Table of Contents

 

 

** **

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,DC 20549**

 

----

 

**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 September 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***                                                                                                                                                  |

 

----

 

**Techwell, Inc.**

(Exactname of registrant as specified 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 all reports required to be filed by Section 13 or 15(d) ofthe Securities Exchange Act of 1934 during the preceding 12 months (or forsuch shorter period that the registrant was required to file such reports), and(2) has been subject to filing requirements for the past90 days.     YES  x   NO  o

 

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

 
| 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 registrantis a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o No x

 

As of October 31, 2008, 21,301,770shares of the Registrant’s common stock, $0.001 par value, were outstanding.

 

 

 

----

Table of Contents

 

**TECHWELL, INC.**

** **

**INDEX**

 
|              | ** **                                                                                                            | **Page** |
|--------------|-----------------------------------------------------------------------------------------------------------------------|----------|
| PART I  | FINANCIAL  INFORMATION                                                                                                | 3        |
|         |                                                                                                                  |     |
| Item 1.      | Financial  Statements (Unaudited)                                                                                     | 3        |
|         |                                                                                                                  |     |
|         | Condensed Consolidated Balance Sheets at September 30,  2008 and December 31, 2007                          | 3        |
|         |                                                                                                                  |     |
|         | Condensed Consolidated Statements of Operations for  the three and nine months ended September 30, 2008 and 2007 | 4        |
|         |                                                                                                                  |     |
|         | Condensed Consolidated Statements of Cash Flows for  the nine months ended September 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                           | 14       |
|         |                                                                                                                  |     |
| Item 3.      | Quantitative  and Qualitative Disclosures About Market Risk                                                           | 26       |
|         |                                                                                                                  |     |
| Item 4.      | Controls and  Procedures                                                                                              | 26       |
|         |                                                                                                                  |     |
| PART II | OTHER INFORMATION                                                                                                     | 27       |
|         |                                                                                                                  |     |
| Item 1.      | Legal Proceedings                                                                                                     | 27       |
|         |                                                                                                                  |     |
| Item 1A.     | Risk  Factors                                                                                                         | 27       |
|         |                                                                                                                  |     |
| Item 2.      | Unregistered  Sales of Equity Securities and Use of Proceeds                                                          | 39       |
|         |                                                                                                                  |     |
| Item 3.      | Defaults Upon  Senior Securities                                                                                      | 39       |
|         |                                                                                                                  |     |
| Item 4.      | Submission of  Matters to a Vote of Security Holders                                                                  | 39       |
|         |                                                                                                                  |     |
| Item 5.      | Other Information                                                                                                     | 39       |
|         |                                                                                                                  |     |
| Item 6.      | Exhibits                                                                                                              | 39       |
|         |                                                                                                                  |     |
|         | Signatures                                                                                                            | 40       |

 

2

----

Table of Contents

 

**PART I—FINANCIALINFORMATION**

 

**Item 1. FinancialStatements**

 

