0.7 million for thethree months ended June 30, 2007, a decrease of 27%. The decrease wasprimarily due to lower rates of returns due to lower interest rates on cash,cash equivalent and investment balances. This was slightly offset by anincrease in cash, cash equivalent and investment balances in the three monthperiod ended June 30, 2008.

 

*Income Taxes.*    Our provision for income taxes was $1.2 millionfor the three months ended June 30, 2008 and $1.1 million for the threemonths ended June 30, 2007.  Oureffective tax rate increased to approximately 40% in the three months ended June 30,2008 from approximately 30% in the three months ended June 30, 2007.  The effective tax rate for both periodsdiffered from the statutory federal income tax rate.  In 2007, our effective tax rate was lowerthan the statutory federal income tax rate primarily due to a partial releaseof valuation allowances for net operating losses.  In 2008, our effective tax rate was greaterthan the statutory federal income tax rate primarily due to non-deductiblestock-based compensation expenses and state income taxes.

 

**Comparisons of the Six Months Ended June 30,2008 and 2007**

 

*Revenues.*   Revenues were $32.6million for the six months ended June 30, 2008 and $28.3 million for thesix months ended June 30, 2007, an increase of 15%.  Revenues from our security surveillanceproducts increased approximately $6.5 million, or 36%, in the six months ended June 30,2008 compared to the six months ended June 30, 2007, primarily as a resultof the increase in sales of our integrated four-in-one security surveillanceproducts.  

 

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Revenues from of ourLCD display products increased by $0.5 million, or 17%, in the six months endedJune 30, 2008 compared to the six months ended June 30, 2007primarily as a result of an increase in demand in the automotive market for vehicleswith an in-car LCD display that utilize our product.  Revenues from video decoder productsdecreased approximately $2.3 million, or 35%, in the six months ended June 30,2008 compared to the six months ended June 30, 2007, primarily as a resultof a decrease in demand for our decoders due to a lack of integrated audiofunctionality. Additionally, sales of our video decoders have also been impactedby the shift to application specific products specifically designed for the LCDdisplay and security surveillance markets. Other revenues decreased by $0.4million, or 61%, in the six months ended June 30, 2008 as compared withthe six months ended June 30, 2007, primarily as a result of decreasedsales of our PCI video decoder products.

 

*Gross Profit and Gross Margin.*  Gross profit was $20.0 million for thesix months ended June 30, 2008 and $16.5 million for the six months ended June 30,2007, an increase of 22%.  Gross margin was 61% for the six monthsended June 30, 2008 increasing from 58% for the six months ended June 30,2007.  The increase in gross margin wasprimarily a result of reduced materialscosts and production costs in the six months ended June 30, 2008 comparedto the same period in 2007 partially attributable to increased volumepurchases and the transition of ourproducts to lower process geometries in the first half of 2008.

 

Weincurred stock-based compensation included in cost of revenues associated withoutsourced manufacturing support and quality assurance personnel of $0.2million and $0.1 million in the six months ended June 30, 2008 and2007, respectively.

 

*Research and Development.*  Research and developmentexpenses were $7.8 million, or 24% of revenues, for the six months ended June 30,2008 and $5.1 million, or 18% of revenues, for the six months ended June 30,2007, an increase in absolute dollars of 53%. The increase in expenseswasprimarily due to $1.8 million of compensation related expensesattributable to the increase in engineering headcount, $0.7 million instock-based compensation and $0.4 million of increased expenses associated withour new subsidiary in Japan.

 

Weincurred stock-based compensation expense associated with research anddevelopment personnel of $1.6 million and $0.8 million in the six monthsended June 30, 2008 and 2007, respectively.  The increase in stock-based compensationexpenses was primarily due to the granting of restricted stock awards to newemployees.

 

*Selling, General and Administrative*.  Selling, general and administrative expenses were$7.5 million, or 23% of revenues, for the six months ended June 30, 2007and $5.6 million, or 20% of revenues, for the six months ended June 30,2007, an increase in absolute dollars of 32%.  The increase in expense was primarily due to increased salary-related expenses ofapproximately $1.0 million associated with new hires to support the expansionof our subsidiary in China and the opening of our Japan office in the secondquarter of 2007, and $0.8 million in stock-based compensation expenses.We expect selling, general and administrative expenses to continue to increasein the future in support of our anticipated growth as we hire additional personnel, expand our sales and marketing effortsand pay increased sales commissions based on a projected increase in salesvolume. Administrative expenses will also increase to cover additionalcosts associated with operating as a public company, such as growth in our information technologyinfrastructure.

 

Weincurred stock-based compensation expense associated with selling, general andadministrative personnel of $1.8 million and $1.0 million the sixmonths ended June 30, 2008 and 2007, respectively.  The increase in stock-based compensationexpenses was primarily due to the granting of restricted stock awards to newemployees.

 

*Interest Income.*    Interestincome was $1.3 million for the six months ended June 30, 2008 and $1.4million for the six months ended June 30, 2007, adecrease of 9%.  The decrease wasdue to lower rates of returns due to lower interest rates offset by highercash, cash equivalent and investment balances during the six month period endedJune 30, 2008.

 

*Income Taxes.*    Ourprovision for income taxes was $2.4 million for the six months ended June 30,2008 and $2.1 million for the six months ended June 30, 2007.  Our effective tax rate increased toapproximately 39% in the six months ended June 30, 2008 from 29% in thesix months ended June 30, 2007.  Theeffective tax rate for both periods differed from the statutory federal incometax rate.  In 2007, our effective taxrate was lower than the statutory federal income tax rate primarily due to apartial release of valuation allowances for net operating losses.  In 2008, our effective tax rate was greaterthan the statutory federal income tax rate primarily due to non-deductiblestock-based compensation expenses and state income taxes.

 

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***Liquidity and Capital Resources***

*** ***

Sinceour inception, we have financed our growth primarily with proceeds from theissuance of preferred stock and common stock and our cash flows fromoperations.  Our cash, cash equivalentsand short and long-term investments were $73.8 million as of June 30, 2008compared to $60.9 million as of June 30, 2007.

 

Netcash provided by operating activities was $ 6.3 million in the six monthsended June 30, 2008. The net cash provided by our operating activities inthe six months ended June 30, 2008 was primarily due to our net income of$3.7 million, as well as non-cash charges from stock-based compensationexpenses of $3.6 million.  These werepartially offset by increases in inventory of $0.5 million and accountsreceivable of $0.4 million, both of which are attributable to the growth in ourrevenue, and decreases in accounts payable of $0.5 million and accrued taxes of$0.2 million primarily due to the timing of payments to vendors and taxauthorities.

 

Net cash provided by operating activities was $6.3 million in the sixmonths ended June 30, 2007.  The netcash provided by our operating activities in the six months ended June 30,2007 was primarily due to our net income of $5.1 million and a decrease in ouraccounts receivable of $0.3 million attributable to the timing of customercollections which was partially offset by a decrease in accounts payable andaccrued liabilities of $1.5 million primarily attributable to a reduction inthe liability for employees bonuses which were accrued throughout 2006 and paidin the first half of 2007 and an increase in prepaid expenses of $0.3 millionassociated with a tax asset, an increase in inventory of $0.2 million tosupport an increase in revenues  and anincrease in other assets of $0.1 million attributable to deposits on newlyleased facilities. We incurred non-cash expenses of $1.9 million forstock-based compensation expense and $0.2 million in depreciation expense inthe six months ended June 30, 2007. We also recognized a tax benefit of $0.9 million attributable to ouremployee equity incentive plans.

 

Netcash provided by our investing activities was $6.0 million in the sixmonths ended June 30, 2008 due to the maturities of our investments of$37.3 million offset by purchases of short and long-term investments of$31.0 million and capital expenditures of $0.2 million.

 

Netcash used in our investing activities was $6.9 million in the six monthsended June 30, 2007 reflecting purchases of short and long-terminvestments of $42.9 million and capital purchases of $0.4 million offset bymaturities of short and long-term investments of $36.4 million.

 

Netcash used in  by financing activities of$0.3 million in the six months ended June 30, 2008 and of $0.5 millionprovided by financing activities in the six months ended June 30, 2007primarily consisted of repurchase of common stock offset by proceeds from theexercise of stock options.