**TECHWELL, INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

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

** **
| ** **                                                                                                                                                                                           | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                           | ** ** | **2008**               | ** ** | **2007**              | ** ** |
|                                                                                                                                                                                                 |       |                   |       |                  |       |
| **ASSETS**                                                                                                                                                                                           |       |                   |       |                  |       |
| Current assets:                                                                                                                                                                                      |       |                   |       |                  |       |
| Cash and cash equivalents                                                                                                                                                                            |       | $                      | 44,675     |                  | $          | 27,177 |   |
| Short-term investments                                                                                                                                                                               |       | 17,992                 |       | 33,384                |       |
| Total cash, cash equivalents and short-term  investments                                                                                                                                             |       | 62,667                 |       | 60,561                |       |
| Accounts receivable                                                                                                                                                                                  |       | 2,363                  |       | 2,095                 |       |
| Inventory                                                                                                                                                                                            |       | 6,014                  |       | 4,753                 |       |
| Deferred income tax assets                                                                                                                                                                           |       | 1,204                  |       | 2,016                 |       |
| Prepaid expenses and other current assets                                                                                                                                                            |       | 1,516                  |       | 1,456                 |       |
| Total current assets                                                                                                                                                                                 |       | 73,764                 |       | 70,881                |       |
| Property and equipment, net                                                                                                                                                                          |       | 1,562                  |       | 1,471                 |       |
| Long-term investments                                                                                                                                                                                |       | 14,626                 |       | 7,839                 |       |
| Deferred income tax assets                                                                                                                                                                           |       | 4,206                  |       | 3,419                 |       |
| Other assets                                                                                                                                                                                         |       | 199                    |       | 127                   |       |
| Total assets                                                                                                                                                                                         |       | $                      | 94,357     |                  | $          | 83,737 |   |
|                                                                                                                                                                                                 |       |                   |       |                  |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                        |       |                   |       |                  |       |
| Current liabilities:                                                                                                                                                                                 |       |                   |       |                  |       |
| Accounts payable                                                                                                                                                                                     |       | $                      | 3,269      |                  | $          | 2,973 |   |
| Accrued liabilities                                                                                                                                                                                  |       | 2,417                  |       | 2,534                 |       |
| Total current liabilities                                                                                                                                                                            |       | 5,686                  |       | 5,507                 |       |
| Deferred rent                                                                                                                                                                                        |       | 133                    |       | 165                   |       |
| Total liabilities                                                                                                                                                                                    |       | 5,819                  |       | 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; 21,217,791 shares and 20,889,349 shares issued and  outstanding at September 30, 2008 and December 31, 2007,  respectively |       | 21                     |       | 21                    |       |
| Additional paid-in capital                                                                                                                                                                           |       | 78,404                 |       | 73,454                |       |
| Deferred stock-based compensation                                                                                                                                                                    |       | (35                    | )          | (160                  | )          |
| Accumulated other comprehensive income  (loss)                                                                                                                                                       |       | (787                   | )          | 44                    |       |
| Retained earnings                                                                                                                                                                                    |       | 10,935                 |       | 4,706                 |       |
| Total stockholders’ equity                                                                                                                                                                      |       | 88,538                 |       | 78,065                |       |
| Total liabilities and stockholders’ equity                                                                                                                                                      |       | $                      | 94,357     |                  | $          | 83,737 |   |

 

The accompanying notes are anintegral part of these condensed consolidated financial statements.

 

3

----

Table of Contents

 

**TECHWELL, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

**(Inthousands, except per share amounts)**

 
| ** **                                                      | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                      | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                      | ** ** | **2008**                         | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                            |       |                             |       |                            |       |   |   |   |   |
| Revenues                                                        |       | $                                | 18,520     |                            | $          | 15,122 |   | $ | 51,133 |   | $ | 43,382 |   |
|                                                            |       |                             |       |                            |       |   |   |   |   |
| Cost of revenues                                                |       | 6,859                            |       | 6,048                           |       | 19,423 |   | 17,828 |   |
|                                                            |       |                             |       |                            |       |   |   |   |   |
| Gross profit                                                    |       | 11,661                           |       | 9,074                           |       | 31,710 |   | 25,554 |   |
|                                                            |       |                             |       |                            |       |   |   |   |   |
| Operating expenses:                                             |       |                             |       |                            |       |   |   |   |   |
| Research and development                                        |       | 4,442                            |       | 3,496                           |       | 12,199 |   | 8,581 |   |
| Selling, general and administrative                             |       | 3,576                            |       | 3,135                           |       | 11,033 |   | 8,767 |   |
| Total operating expenses                                        |       | 8,018                            |       | 6,631                           |       | 23,232 |   | 17,348 |   |
|                                                            |       |                             |       |                            |       |   |   |   |   |
| Income from operations                                          |       | 3,643                            |       | 2,443                           |       | 8,478 |   | 8,206 |   |
| Interest income                                                 |       | 507                              |       | 819                             |       | 1,802 |   | 2,235 |   |
|                                                            |       |                             |       |                            |       |   |   |   |   |
| Income before income taxes                                      |       | 4,150                            |       | 3,262                           |       | 10,280 |   | 10,441 |   |
| Income tax (benefit) provision                                  |       | 1,634                            |       | (2,154                          | )          | 4,051 |   | (80 | ) |
|                                                            |       |                             |       |                            |       |   |   |   |   |
| Net income                                                      |       | $                                | 2,516      |                            | $          | 5,416 |   | $ | 6,229 |   | $ | 10,521 |   |
|                                                            |       |                             |       |                            |       |   |   |   |   |
| Basic net income per share                                      |       | $                                | 0.12       |                            | $          | 0.26 |   | $ | 0.30 |   | $ | 0.51 |   |
| Diluted net income per share                                    |       | $                                | 0.11       |                            | $          | 0.25 |   | $ | 0.28 |   | $ | 0.48 |   |
|                                                            |       |                             |       |                            |       |   |   |   |   |
| Weighed average shares used in computing  net income per share: |       |                             |       |                            |       |   |   |   |   |
| Basic                                                           |       | 21,169                           |       | 20,822                          |       | 21,054 |   | 20,741 |   |
| Diluted                                                         |       | 22,080                           |       | 21,768                          |       | 22,038 |   | 21,795 |   |