 

Webelieve our existing cash and cash equivalents and investments balances, aswell as cash expected to be generated from operating activities, will besufficient to meet our anticipated cash needs for at least the next12 months.

 

At June 30, 2008, weheld approximately $6.7 million of investments, classified as long-term assets,with an auction reset feature, which are referred to as “auction ratesecurities”, whose underlying assets are generally student loans which aresubstantially backed by the federal government. The carrying value of ourinvestment in these auction rate securities has been valued lower than theirpar value of $7.1 million as of June 30, 2008.  We have deemed this loss in fair value astemporary as we currently have the ability and intent to hold these investmentsuntil recovery of the auction process or until maturity.  The loss in fair value was recorded asan unrealized loss reported in a separate component of stockholders’ equity andincluded in accumulated other comprehensive loss. Our holdings of auction rate securitiesdecreased from $11.6 million at December 31, 2007 due to successful salesof several auction rate securities at the carrying value in the first quarterof 2008. In February and March of 2008, auctions failed for ourauction rate securities, and there is no assurance that successful auctions onthe other auction rate securities in our investment portfolio will continue tosucceed. Our ability to liquidate our investment and fully recover the carryingvalue of our investment in the near term may be limited or not exist and as aresult we have classified these investments as long-term. An auction failuremeans that the parties wishing to sell securities could not. All of our auctionrate securities, including those subject to the failure, were rated AAA at thetime of purchase, the highest rating, by a rating agency. If the issuers ofthese securities are unable to successfully close future auctions and theircredit ratings deteriorate, we may in the future be required to record animpairment charge on these investments. Webelieve that the underlying credit quality of the assets backing our auctionrate securities have not been impacted by the reduced liquidity of theseinvestments. We are continuing to evaluate the credit quality,

 

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classification and valuation of our auction ratesecurities; however, we are not yet able to quantify the amount of impairment,if any, or change in classification in these investments at this time. Based on our expected operating cash flows,and our other sources of cash, we do not anticipate the potential lack ofliquidity on these investments will affect our ability to execute our currentbusiness plan.

 

                Our long-term future capitalrequirements will depend on many factors, including our level of revenues, thetiming and extent of spending to support our product development efforts, theexpansion of sales and marketing activities, the timing of our introductions ofnew products, the costs to ensure access to adequate manufacturing capacity,the continuing market acceptance of our products and our ability to liquidateour auction rate securities in a timely manner. We could be required, or couldelect, to seek additional funding through public or private equity or debtfinancing and additional funds may not be available on terms acceptable to usor at all.

 

***Off-Balance SheetArrangements***

 

As of June 30, 2008, we have no off-balance sheetarrangements as defined in Item 303(a)(4) of the Securities and ExchangeCommission’s Regulation S-K.

 

** *Contractual Obligations***

 

The following table identifies ourcommitments to settle contractual obligations as of June 30, 2008:

 
| ** **                    | ** ** | **Payment Due by Period** | ** ** |
|-------------------------------|------------|------------------------------------------|------------|
| ** **                    | ** ** | **Total**                                | ** ** | **Less than 1   year** | ** ** | **1-3 years** | ** ** | **4-5 years** | ** ** |
|                          |       |                                     |       |   |   |   |   |   |   |
| Minimum lease commitments (1) |       | $                                        | 1,660      |   | $ | 631 |   | $ | 745 |   | $ | 284 |   |
| Purchase commitments          |       | 3,311                                    |       | 3,311 |   | — |   | — |   |
| Total commitments             |       | $                                        | 4,971      |   | $ | 3,942 |   | $ | 745 |   | $ | 284 |   |

 

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(1) The increase from the prior quarter is a result of new facility leasearrangements entered into during the quarter ending June 30, 2008 in Chinaand South Korea.

 

***Recent Accounting Pronouncements***

 

InSeptember 2006, the FASB issued SFAS No. 157,*Fair Value Measurements*, which definesfair value, establishes a framework for measuring fair value in generallyaccepted accounting principles, and expands disclosures about fair valuemeasurements. This statement applies to other accounting pronouncements thatrequire or permit fair value measurements, the FASB having previously concludedin those accounting pronouncements that fair value is the relevant measurementattribute. Accordingly, this Statement does not require any new fair valuemeasurements. SFAS No. 157 is effective for financial statements issuedfor fiscal years beginning after November 15, 2007. However, on February 12,2008, the FASB issued SFAS No. 157-2 which delays the effective date ofSFAS No. 157 for all nonfinancial assets and nonfinancial liabilities,except those that are recognized or disclosed at fair value in the financialstatements on a recurring basis (at least annually). SFAS No. 157-2partially defers the effective date of SFAS No. 157 to fiscal yearsbeginning after November 15, 2008, and interim periods within those fiscalyears for items within the scope of this FASB Staff Position. EffectiveJanuary 1, 2008, we adopted SFAS No. 157 for financial assetsand liabilities recognized at fair value on a recurring basis except as itapplies to those nonfinancial assets and nonfinancial liabilities as noted inSFAS No. 157-2. The partial adoption of SFAS No. 157 did not have amaterial impact on the consolidated financial positions, results of operationsor cash flows.

 

InFebruary 2007, the FASB issued SFAS No. 159, *The FairValue Option for Financial Assets and Financial Liabilities – including anAmendment of FASB Statement No. 115*, to permit all entities tochoose to elect, at specified election dates, to measure eligible financialinstruments at fair value, to report unrealized gains and losses on items forwhich the fair value option has been elected in earnings at each subsequentreporting date, and recognize upfront costs and fees related to those items inearnings as incurred and not deferred. An entity is prohibited fromretrospectively applying SFAS No. 159, unless it chooses early adoption.SFAS No. 159 is effective as of the beginning of the first fiscal yearthat begins after November 15, 2007. Effective January 1, 2008, weadopted SFAS No. 159. The adoption of SFAS No. 159 did not have amaterial impact on the consolidated financial positions, results of operationsor cash flows.

 

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InJune 2007, the EITF reached a consensus on Issue No. 07-3, *Accounting for Nonrefundable Advance Payments forGoods or Services Received to Be Used in Future Research and DevelopmentActivities*. Nonrefundable advance payments for goods or servicesthat will be used or rendered for future research and development activitiesshould be deferred and capitalized. Such amounts should be recognized as anexpense as the related goods are delivered or the services are performed, orwhen the goods or services are no longer expected to be provided. This Issue iseffective for fiscal years beginning after December 15, 2007, and earlierapplication is not permitted. Effective January 1, 2008, we adopted EITFNo. 07-3. The adoption of EITF No. 07-03 did not have a materialimpact on the consolidated financial positions, results of operations or cashflows.

 

**ITEM 3. Qualitative andQuantitative Disclosure about Market Risk**

 

The primary objectives of our investment activity are to preserveprincipal, provide liquidity and maximize income without significantlyincreasing the risk. Some of the securities we invest in are subject to marketrisk. This means that a change in prevailing interest rates may cause theprincipal amount of the investment to fluctuate. To minimize this risk, wemaintain our portfolio of cash equivalents, short and long-term investments indemand accounts, money market funds, commercial paper, corporate bonds, U.S.government agency securities and auction rate securities which are investmentgrade securities with a maximum dollar weighted maturity of two years or less.The risk associated with fluctuating interest rates is limited to ourinvestment portfolio, and we believe that a 10% change in interest rates wouldnot have a significant impact on our interest income.

 

AtJune 30, 2008, we held approximately $6.7 million of investments,classified as long-term assets, with an auction reset feature, which arereferred to as “auction rate securities”, whose underlying assets are generallystudent loans which are substantially backed by the federal government. Thecarrying value of our investment in these auction rate securities has beenvalued lower than their par value of $7.1 million as of June 30,2008.  We have deemed this loss in fairvalue as temporary as we currently have the ability and intent to hold theseinvestments until recovery of the auction process or until maturity.  The loss in fair value was recorded asan unrealized loss reported in a separate component of stockholders’ equity andincluded in accumulated other comprehensive loss. Our holdings of auction rate securitiesdecreased from $11.6 million at December 31, 2007 due to successful salesof several auction rate securities at the carrying value in the first quarterof 2008. In February and March of 2008, auctions failed for ourauction rate securities, and there is no assurance that successful auctions onthe other auction rate securities in our investment portfolio will continue tosucceed. Our ability to liquidate our investment and fully recover the carryingvalue of our investment in the near term may be limited or not exist and as aresult we have classified these investments as long-term. An auction failuremeans that the parties wishing to sell securities could not. All of our auctionrate securities, including those subject to the failure, were rated AAA at thetime of purchase, the highest rating, by a rating agency. If the issuers ofthese securities are unable to successfully close future auctions and theircredit ratings deteriorate, we may in the future be required to record animpairment charge on these investments. Webelieve that the underlying credit quality of the assets backing our auctionrate securities have not been impacted by the reduced liquidity of these investments.We are continuing to evaluate the credit quality, classification and valuationof our auction rate securities; however, we are not yet able to quantify theamount of impairment, if any, or change in classification in these investmentsat this time. Based on our expected operating cash flows, and our othersources of cash, we do not anticipate the potential lack of liquidity on theseinvestments will affect our ability to execute our current business plan. Webelieve our existing cash balances, as well as cash expected to be generatedfrom operating activities, will be sufficient to meet our anticipated cashneeds for at least the next 12 months.

 

To date, our international customer agreements have been denominatedsolely in U.S. dollars, and accordingly, we have not been exposed to foreigncurrency exchange rate fluctuations from customer agreements, and do notcurrently engage in foreign currency hedging transactions. However, thefunctional currency of our operations in Taiwan, South Korea, Japan and Chinais the U.S. dollar and our local accounts are maintained in the local currencyin Taiwan, South Korea, Japan and China, respectively, and thus we are subjectto foreign currency exchange rate fluctuations associated with remeasurement toU.S. dollars. Such fluctuations have not been significant historically and webelieve that a 10% change in exchange rates would not have a significant impacton our operating expenses.

 

**ITEM 4. Controls andProcedures**

 

(a) *** Evaluation of disclosure controls and procedures.***   Wemaintain “disclosure controls and procedures,” as such term is defined inRule 13a-15(e) and 15d-15(e) under the Securities Exchange Actof 1934 (the “Exchange Act”), that are designed to ensure that informationrequired to be disclosed by us in reports that we file or submit 

 

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under the Exchange Act isrecorded, processed, summarized, and reported within the time periods specifiedin Securities and Exchange Commission rules and forms, and that suchinformation is accumulated and communicated to our management, including ourchief executive officer and chief financial officer, as appropriate, to allowtimely decisions regarding required disclosure. In designing and evaluating ourdisclosure controls and procedures, management recognized that disclosurecontrols and procedures, no matter how well conceived and operated, can provideonly reasonable, not absolute, assurance that the objectives of the disclosurecontrols and procedures are met. Our disclosure controls and procedures havebeen designed to meet the reasonable assurance standards. Additionally, indesigning disclosure controls and procedures, our management necessarily wasrequired to apply its judgment in evaluating the cost-benefit relationship ofpossible disclosure controls and procedures. The design of any disclosurecontrols and procedures also is based in part upon certain assumptions aboutthe likelihood of future events, and there can be no assurance that any designwill succeed in achieving its stated goals under all potential futureconditions.

 

Based on the evaluation as of the end of the period covered by thisQuarterly Report on Form 10-Q, our chief executive officer and chieffinancial officer have concluded that, as of such date, our disclosure controlsand procedures were effective.

 

(b) *** Changes in internal control over financial reporting.***  There was no change in our internal control over financial reporting (asdefined in Rule 13a-15(f) and 15d-15(f) under the Exchange Act)that occurred during the period covered by this Quarterly Report onForm 10-Q that has materially affected, or is reasonably likely tomaterially affect, our internal control over financial reporting.

 

**PART II—OTHERINFORMATION**

 

**ITEM1.****          LegalProceedings**

 

We are currently not a party to any other material legalproceedings. We may from time to time become involved in litigation relating toclaims arising from our ordinary course of business. These claims, even if notmeritorious, could result in the expenditure of significant financial andmanagerial resources.

 

**ITEM1A.****       RiskFactors**

 

If any of the following risks actually occur, our business, results ofoperations and financial condition could suffer significantly.

 

**Risks Related to Our Business**

 

***Fluctuations in ourrevenue and operating results on a quarterly basis could cause the market priceof our common stock to decline.***

 

Our revenue and operating results are difficult to predict, have in thepast fluctuated, and may in the future fluctuate from quarter to quarter. It ispossible that our operating results in some quarters will be below marketexpectations. This would likely cause the market price of our common stock todecline. Our quarterly operating results are affected by a number of factors,including:

 

·                  unpredictable volume and timing ofcustomer orders, which are not fixed by contract but vary on a purchase orderbasis;

·                  uncertain demand in the consumermarket for LCD display products;

·                  the loss of one or more of ourcustomers, causing a significant reduction or postponement of orders from thesecustomers;

·                  decreases in the overall averageselling prices of our products;

·                  changes in the relative sales mix ofour products;

·                  changes in our cost of finishedgoods;

·                  the availability, pricing andtimeliness of delivery of other components used in our customers’ products;

·                  our customers’ sales outlook,purchasing patterns and inventory adjustments based on demands and generaleconomic conditions;

 

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·                  product obsolescence and our abilityto manage product transitions;

·                  our ability to successfully develop,introduce and sell new or enhanced products in a timely manner;

·                  the timing of new productannouncements or introductions by us or by our competitors; and

·                  fluctuations in our effective taxrate.

 

We base our planned operating expenses in part on our expectations offuture revenue, and a significant portion of our expenses is relatively fixedin the short term. We have limited historical financial data from which topredict future sales for our products. As a result, it is difficult for us toforecast our future revenue and budget our operating expenses accordingly. Ifrevenue for a particular quarter is lower than we expect, we likely will beunable to proportionately reduce our operating expenses for that quarter, whichwould harm our operating results for that quarter.

 

***We have only beenprofitable since 2005 and may not sustain or increase profitability in thefuture which may cause the market price of our common stock to decline.***

 

We first became profitable in the second quarter of 2005. We incurredsignificant net losses prior to that quarter. To sustain or increaseprofitability, we will need to generate and sustain substantially higherrevenue while maintaining reasonable cost and expense levels. We currentlyexpect to increase expense levels in each of the next several quarters tosupport increased research and development and sales and marketing efforts.These expenditures may not result in increased revenue or customer growth.Because many of our expenses are fixed in the short term, or are incurred inadvance of anticipated sales, we may not be able to decrease our expenses in atimely manner to offset any shortfall of sales. We also believe our futureeffective tax rate will increase over our historical annual effective tax ratethat has been less than 10% of our pre-tax income, which will harm ourfinancial results and negatively impact our profitability. We may not be ableto sustain or increase profitability on a quarterly or an annual basis. Thismay, in turn, cause the price of our common stock to decline.

 

***If the growth ofdemand for digital video applications for the security surveillance, automotiveand consumer and PC  markets does notcontinue, our ability to increase our revenue could suffer.***

 

Our ability to increase our revenue will depend on increased demand fordigital video applications in the security surveillance, automotive andconsumer markets. If our target markets do not grow as rapidly or to the extentwe anticipate, our business could suffer. The growth of our target markets isuncertain and will depend in particular upon:

 

·                  consumerconfidence and the continued increase of consumer spending levels;

·                  the pace atwhich new digital video applications are adopted;

·                  a continuedreduction in the costs of products in these markets; and

·                  theavailability, at a reasonable price, of components required by such products,such as LCD panels.

 

***Our success depends on our ability todevelop and introduce of new products, which we may not be able to do in atimely manner, as product development in smaller wafer fabrication geometriesbecomes more complex and costly.***

 

Thedevelopment of new products is highly complex, and we have experienced somedelays in bringing new products to the market in the past. As our productsintegrate new, more advanced functions, they become more complex andincreasingly difficult to design. In addition, in our effort to decrease cost,we intend to design new products in smaller fabrication geometries, some ofwhich we may have no prior experience of success. In the past, we haveexperienced some difficulties in shifting to smaller geometry processtechnologies.