 

The accompanying notes are anintegral part of these condensed consolidated financial statements.

 

4

----

Table of Contents

 

**TECHWELL, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

**(Inthousands)**

 
| ** **                                                                         | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                         | ** ** | **September 30,**          | ** ** |
| ** **                                                                         | ** ** | **2008**                        | ** ** | **2007** | ** ** |
| **Cash flows from operating activities:**                                          |       |                            |       |   |   |
| Net income                                                                         |       | $                               | 6,229      |   | $ | 10,521 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |       |                            |       |   |   |
| Depreciation and amortization                                                      |       | 526                             |       | 325 |   |
| Stock-based compensation                                                           |       | 5,433                           |       | 3,243 |   |
| Tax benefit from employee equity incentive  plan                                   |       | 211                             |       | 887 |   |
| Realized gain on investments                                                       |       | (18                             | )          | — |   |
| Deferred income taxes                                                              |       | 25                              |       | (5,133 | ) |
| Changes in assets and liabilities:                                                 |       |                            |       |   |   |
| Accounts receivable                                                                |       | (268                            | )          | 819 |   |
| Inventory                                                                          |       | (1,261                          | )          | 55 |   |
| Prepaid expenses and other current assets                                          |       | (310                            | )          | 24 |   |
| Other assets                                                                       |       | (72                             | )          | (83 | ) |
| Accounts payable                                                                   |       | 360                             |       | (426 | ) |
| Accrued liabilities                                                                |       | 69                              |       | (821 | ) |
| Income taxes payable                                                               |       | (204                            | )          | 1,490 |   |
| Deferred rent                                                                      |       | (32                             | )          | 202 |   |
| Net cash provided by operating activities                                          |       | 10,688                          |       | 11,103 |   |
| **Cash flows from investing activities:**                                          |       |                            |       |   |   |
| Purchases of property and equipment                                                |       | (413                            | )          | (794 | ) |
| Purchases of investments                                                           |       | (46,357                         | )          | (77,210 | ) |
| Proceeds from maturities of investments                                            |       | 54,149                          |       | 75,098 |   |
| Net cash provided by (used in) investing  activities                               |       | 7,379                           |       | (2,906 | ) |
| **Cash flows from financing activities:**                                          |       |                            |       |   |   |
| Proceeds from exercise of stock options                                            |       | 354                             |       | 547 |   |
| Repurchase of common stock upon release of  restricted stock awards                |       | (923                            | )          | — |   |
| Net cash provided by (used in) financing  activities                               |       | (569                            | )          | 547 |   |
| Net increase in cash and cash equivalents                                          |       | 17,498                          |       | 8,744 |   |
| Cash and cash equivalents at beginning of  period                                  |       | 27,177                          |       | 13,201 |   |
| Cash and cash equivalents at end of period                                         |       | $                               | 44,675     |   | $ | 21,945 |   |
|                                                                               |       |                            |       |   |   |
| **Supplemental disclosure of non-cash  investing and financing activities:**       |       |                            |       |   |   |
| Accrued equipment purchase costs                                                   |       | $                               | 19         |   | $ | 295 |   |
| Gross issuance of restricted stock awards                                          |       | 3,773                           |       | 34 |   |

 

The accompanying notes are anintegral part of these condensed consolidated financial statements.

 

5

----

Tableof Contents

 

**TECHWELL, INC.**

**NOTESTO 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 7,1997 and reincorporated in Delaware on March 30, 2006. The Company is afabless semiconductor company that designs, markets and sells mixed signalintegrated circuits for multiple video applications in the securitysurveillance, 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 consolidatedfinancial statements of the Company have been prepared without audit inaccordance with the rules and regulations of the Securities and ExchangeCommission.  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, theaccompanying unaudited condensed consolidated financial statements reflect alladjustments (consisting only of normal recurring adjustments) necessary tosummarize fairly the Company’s financial position, results of operations andcash flows for the interim periods presented. The operating results for thethree and nine months ended September 30, 2008 are not necessarilyindicative of the results that may be expected for the year ending December 31,2008 or for any other future period.

 

***Principles of Consolidation and Year End***

*** ***

The condensed consolidated financialstatements include the accounts of the Company and its subsidiaries. All significantintercompany transactions and balances have been eliminated in consolidation.The Company reports its financial results 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 products; the Company’s customers’ sales outlook, purchasing patternsand inventory adjustments based on demand and general economic conditions;product obsolescence and the Company’s ability to manage product transitions;the Company’s ability to successfully develop, introduce and sell new orenhanced products in a timely manner; and the timing of new productannouncements or introductions by the Company or by its competitors.

 

6

----

Table of Contents

 

***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. Pursuant to Statement of FinancialAccounting Standards (“SFAS”) No. 157, *Fair ValueMeasurement*, (“SFAS No. 157”), the Company adopted theprovisions of SFAS No. 157 effective January 1, 2008, which definesfair value, establishes a framework for measuring fair value and expands disclosuresabout fair value measurements required under other accountingpronouncements.  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 consistsof net unrealized losses on available-for-sale investments. The change inunrealized losses on investments was an increase of $0.4 million in the threemonths ended September 30, 2008 and a decrease of $40,000 in the threemonths ended September 30, 2007. The change in unrealized losses on investments was an increase of $0.8million in the nine months ended September 30, 2008 and a decrease of$28,000 in the nine months ended September 30, 2007.

 

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

 

The Company has equity incentive plans (“Plans”) under which it may grantstock options, restricted stock awards, stock units and stock appreciationrights to employees, consultants and directors. At September 30, 2008, thetotal number of shares available for issuance under the Plans was1,584,737.  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 September 30, 2008, 10,834 shares exercised priorto vesting are subject to repurchase by the Company.

 

Effective January 1, 2006, the Company adopted SFAS No. 123(revised 2004), *Share-Based Payment*, (“SFAS No. 123(R)”)which requires the measurement and recognition of compensation expense for allshare-based payment awards made to employees and directors, including employeestock options, based on estimated fair values recognized over the requisiteservice period. Prior to the adoption of SFAS No. 123(R), the Companyaccounted for stock-based compensation awards issued to its employees using theintrinsic value measurement provisions of Accounting Principles Board Opinion No. 25(“APB Opinion No. 25”), *Accounting for StockIssued to Employees*.

 

The Companyadopted SFAS No. 123(R) using the prospective transition method.Under this method, SFAS No. 123(R) is applied to new awards and toawards modified, repurchased or cancelled after the adoption date of January 1,2006. Compensation cost previously recorded under APB Opinion No. 25 forawards outstanding at the adoption date, such as unvested options, continues tobe recognized as the options vest. Accordingly, for the three and nine monthsended September 30, 2008 and 2007, stock-based compensation expenseincludes compensation cost related to estimated fair values of awards grantedafter the date of adoption of SFAS No. 123(R) and compensation costsrelated to unvested awards at the date of adoption based on the intrinsicvalues as previously recorded under APB Opinion No. 25.

 

7

----

Table of Contents

 

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

 
| ** **                             | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                             | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                             | ** ** | **2008**                         | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
| Cost of revenues                       |       | $                                | 122        |                            | $          | 77 |   | $ | 366 |   | $ | 193 |   |
| Research and development               |       | 901                              |       | 579                             |       | 2,453 |   | 1,414 |   |
| Selling, general and administrative    |       | 825                              |       | 660                             |       | 2,614 |   | 1,637 |   |
| Related tax effect                     |       | (676                             | )          | (141                            | )          | (1,957 | ) | (582 | ) |
| Total stock-based compensation expense |       | $                                | 1,172      |                            | $          | 1,175 |   | $ | 3,476 |   | $ | 2,662 |   |

 

Total compensation cost attributable to activities capitalized intoinventory was not significant in any period presented.