 

Completingthese projects is extremely challenging, time-consuming and expensive, and wecan give no assurance that we will succeed or succeed in a timely andcost-effective manner. Product development delays may result from unanticipatedengineering complexities, changing market or competitive product requirementsor specifications, difficulties in overcoming resource limitations, theinability to license third-party technology or other factors. If we are unableto develop products successfully, in a timely and cost-effective manner, ourbusiness, financial condition and results of operations could suffer.

 

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***The average sellingprices of our semiconductor products may be subject to rapid price declineswhich could harm our revenue and gross profits.***

 

The semiconductor products we develop and sell may be subject to rapiddeclines in average selling prices. From time to time, we have had to reduceour prices significantly to meet customer requirements, and we may be requiredto reduce our prices in the future. This would cause our gross margins todecline which in turn may negatively impact our operating results. Our financialresults will suffer if we are unable to offset any reductions in our averageselling prices by increasing our sales volumes, reducing our costs ordeveloping new or enhanced products on a timely basis with higher sellingprices or gross margins.

 

***We face intensecompetition and may not be able to compete effectively, which could reduce ourmarket share and decrease our net revenue and profitability.***

 

The markets in which we operate are extremely competitive and arecharacterized by rapid technological change, continuously evolving customerrequirements and declining average selling prices. We may not be able tocompete successfully against current or potential competitors. If we do notcompete successfully, our market share and revenue may decline. We compete withlarge semiconductor manufacturers and designers. Most of our current andpotential competitors have longer operating histories, significantly greaterresources and name recognition and a larger base of customers than we do. Thismay allow them to respond more quickly than we can to new or emergingtechnologies or changes in customer requirements. In addition, thesecompetitors may have greater credibility with our existing and potentialcustomers. Many of our current and potential customers have their owninternally developed semiconductor solutions and may choose not to purchaseproducts from third party suppliers like us.

 

***We depend on key andhighly skilled personnel to operate our business, and if we are unable toretain our current personnel and hire additional personnel, our ability todevelop and market our products could be harmed.***

 

We believe our future success will depend in large part upon ourability to attract and retain highly skilled managerial, engineering and salesand marketing personnel. The loss of any key employees or the inability toattract or retain qualified personnel, including engineers and sales andmarketing personnel, could delay the development and introduction of, and harmour ability to sell, our products and harm the market’s perception of us. Webelieve that our future success is highly dependent on the contributions ofFumihiro Kozato, our president and chief executive officer, and Dr. FengKuo, our chief technical officer. We do not have long-term employment contractswith these or any other key personnel, and their knowledge of our business andindustry would be extremely difficult to replace.

 

***If we fail todevelop new products and enhance our existing products in order to react torapid technological change and market demands, our business will suffer.***

 

We must develop new products and enhance our existing products withimproved technologies to meet rapidly evolving customer requirements. We needto design products for customers who continually require higher performance andfunctionality at lower costs. We must, therefore, continue to cost-effectivelyadd features that enhance performance and functionality to our products. Thedevelopment process for these advancements is lengthy and requires us toaccurately anticipate market trends. Our failure to accurately anticipatemarket trends in a timely manner will harm the market acceptance of ourproducts and the sales of our products. For example, we wereexcluded from certain customer qualification processes in the past due to thelack of integrated audio functionality in our general purpose decoders. As partof our continued investment in new technologies, we intend to add integrated audiofunctionality to our general purpose decoders in the near term to address themarket requirements of our customers.

 

Developing and enhancing these products is uncertain and can betime-consuming, costly and complex. There is a risk that these developments andenhancements will be late, fail to meet customer or market specifications ornot be competitive with products from our competitors that offer comparable orsuperior performance and functionality. Any new products or productenhancements may not be accepted in new or existing markets. Our business willsuffer if we fail to develop and introduce new products or product enhancementson a cost-effective basis.

 

***If we fail toachieve initial design wins for our products, we may lose the opportunity forsales for a significant period of time to customers and be unable to recoup ourinvestments in our products.***

 

We expend considerable resources in order to achieve design wins forour products, especially our new products and product enhancements. Once acustomer designs a semiconductor into a product, it is likely to continue touse the same semiconductor or enhanced versions of that semiconductor from thesame supplier across a number 

 

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of similar and successorproducts for a lengthy period of time due to the significant costs associatedwith qualifying a new supplier and potentially redesigning the product toincorporate a different semiconductor. If we fail to achieve an initial designwin in a customer’s qualification process, we may lose the opportunity forsignificant sales to that customer for a number of its products and for alengthy period of time. This may cause us to be unable to recoup ourinvestments in our products, which would harm our business.

 

***If we fail todevelop, in a timely manner, or at all, technologies that address the demandsof a shift from analog broadcast TV to digital broadcast TV, our operatingresults could suffer.***

 

Our semiconductors are principally designed to decode analog broadcastTV signals into digital images. In February 2009, transmission ofbroadcast TV signals will no longer be permitted in analog and all signals mustbe in a digital format. Weare in the process of developing mixed signal and digital technology to decodedigital signals. However, transmission of digital video involves a combinationof emerging technologies. The complexities of these technologies and the variabilityin implementations between manufacturers may cause our development ofsemiconductors to be costly and time-consuming. We may never obtain thebenefits of our investment in developing this technology. The complexities ofdigital broadcast technologies may also cause some of the semiconductors we aredeveloping to ultimately work incorrectly for reasons that may be eitherrelated or unrelated to our products, or not be interoperable with other keyproducts. Delays or difficulties in integrating our semiconductors into digitalbroadcast TV products or the failure of products incorporating digitalbroadcast TV to achieve broad market acceptance could have an adverse effect onour business.

 

***A significant portion of our products aresold into the consumer and security surveillance markets, and if sales of oursemiconductors into these markets decline or do not increase, or if we do notincrease our sales into the automotive market, our business and financialresults could suffer.***

 

Wesell semiconductors targeted for the security surveillance, automotive,consumer and PC markets. For the year ended December 31, 2007 more than85% of our sales were derived from the sale of our products designed for theconsumer and security surveillance markets. If sales of semiconductors intothese markets decline or do not increase, or if demand slows in these marketsgenerally, our operating results would suffer. In addition, we have increasedour focus on the automotive market and devoted substantial resources to the developmentof semiconductors for digital video applications that address this market. Ifwe are not successful in selling our semiconductors into this market, we maynot recover the costs associated with our efforts in this area and ouroperating results could suffer.

 

***Our business issubject to seasonality, which is likely to cause our revenues to fluctuate.***

 

Our business is subject to seasonality as a result of our targetmarkets and the location of our customers. We sell a significant number of oursemiconductors into the consumer market. Our customers who manufacture productsfor the consumer market experience seasonality in the sales of their products,which in turn may affect the timing and volume of orders for oursemiconductors. Because the consumer market for digital video applications ischaracterized by this seasonality, our operating results may vary significantlyfrom quarter to quarter. For example, we generally experience lower sales inthe first calendar quarter with our video decoder and LCD display products as aresult of the seasonality associated with the consumer markets. In addition, asignificant number of our semiconductors are sold to customers located in Asia,primarily to customers located in regions who observe the Lunar New Year holiday,also referred to as Chinese New Year. Typically, our foreign offices and thoseof our customers are closed for a week or more during the extended holidayperiod. For the three and six months ended June 30, 2008, approximately93% of our revenues were attributable to customers located in regions thatobserve the Lunar New Year holiday. As a result, we typically experiencefluctuations in our first calendar quarter due in part to a slowing of businessactivity around the period of the Lunar New Year holiday. These salesfluctuations are expected to continue.