 

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,*(“SFAS No. 128”)*.* Under SFAS No. 128, basic net income per share is calculated bydividing net income by the weighted average number of common stock sharesoutstanding during the period excluding shares subject to repurchase. Dilutednet income per share reflects the effects of potentially dilutive securities,which consist of common stock options, restricted stock awards and common stocksubject to repurchase.

 

A reconciliation of shares used in thecalculation of basic and diluted net income per share is as follows (inthousands):

 
| ** **                                              | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                              | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                              | ** ** | **2008**                         | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                    |       |                             |       |                            |       |   |   |   |   |
| Weighted average common shares outstanding              |       | 21,181                           |       | 20,860                          |       | 21,071 |   | 20,787 |   |
| Weighted average shares subject to  repurchase          |       | (12                              | )          | (38                             | )          | (17 | ) | (46 | ) |
| Shares used to calculate basic net income  per share    |       | 21,169                           |       | 20,822                          |       | 21,054 |   | 20,741 |   |
| Effect of dilutive securities:                          |       |                             |       |                            |       |   |   |   |   |
| Common stock options and restricted stock  awards       |       | 911                              |       | 946                             |       | 984 |   | 1,054 |   |
| Dilutive potential common stock                         |       | 911                              |       | 946                             |       | 984 |   | 1,054 |   |
| Shares used to calculate dilutive net  income per share |       | 22,080                           |       | 21,768                          |       | 22,038 |   | 21,795 |   |

 

# **Note 4. Income Taxes**

# ** **

The Company accounts for income taxes under the provisions of SFAS No. 109,*Accounting for Income Taxes ,*(“SFAS No. 109”). 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 September 30, 2008, theCompany’s total deferred tax assets were principally comprised of net operatingloss carryforwards, 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 foreign jurisdictions taxauthorities.

 

The Company’s effective tax rate is based onthe estimated annual effective tax rate in accordance with SFAS No. 109.In the three and nine months ended September 30, 2008, the effective taxrate differed from the statutory federal income tax rate primarily because ofthe impact of stock-based compensation, research and development credits and state income taxes.  In the three and nine months ended September 30,2007, the effective tax rate differed from the statutory federal income taxrate primarily because the Company recognized a benefit as result

 

8

----

Table of Contents

 

of the release of the valuationallowance for the deferred tax assets and the Company utilized prior netoperating losses to offset taxable income.

 

**Note 5.  FinancialInstruments**

 

The Company’s investments are considered available-for-sale and primarilyconsist of corporate bonds, US government agency securities and commercialpaper. These securities other than auction rate securities, or ARS, are carriedat fair market value based on market quotes. The Company has also madeinvestments in ARS and these investments are intended to provide liquidity viaan auction process that resets the applicable interest rate at predeterminedcalendar intervals, allowing investors to either roll over their holdings orgain immediate liquidity by selling such interests at par. Recently, however,uncertainties in the credit markets have affected all of the Company’s holdingsin ARS investments and auctions for the Company’s investments in thesesecurities have failed to settle on their respective settlement dates. Consequently,the investments are not currently liquid and the Company will not be able toaccess these funds until a future auction of these investments is successful ora buyer is found outside of the auction process. All of the ARS investmentswere investment grade quality and were in compliance with the Company’sinvestment policy at the time of acquisition. The Company currently has theability and intent to hold these ARS investments until a recovery of theauction process or until maturity. As of September 30, 2008, the entireARS investment balance of $6.6 million is classified as long-term investment onits condensed consolidated balance sheet because of the Company’s inability todetermine when its investments in ARS would settle.

 

Effective January 1, 2008, the Company adopted the provisions ofSFAS 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.

 

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 September 30, 2008, the Company had $6.6 million of auction ratesecurities, the fair value of which has been measured using Level 3 inputs. TheseARS are collateralized mostly with Student Loan Auction Rate Certificates. Themonthly auctions have historically provided a liquid market for thesesecurities. The ARS in the Company’s portfolio had successful auctions until January 2008and as 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 Level 3 category as of September 30,2008.