 

***We manufacture ourproducts based on our estimates of customer demand, and if our estimates areincorrect our financial results could be negatively impacted.***

 

Our sales are made on the basis of purchase orders rather thanlong-term purchase commitments. In addition, our customers may cancel purchaseorders or defer the shipments of our products. We manufacture our productsaccording to our estimates of customer demand. This process requires us to makemultiple demand forecast assumptions, each of which may introduce error intoour estimates. If we overestimate customer demand, we may manufacture productsthat we may not be able to sell. As a result, we would have excess inventory,which would 

 

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increase our losses.Conversely, if we underestimate customer demand or if sufficient manufacturingcapacity were unavailable, we would forego revenue opportunities, lose marketshare and damage our customer relationships.

 

***We do not expect tosustain the growth rate of our recent revenues.***

 

Our revenues increased approximately 109% in 2005 from 2004 andapproximately 49% in 2006 from 2005. We do not expect to achieve similar growthrates in future periods. For example, our revenues increased approximately 11%in 2007 from 2006 and 15% in the six months ended June 30, 2008 comparedto the six months ended June 30, 2007.  You should not rely on the results of anyprior quarterly or annual periods as an indication of our future operatingperformance. If we are unable to maintain adequate revenue growth, our stockprice may decline and we may not have adequate financial resources to executeour business objectives.

 

***We may pursueacquisitions or investments in complementary technologies and businesses, whichcould harm our operating results and may disrupt our business.***

 

In the future, we may pursue acquisitions of, or investments in,complementary technologies and businesses. Acquisitions present a number ofpotential risks and challenges that could, if not met, disrupt our businessoperations, increase our operating costs and reduce the value to us of theacquired company. Even if we are successful, we may not be able to integratethe acquired businesses, products or technologies into our existing businessand products. Furthermore, potential acquisitions and investments, whether ornot consummated, may divert our management’s attention and require considerablecash outlays at the expense of our existing operations. In addition, tocomplete future acquisitions, we may issue equity securities, incur debt,assume contingent liabilities or have amortization expenses and write-downs ofacquired assets, which could adversely affect our profitability.

 

***Changes in our taxrates will affect our future results.***

 

Our future effective tax rates will be favorably or unfavorablyaffected by the absolute amount and future geographic distribution of ourpre-tax income, our ability to take advantage of the available tax planningstrategies and the availability of tax credits. Prior to September 30,2007, we determined that it was not more likely than not that our deferred taxassets would be recovered from future taxable income. Therefore we provided avaluation allowance for our deferred tax assets. At September 30, 2007, weassessed the recoverability of our deferred tax assets. As a result of thisassessment, we released the valuation allowance recorded against our deferredtax assets of approximately $5.5 million. Our effective tax rate for the yearsended December 31, 2007 and 2006 was approximately (4)% and 9%,respectively. The negative effective tax rate in 2007 was a result of therelease of the valuation allowance on our deferred tax assets. However, weexpect our effective tax rate to increase significantly in 2008 and to rangebetween 35% and 40%. In addition, we are subject to the examination of ourincome tax returns by the Internal Revenue Service and other tax authorities.The outcomes of these examinations, if they occur, could harm our net incomeand financial condition.

 

***We may not be ableto manage our future growth effectively, and we may need to incur significantexpenditures to address the additional operational and control requirements ofour growth.***

 

We are experiencing a period of significant growth and expansion, whichhas placed, and any future expansion will continue to place, a significantstrain on our management, personnel, systems and financial resources. We havehired additional employees to support an increase in research and developmentas well as increase our sales and marketing efforts, which resulted inincreasing our headcount from 96 employees at the end of 2006 to 142 employeesat the end of 2007. To manage our growth successfully, we believe we musteffectively:

 

·                  train, integrateand manage additional qualified engineers for research and developmentactivities, sales and marketing personnel and financial and informationtechnology personnel;

·                  continue toenhance our customer resource management and manufacturing management systems;

·                  implementadditional and improve existing administrative, financial and operationssystems, procedures and controls, including the requirements of theSarbanes-Oxley Act of 2002;

·                  expand andupgrade our technological capabilities; and

·                  manage multiplerelationships with our customers, distributors, suppliers and other thirdparties.

 

Our efforts may require substantial managerial and financial resourcesand may increase our operating costs even though these efforts may not besuccessful. If we are unable to manage our growth effectively, we may not be 

 

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able to take advantage ofmarket opportunities, develop new products, satisfy customer requirements,execute our business plan or respond to competitive pressures.

 

***We may experienceunforeseen delays, expenses or lower than expected product yields for oursemiconductors manufactured by our third party vendors, which could increaseour costs and prevent us from recognizing the benefits of new technologies wedevelop.***

 

We occasionally have experienced delays in completing the developmentand introduction of new products and product enhancements, and we couldexperience delays in the future that may render our new or enhanced products,when introduced, obsolete and unmarketable. In addition, it is often difficultfor semiconductor foundries to achieve satisfactory product yields. Productyields depend on both our product design and the manufacturing processtechnology unique to the semiconductor foundry. Since low yields may resultfrom either design or process difficulties, identifying yield problems can onlyoccur well into the production cycle after a product that can be physicallyanalyzed and tested exists. Poor yields from our foundry could cause us to sellour products at lower gross margins and therefore harm our financial results.

 

***Defects in ourproducts could increase our costs, cause customer claims and delay our productshipments.***

 

Although we test our products, they are complex and may contain defectsand errors. In the past, we have encountered defects and errors in ourproducts. For example, in 2003 we were unable to sell certain products to acustomer for whom these products were specifically designed as a result of ourfailure to produce a product that met this customer’s specifications. Webelieve this customer secured the product from another vendor. Delivery ofproducts with defects or reliability, quality or compatibility problems maydamage our reputation and our ability to retain existing customers and attractnew customers. In addition, product defects and errors could result inadditional development costs, diversion of technical resources, delayed productshipments, increased product returns and product liability claims against us,which may not be fully covered by insurance. Any of these could harm ourbusiness.

 

***We rely on a limitednumber of independent subcontractors for the manufacture, assembly and testingof our semiconductors, and the failure of any of these third-party vendors todeliver products or otherwise perform as requested could damage ourrelationships with our customers, decrease our sales and limit our growth.***

 

We do not have our own manufacturing or assembly facilities and havevery limited in-house testing facilities. Therefore, we must rely on third-partyvendors to manufacture, assemble and test the products we design. We currentlyrely on Taiwan Semiconductor Manufacturing Corporation, or TSMC, to produce themajority of our semiconductors. We rely on Advanced SemiconductorEngineering, Inc., or ASE, to assemble, package and test many of ourproducts. If these vendors do not provide us with high-quality products,services and production and test capacity in a timely manner, or if one or moreof these vendors terminates its relationship with us, we may be unable toobtain satisfactory replacements to fulfill customer orders on a timely basis,our relationships with our customers could suffer and our sales could decrease.Other significant risks associated with relying on these third-party vendorsinclude:

 

·                  reduced controlover product cost, delivery schedules and product quality;

·                  potential priceincreases;

·                  inability toachieve required production or test capacity and achieve acceptable yields on atimely basis;

·                  longer deliverytimes;

·                  increased exposureto potential misappropriation of our intellectual property;

·                  shortages ofmaterials that foundries use to manufacture products;

·                  labor shortagesor labor strikes; and

·                  quarantines orclosures of manufacturing facilities due to the outbreak of viruses, such asSARS, the avian flu or any similar future outbreaks in Asia.

 

We currently do not have long-term supply contracts with any of ourthird-party vendors. Therefore, they are not obligated to perform services orsupply products to us for any specific period, in any specific quantities or atany specific price, except as may be provided in a particular purchase order.Neither TSMC nor ASE has provided contractual assurances to us that adequatecapacity will be available for us to meet future demand for our products. Thesethird party vendors may allocate capacity to the production of other companies’products while reducing 

 

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deliveries to us on shortnotice. In particular, other customers that are larger and better financed thanwe are or that have long-term agreements with TSMC or ASE may cause either orboth of them to reallocate capacity to those customers, decreasing the capacityavailable to us.

 

***We plan to retainadditional foundries to manufacture our semiconductors, which could disrupt ourcurrent manufacturing process and negatively impact our sales volumes and netrevenue.***

 

We are a fabless semiconductor company which relies on third-partymanufacturers or foundries to manufacture our semiconductors. We are reliant onthese foundries for the manufacture of our products as well as providingservices to assist us in getting our products into production. As a result ofthe complexity in manufacturing our semiconductors, it is difficult todetermine if a new foundry will be able to successfully produce our products.We may not be able to enter into a relationship with a new foundry thatproduces satisfactory yields on a cost-effective basis. If we need anotherfoundry because of increased demand, or the inability to obtain timely andadequate deliveries from our current provider, we might not be able tocost-effectively and quickly retain other vendors to satisfy our requirements.Any failure to successfully integrate a new foundry could negatively impact oursales volumes and net revenue.

 

***Our business dependson international customers, suppliers and operations in Asia, and as a resultwe are subject to regulatory, operational, financial and political risks, whichcould adversely affect our financial results.***

 

The percentage of our revenues attributable to sales to customers inAsia was approximately 98% for both the six months ended June 30, 2008 and2007. We expect that revenues from customers in Asia will continue to accountfor substantially all of our revenues. All our sales currently are denominatedin U.S. dollars. As a result, an increase in the value of the U.S. dollarrelative to foreign currencies could make our products less competitive ininternational markets.

 

Currently, we maintain international sales offices in Asia, and we relyon a network of third-party sales representatives to sell our productsinternationally. We have also established offices in China, Japan, Taiwan andSouth Korea, which serve various aspects of our business. Moreover, we have inthe past relied on, and expect to continue to rely on, suppliers, manufacturersand subcontractors primarily located in Taiwan. Accordingly, we are subject toseveral risks and challenges, any of which could harm our business andfinancial results. These risks and challenges include:

 

·                  difficulties andcosts of staffing and managing international operations across differentgeographic areas and cultures;

·                  compliance witha wide variety of domestic and foreign laws and regulations, including thoserelating to the import or export of semiconductor products;

·                  legaluncertainties regarding taxes, tariffs, quotas, export controls, export licensesand other trade barriers;

·                  foreign currencyexchange fluctuations relating to our international operating activities;

·                  our ability toreceive timely payment and collect our accounts receivable;

·                  political, legaland economic instability, foreign conflicts and the impact of regional andglobal infectious illnesses, such as the SARS outbreak or avian flu in thecountries in which we and our customers, suppliers, manufacturers andsubcontractors are located;

·                  legaluncertainties regarding protection for intellectual property rights in somecountries; and

·                  fluctuations infreight rates and transportation disruptions.

 

***Our sales cycle canbe lengthy, which could result in uncertainty and delays in generating revenue.***

 

Because our products are based on constantly evolving technologies, wehave experienced a lengthy sales cycle for some of our semiconductors,particularly those designed for digital video applications in the automotivemarket. Our sales cycle typically ranges from six to 24 months. We may experiencea delay between the time we increase expenditures for research and development,sales and marketing efforts and inventory and the time we generate revenue, ifany, from these expenditures. In addition, because we do not have long-termcommitments from our customers, we must repeat our sales process on a continualbasis even for current customers looking to purchase a new product. As aresult, our business could be harmed if a customer reduces or delays itsorders, chooses not to release products incorporating our semiconductors orelects not to purchase a new product or product enhancements from us.

 

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***We primarily sellour semiconductors through a limited number of distributors, and if ourrelationships with one or more of those distributors were to terminate, ouroperating results may be harmed.***

 

We market and distribute our products primarily through a limited numberof******distributors,most of which are located in Asia. This distribution channel has beencharacterized by rapid change and consolidations. Distributors have accountedfor a significant portion of our revenues in the past. Sales to ourdistributors represented approximately 77% of our revenues in 2007 and 75% ofour revenues in the six months ended June 30, 2008.

 

Our operating results and financial condition could be significantlydisrupted by the loss of one or more of our current distributors and salesrepresentatives, volume pricing discounts, order cancellations, delays inshipment by one of our major distributors or sales representatives or thefailure of our distributors or sales representatives to successfully sell ourproducts.

 

***We rely primarilyupon copyright and trade secret laws and contractual restrictions to protectour proprietary rights, and, if these rights are not sufficiently protected,our ability to compete and generate revenue could suffer.***

 

We seek to protect our proprietary design processes, documentation andother written materials primarily under trade secret and copyright laws. Wealso typically require employees and consultants with access to our proprietaryinformation to execute confidentiality agreements. The steps taken by us toprotect our proprietary information may not be adequate to preventmisappropriation of our technology. In addition, our proprietary rights may notbe adequately protected because:

 

·                  the laws ofother countries in which we market our semiconductors, such as some countriesin the Asia/Pacific region, may offer little or no protection for ourproprietary technologies;

·                  people may notbe deterred from misappropriating our technologies despite the existence oflaws or contracts prohibiting these actions; and

·                  policingunauthorized use of our intellectual property may be difficult, expensive andtime-consuming, and we may be unable to determine the extent of anyunauthorized use.

 

Reverse engineering, unauthorized copying or other misappropriation ofour proprietary technologies could enable third parties to benefit from ourtechnologies without compensating us for doing so. For example, if the foundrythat manufactures our semiconductors loses control of our intellectualproperty, it would be more difficult for us to take remedial measures since itis located in Taiwan, which does not have the same protection for intellectualproperty as is provided in the United States. Any inability to adequatelyprotect our proprietary rights could harm our ability to compete, generaterevenue and grow our business.

 

***We may not obtainsufficient patent protection on the technology embodied in the semiconductorswe currently manufacture and market, which could harm our competitive positionand increase our expenses.***

 

Although we rely primarily on trade secret laws and contractualrestrictions to protect the technology in the semiconductors we currentlymanufacture and market, our success and ability to compete in the future mayalso depend to a significant degree upon obtaining patent protection for ourproprietary technology. As of December 31, 2007, we had three issuedpatents in the United States and five patent applications pending in the UnitedStates and three applications pending in foreign jurisdictions. These patentsand patent applications cover aspects of the technology in the semiconductorswe currently manufacture and market, including a patent for our video decodingarchitecture. Patents that we currently own do not cover all of thesemiconductors that we presently manufacture and market. Our patent applicationsmay not result in issued patents, and even if they result in issued patents,the patents may not have claims of the scope we seek. In addition, any issuedpatents may be challenged, invalidated or declared unenforceable. The term ofany issued patents would be 20 years from its filing date and if ourapplications are pending for a long time period, we may have a correspondinglyshorter term for any patent that may issue. Our issued patents have expirationdates ranging from September 2, 2019 to March 27, 2020. Our presentand future patents may provide only limited protection for our technology andmay not be sufficient to provide us with competitive advantages. For example,competitors could be successful in challenging any issued patents or, alternatively,could develop similar or more advantageous technologies on their own or designaround our patents. Also, patent protection in certain foreign countries maynot be available or may be limited in scope and any patents obtained may not beas readily enforceable as in the United States, making it difficult for us toeffectively protect our intellectual property from misuse or infringement byanyone in these countries. Our inability to obtain and enforce our intellectualproperty rights in some countries may harm our business. In addition, given thecosts of obtaining 

 

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patent protection, we maychoose not to protect certain innovations that later turn out to be importantto our business or our competitive position.

 

***Intellectualproperty litigation, which is common in our industry, could be costly, harm ourreputation, limit our ability to sell our products and divert the attention ofmanagement and technical personnel.***

 

Our industry is characterized by frequent litigation regarding patentand other intellectual property rights. For example, we were a party toan administrative proceeding in front of the intellectual property tribunal inSouth Korea in which another party unsuccessfully sought a determination thatour TW2824 and TW2834 products infringed a South Korean patent allegedly heldby that party. We have certain indemnification obligations to customers underour contract development projects with respect to any infringement of third-partypatents and intellectual property rights by our products. If a lawsuit were tobe filed against us in connection with claims of infringement, our businesswould be harmed.

 

Questions of infringement in the digital video applications marketinvolve highly technical and subjective analyses. Litigation may be necessaryin the future to enforce any patents we may receive and other intellectualproperty rights, to protect our trade secrets, to determine the validity andscope of the proprietary rights of others or to defend against claims ofinfringement or invalidity, and we may not prevail in any future litigation.Litigation, whether or not determined in our favor or settled, could be costly,could harm our reputation, could cause our customers to use our competitors’products and could divert the efforts and attention of our management andtechnical personnel from normal business operations. In addition, adversedeterminations in litigation could result in the loss of our proprietaryrights, subject us to significant liabilities, require us to seek licenses fromthird parties or prevent us from licensing our technology or selling ourproducts, any of which could seriously harm our business.