 

9

----

Table of Contents

 

TheCompany has used a discounted cash flow model to determine the estimated fairvalue of its investment in ARS as of September 30, 2008. The assumptionsused in 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 September 30, 2008, the Company determined there was adecline in the fair value of its ARS investments of approximately $0.2 millionduring the three months ended September 30, 2008 and a total decline infair value of $0.6 million for the nine months ended September 30, 2008.  Thedecline in fair value was deemed temporary as the Company currently has theability and intent to hold these ARS investments until a recovery of theauction process or until maturity. As of September 30, 2008, the Companyhas classified the entire ARS investment balance as long-term investments onits condensed consolidated balance sheet because of the Company’s belief thatit will take longer than one year for its investments in ARS to settle.

 

Thefair value decline in ARS of approximately $0.6 million was recorded asan unrealized loss reported in a separate component of stockholders’ equity andincluded in accumulated other comprehensive loss as of September 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) in the three months ended September 30, 2008 was anincrease of $0.2 million and in the nine months ended September 30, 2008was an increase of $0.6 million.

 

Fair value measurements of financial assets carried at fair value as ofSeptember 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        |       | $                | 31,840     |             | $          | —           |       | $         | —     |   | $ | 31,840 |   |
| Corporate bonds           |       | 9,859            |       | —           |       | —           |       | 9,859     |       |
| Municipal bonds           |       | 1,000            |       | —           |       | —           |       | 1,000     |       |
| Treasuries                |       | 11,245           |       | —           |       | —           |       | 11,245    |       |
| Commercial paper          |       | 12,190           |       | —           |       | —           |       | 12,190    |       |
| Auction rate securities   |       | —           |       | —           |       | 6,550            |       | 6,550     |       |
| Total                     |       | $                | 66,134     |             | $          | —           |       | $         | 6,550      |   | $ | 72,684 |   |
| Amount included in:       |       |             |       |             |       |             |       |      |       |
| Cash and cash equivalents |       | $                | 40,066     |             | $          | —           |       | $         | —     |   | $ | 40,066 |   |
| Short-term investments    |       | 17,992           |       | —           |       | —           |       | 17,992    |       |
| Long-term investments     |       | 8,076            |       | —           |       | 6,550            |       | 14,626    |       |
| Total                     |       | $                | 66,134     |             | $          | —           |       | $         | 6,550      |   | $ | 72,684 |   |

 

**               **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 loss included in  accumulated other comprehensive loss |       | (305      | )          |
| Transfer into Level 3                                                   |       | 7,100     |       |
| Ending balances as of March 31, 2008                               |       | 6,795     |       |
| Total unrealized loss included in  accumulated other comprehensive loss |       | (85       | )          |
| Ending balances as of June 30, 2008                                |       | 6,710     |       |
| Total unrealized loss included in  accumulated other comprehensive loss |       | (160      | )          |
| Ending balances as of September 30,  2008                          |       | $         | 6,550      |   |

 

In October 2008, the Company received an offer from one of itsinvestment providers, which currently holds the Company’s ARSs and from whomthe Company had purchased the securities, to sell at par value the ARSs

 

10

----

Tableof Contents

 

back to the investment provider by 2010.  The Company is in the process of evaluatingthe offer and the impact to its consolidated financial statements.

 

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

 

**Inventory**(inthousands):

 

| ** **      | ** ** | **September 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|-----------------|------------|----------------------------------|------------|---------------------------------|------------|
| Finished goods  |       | $                                | 3,375      |                            | $          | 3,194 |   |
| Work in process |       | 2,639                            |       | 1,559                           |       |
|            |       |                             |       |                            |       |
|            |       | $                                | 6,014      |                            | $          | 4,753 |   |

 

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

 

| ** **                                      | ** ** | **September 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| Equipment                                       |       | $                                | 2,236      |                            | $          | 1,727 |   |
| Software                                        |       | 553                              |       | 546                             |       |
| Furniture and fixtures                          |       | 308                              |       | 279                             |       |
| Leasehold improvements                          |       | 443                              |       | 414                             |       |
|                                            |       | 3,540                            |       | 2,966                           |       |
|                                            |       |                             |       |                            |       |
| Less accumulated depreciation and  amortization |       | (1,978                           | )          | (1,495                          | )          |
|                                            |       |                             |       |                            |       |
|                                            |       | $                                | 1,562      |                            | $          | 1,471 |   |

 