 

***Our headquarters arelocated in the State of California and our third-party manufacturing, assemblyand testing vendors have facilities in the State of Washington and in Asia,areas subject to significant earthquake risks. Any disruption to our or theiroperations resulting from earthquakes or other natural disasters could causesignificant delays in the production or shipment of our products.***

 

TSMC, which manufactures our semiconductors, has facilities in theState of Washington and in Taiwan. Our assembly and testing vendors’ facilitiesare primarily located in Taiwan. In addition, our headquarters are located inNorthern California. The risk of an earthquake or extreme weather in thePacific Rim region or an earthquake in Northern California or Washington Stateis significant due to the proximity of major earthquake fault lines. InSeptember 1999, a major earthquake in Taiwan affected the facilities ofTSMC and ASE, our primary assembly vendor, as well as other providers offoundry, packaging and test services. As a result of these natural disasters,these contractors suffered power outages and disruptions that impaired theirproduction capacity. In March 2002 and June 2003, additionalearthquakes occurred in Taiwan. In 2005, several typhoons also disrupted theoperations of TSMC and ASE. As a result of these natural disasters,these contractors suffered power outages and disruptions that impaired theirproduction capacity. The occurrence of earthquakes or other naturaldisasters could result in the disruption of our foundry or assembly and testcapacity. We may not be able to obtain alternate capacity on favorable terms,if at all, which could harm our operating results.

 

***Changes to financialaccounting standards may affect our results of operations and cause us tochange our business practices.***

 

We prepare our financial statements to conform to accounting principlesgenerally accepted in the United States of America, or GAAP. These accountingprinciples are subject to interpretation by the Financial Accounting StandardsBoard, or FASB, the Securities and Exchange Commission, or SEC, and variousbodies formed to interpret and create appropriate accounting policies. A changein those policies can have a significant effect on our reported results and mayaffect our reporting of transactions completed before a change is announced.Changes to those rules or the questioning of current practices mayadversely affect our reported financial results or the way we conduct ourbusiness. For example, accounting policies affecting many aspects of ourbusiness, including rules relating to employee stock option grants, haverecently been revised. The FASB and other agencies have made changes to GAAPthat required us, starting in our first quarter of 2006, to record a charge toearnings for the estimated fair value of employee stock option grants and otherequity incentives, whereas under prior accounting rules charges wererequired only for the intrinsic value, if any, of such awards to employees. Wemay have significant and ongoing accounting charges under the newrules resulting from option grant and other equity incentive expensing,which could reduce our overall net income. In addition, since we historicallyhave used equity-related compensation as a component of our total employeecompensation program, the accounting change could 

 

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make the use of equity-relatedcompensation less attractive to us or require us to pay more cash compensationand therefore make it more difficult for us to attract and retain employees.

 

***Management may applyour cash, cash equivalents, short-term and long-term investments to uses thatdo not increase our market value or improve our operating results.***

 

We intend to use our cash, cash equivalents, short-term and long-terminvestments for general corporate purposes, including working capital andcapital expenditures. We may also use a portion of our cash, cash equivalents,short-term and long-term investments to acquire or invest in complementarytechnologies, businesses or other assets. We have not reserved or allocated ourcash, cash equivalents, short-term and long-term investments for any specificpurpose, and we cannot state with certainty how our management will use ourcash, cash equivalents, short-term and long-term investments. Accordingly, ourmanagement has considerable discretion in applying our cash, cash equivalents,short-term and long-term investments and may use our cash, cash equivalents,short-term and long-term investments for purposes that do not result in anyincrease in our results of operations or market value. Until the cash, cashequivalents, short-term and long-term investments are used, they may be placedin investments that do not produce income or that lose value.

 

**Risks Related to Our Industry**

 

***Due to the cyclicalnature of the semiconductor industry, our operating results may fluctuatesignificantly, which could adversely affect the market price of our commonstock.***

 

The semiconductor industry is highly cyclical and subject to rapidchange and evolving industry standards and, from time to time, has experiencedsignificant downturns. These downturns are characterized by decreases inproduct demand, excess customer inventories and accelerated erosion of prices.These factors have caused and could cause substantial fluctuations in our netrevenue and in our operating results. Any downturns in the semiconductorindustry may be severe and prolonged, and any failure of this industry to fullyrecover from downturns could harm our business. The semiconductor industry alsoperiodically experiences increased demand and production capacity constraints,which may affect our ability to ship products. Accordingly, our operatingresults have varied and may vary significantly as a result of the generalconditions in the semiconductor industry, which could cause our stock price todecline.

 

***The demand forsemiconductors is affected by general economic conditions, which could impactour business.***

 

The United States and international economies have recently experienceda period of slow economic growth. A sustained economic recovery is uncertain.In addition, terrorist acts and similar events, turmoil in the Middle East orwar in general, could contribute to a slowdown of the market demand for ourproducts. If the economic recovery slows down as a result of the recenteconomic, political and social turmoil, or if there are further terroristattacks in the United States or elsewhere, we may experience decreases in thedemand for our products, which may harm our operating results. Our business hasbeen adversely affected by previous economic downturns. For example, during theglobal economic downturn in 2002 to 2003, demand for many semiconductor andconsumer electronics products suffered as consumers delayed purchasingdecisions or changed or reduced their discretionary spending. As a result,demand for our products suffered and we had to implement restructuringinitiatives to align our corporate spending with a slower than anticipatedrevenue growth during that timeframe.

 

**Risks Related to Our Common Stock**

 

***Our stock price hasbeen volatile and you may not be able to resell shares of our common stock ator above the price you paid, or at all.***

 

The trading price of our common stock has experienced wide fluctuationsdue to the factors discussed in this risk factors section and elsewhere in thisQuarterly Report on Form 10-Q. For example, in the three months endedJune 30, 2008, the closing price of our stock ranged from a low of $10.50on April 30, 2008 to a high of $14.17 on June 5, 2008. In addition,the stock market in general has, and The NASDAQ Global Market and technologycompanies in particular have, experienced extreme price and volumefluctuations. These trading prices and valuations may not be sustainable. Thesebroad market and industry factors may decrease the market price of our commonstock, regardless of our actual operating performance. In addition, in thepast, following periods of volatility in the overall market and the marketprice of a company’s securities, securities class action litigation has oftenbeen instituted against companies that experienced such volatility. Thislitigation, if instituted against us, 

 

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regardless of its outcome,could result in substantial costs and a diversion of our management’s attentionand resources.

 

***If securities orindustry analysts do not publish research or reports about our business, or ifthey change their recommendations regarding our stock adversely, our stockprice and trading volume could decline.***

 

The trading market for our common stock is influenced by the researchand reports that industry or securities analysts publish about us or ourbusiness. If one or more of the analysts who cover us downgrade our stock, ourstock price would likely decline. If one or more of these analysts ceasecoverage of our company or fail to regularly publish reports on us, we couldlose visibility in the financial markets, which in turn could cause our stockprice or trading volume to decline.

 

***Our ability to raisecapital in the future may be limited and our failure to raise capital whenneeded could prevent us from executing our growth strategy.***

 

We believe that our existing cash and cash equivalents and ourinvestments will be sufficient to meet our anticipated cash needs for at leastthe next 12 months. The timing and amount of our working capital and capitalexpenditure requirements may vary significantly depending on numerous factors,including:

 

·                  marketacceptance of our products;

·                  the need toadapt to changing technologies and technical requirements;

·                  the existence ofopportunities for expansion; and

·                  access to andavailability of sufficient management, technical, marketing and financialpersonnel.

 

If our capital resources are insufficient to satisfy our liquidityrequirements, we may seek to sell additional equity securities or debtsecurities or obtain debt financing. The sale of additional equity securitiesor convertible debt securities would result in additional dilution to our stockholders.Additional debt would result in increased expenses and could result incovenants that would restrict our operations. We have not made arrangements toobtain additional financing and there is no assurance that financing, ifrequired, will be available in amounts or on terms acceptable to us, if at all.

 

***Substantial futuresales of our common stock in the public market could cause our stock price tofall.***

 

Additional sales of our common stock in the public market, or theperception that these sales could occur, could cause the market price of ourcommon stock to decline. At June 30, 2008, we had 21,140,182 shares ofcommon stock outstanding. A substantial portion of these shares of common stockare entitled to rights to cause us to register the sale of those shares underthe Securities Act. Registration of these shares under the Securities Act wouldresult in these shares, other than shares purchased by our affiliates, becomingfreely tradable without restriction under the Securities Act immediately uponthe effectiveness of the registration.

 

Some of our officers and directors have entered into 10b5-1 tradingplans, which generally provide for pre-determined sales of stock by theseofficers. The sales of stock by our officers and directors, even if madepursuant to these 10b5-1 trading plans, may cause our stock price to fall.

 

***Our corporateactions are substantially controlled by officers, directors, principalstockholders and affiliated entities.***

 

Our directors, executive officers and their affiliated entitiesbeneficially own a significant percentage of our outstanding common stock.These stockholders, if they acted together, could exert substantial controlover matters requiring approval by our stockholders, including electingdirectors and approving mergers or other business combination transactions.This concentration of ownership may also discourage, delay or prevent a changein control of our company, which could deprive our stockholders of anopportunity to receive a premium for their stock as part of a sale of ourcompany and might reduce our stock price. These actions may be taken even ifthey are opposed by our other stockholders.

 

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***Delaware law and ourcorporate charter and bylaws contain anti-takeover provisions that could delayor discourage takeover attempts that stockholders may consider favorable.***

 

Provisions in our certificate of incorporation, as amended andrestated, may have the effect of delaying or preventing a change of control orchanges in our management. These provisions include the following:

 

·                  the right of theboard of directors to elect a director to fill a vacancy created by theexpansion of the board of directors;

·                  the prohibitionof cumulative voting in the election of directors, which would otherwise allowless than a majority of stockholders to elect director candidates;

·                  the requirementfor advance notice for nominations for election to the board of directors orfor proposing matters that can be acted upon at a stockholders’ meeting;

·                  the ability ofthe board of directors to alter our bylaws without obtaining stockholderapproval;

·                  the ability ofthe board of directors to issue, without stockholder approval, up to 10,000,000shares of preferred stock with terms set by the board of directors, whichrights could be senior to those of common stock;

·                  the requiredapproval of holders of at least two-thirds of the shares entitled to vote at anelection of directors to adopt, amend or repeal our bylaws or amend or repealthe provisions of our certificate of incorporation regarding theindemnification of directors and officers and the ability of stockholders totake action;

·                  the requiredapproval of holders of at least a majority of the shares entitled to vote at anelection of directors to remove directors for cause; and

·                  the eliminationof the right of stockholders to call a special meeting of stockholders and totake action by written consent.

 

In addition, because we are incorporated in Delaware, we are governedby the provisions of Section 203 of the Delaware General Corporation Law.These provisions may prohibit or restrict large stockholders, in particularthose owning 15% or more of our outstanding voting stock, from merging orcombining with us. These provisions in our certificate of incorporation andbylaws and under Delaware law could discourage potential takeover attempts andcould reduce the price that investors might be willing to pay for shares of ourcommon stock in the future and result in our market price being lower than itwould without these provisions.

 

***We have incurred andwill continue to incur increased costs as a result of being a public company.***

 

As a public company, we have incurred and will continue to incursignificant legal, accounting and other expenses that we did not incur as aprivate company. In addition, the Sarbanes-Oxley Act of 2002, as well as newrules subsequently implemented by the SEC and NASDAQ, have requiredchanges in corporate governance practices of public companies. We expect thesenew rules and regulations to increase our legal and financial compliancecosts and to make some activities more time-consuming and costly. For example,as a result of becoming a public company, we have added an independentdirector, created additional board committees and adopted policies regardinginternal controls and disclosure controls and procedures. In addition, we haveincurred and will continue to incur additional costs associated with our publiccompany reporting requirements. We continue to evaluate and monitordevelopments with respect to these new rules, and we cannot predict or estimatethe amount of additional costs we may incur or the timing of such costs.

 

**ITEM2.****          Unregistered Sales ofEquity Securities and Use of Proceeds**

 

Not applicable.

 

**ITEM3.****          Defaults Upon SeniorSecurities**

 

Not applicable.

 

**ITEM4.****          Submission of Matters to aVote of Security Holders**

 

The annual meeting of stockholders was heldat our principal executive offices in San Jose, California on June 24,2008. Six incumbent directors were re-elected to serve until our next annualmeeting of stockholders, or until their successors are duly elected andqualified. The results of this election, which no abstention votes werecast,  are as follows:

 

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| **Name of Director** | ** ** | **Votes for   (shares)** | ** ** | **Votes against   (shares)** | ** ** |
|--------------------------------|------------|------------------------------------|------------|----------------------------------------|------------|
| Fumihiro Kozato                |       | 12,099,829                         |       | 1,221,844                              |       |
| Robert D. Cochran              |       | 12,025,632                         |       | 1,296,041                              |       |
| Richard H. Kimball             |       | 11,555,074                         |       | 1,766,599                              |       |
| Dr. C.J. Koomen           |       | 11,843,524                         |       | 1,478,149                              |       |
| Justine Lien                   |       | 12,097,329                         |       | 1,224,344                              |       |
| Dr. Phillip Salsbury      |       | 11,871,440                         |       | 1,450,233                              |       |

 

On a proposal to ratify the appointment ofDeloitte & Touche LLP as our independent registered public accountingfirm for the current fiscal year, there were 13,290,312 votes cast in favor,31,361 votes cast against and no abstentions.

 

**ITEM5.****          Other Information**

 

Not applicable.

 

**ITEM6.****          Exhibits**

 

(a)                                   Exhibits

 
| Exhibit  Number | ** ** | **Description**                                                                                                                                                            |
|-----------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **      | ** ** | ** **                                                                                                                                                                 |
| 31.1            |       | Certification of Chief Executive Officer pursuant to  Securities Exchange Act Rules 13a-15(e), as adopted pursuant to Section 302  of the Sarbanes-Oxley Act of 2002. |
|            |       |                                                                                                                                                                       |
| 31.2            |       | Certification of Chief Financial Officer pursuant to  Securities Exchange Act Rules 13a-15(e), as adopted pursuant to Section 302  of the Sarbanes-Oxley Act of 2002. |
|            |       |                                                                                                                                                                       |
| 32.1 (1)        |       | Certification of Chief Executive Officer pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                  |
|            |       |                                                                                                                                                                       |
| 32.2 (1)        |       | Certification of Chief Financial Officer pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                  |

 

----

| (1) | The material contained in Exhibit 32.1 and Exhibit 32.2 is  not deemed “filed” with the SEC and is not to be incorporated by reference  into any filing of the Company under the Securities Act of 1933 or the  Securities Exchange Act of 1934, whether made before or after the date hereof  and irrespective of any general incorporation language contained in such  filing, except to the extent that the registrant specifically incorporates it  by reference. |
|-----|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

38

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Table of Contents

 

**Signatures**

 

Pursuant to the requirements of the Securities Exchange Act of 1934, asamended, the registrant has duly caused this report to be signed on its behalfby the undersigned thereunto duly authorized.

 

 
| Dated: August 7, 2008 |                                                                                 |
|----------------------------|--------------------------------------------------------------------------------------|
|                       |                                                                                 |
|                       |                                                                                 |
|                       | /s/ Fumihiro Kozato                                                                  |
|                       | Fumihiro Kozato**                                                                    |
|                       | President and Chief Executive  Officer                                               |
|                       |                                                                                 |
| Dated: August 7, 2008 |                                                                                 |
|                       |                                                                                 |
|                       |                                                                                 |
|                       | /s/ Mark Voll                                                                        |
|                       | Mark Voll  Vice President of Finance and Administration  and Chief Financial Officer |

** **

**39**

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