**Accrued liabilities**(in thousands):

 

| ** **                           | ** ** | **September 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| Accrued compensation                 |       | $                                | 1,687      |                            | $          | 1,008 |   |
| Accrued inventory purchases          |       | 263                              |       | 461                             |       |
| Customer advances                    |       | 114                              |       | 280                             |       |
| Taxes payable                        |       | —                           |       | 204                             |       |
| Accrued tape out expenses            |       | 31                               |       | 158                             |       |
| Legal and professional services fees |       | 61                               |       | 116                             |       |
| Exercise of unvested stock options   |       | 32                               |       | 62                              |       |
| Other                                |       | 229                              |       | 245                             |       |
|                                 |       |                             |       |                            |       |
|                                 |       | $                                | 2,417      |                            | $          | 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 percentages of total revenues by geographic location are asfollows:

 
| ** **    | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **    | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **    | ** ** | **2008**                         | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
| China         |       | 41                               | %          | 26                              | %          | 35 | % | 21 | % |
| Taiwan        |       | 29                               |       | 41                              |       | 31 |   | 43 | % |
| South Korea   |       | 25                               |       | 28                              |       | 28 |   | 31 |   |
| Japan         |       | 3                                |       | 3                               |       | 4 |   | 3 |   |
| United States |       | 1                                |       | 1                               |       | 1 |   | 1 |   |
| Other         |       | 1                                |       | 1                               |       | 1 |   | 1 |   |
| Total         |       | 100                              | %          | 100                             | %          | 100 | % | 100 | % |

 

11

----

Table of Contents

 

Revenues by product line are as follows (in thousands):

 
| ** **               | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **               | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **               | ** ** | **2008**                         | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
| Security Surveillance(1) |       | $                                | 14,409     |                            | $          | 10,247 |   | $ | 38,873 |   | $ | 28,250 |   |
| Video Decoders(2)        |       | 2,100                            |       | 3,320                           |       | 6,356 |   | 9,842 |   |
| LCD Display(3)           |       | 1,995                            |       | 1,293                           |       | 5,655 |   | 4,427 |   |
| Other(4)                 |       | 16                               |       | 262                             |       | 249 |   | 863 |   |
| Total                    |       | $                                | 18,520     |                            | $          | 15,122 |   | $ | 51,133 |   | $ | 43,382 |   |

 

----

| (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.                                                                                                                                                                                         |

 

The following is a summary of long-lived assets by geographicregion (in thousands):

 

| **Country**   | ** ** | **September 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|---------------|------------|----------------------------------|------------|---------------------------------|------------|
| United States |       | $                                | 1,345      |                            | $          | 1,187 |   |
| Taiwan        |       | 92                               |       | 67                              |       |
| South Korea   |       | 10                               |       | 39                              |       |
| China         |       | 43                               |       | 45                              |       |
| Japan         |       | 72                               |       | 133                             |       |
|          |       |                             |       |                            |       |
| Total         |       | $                                | 1,562      |                            | $          | 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** | ** ** | **Nine Months Ended** | ** ** |
| ** **   | ** ** | **September 30,**               | ** ** | **December 31,**            | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| **Customer** | ** ** | **2008**                             | ** ** | **2007**                         | ** ** | **2008** | ** ** | **2007** | ** ** | **2008** | ** ** | **2007** | ** ** |
| A            |       | *                                    | %          | 14                               | %          | 37 | % | 24 | % | 32 | % | 19 | % |
| B            |       | *                                    |       | 28                               |       | * |   | * |   | * |   | * |   |
| C            |       | 15                                   |       | 19                               |       | * |   | * |   | * |   | * |   |
| D            |       | 16                                   |       | *                                |       | * |   | * |   | * |   | * |   |
| E            |       | 20                                   |       | *                                |       | 11 |   | 12 |   | 11 |   | * |   |
| F            |       | *                                    |       | *                                |       | * |   | 11 |   | * |   | * |   |
| G            |       | 10                                   |       | *                                |       | * |   | * |   | * |   | * |   |

 

----

*   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 $8,000from this law firm for legal services in the three months ended September 30,2008.  The Company did not incur any feesfrom this law firm for legal services in the three months ended September 30,2007. The Company incurred fees of $21,000 and $12,000 from this law firm forlegal services 

 

12

----

Table of Contents

 

in the nine months ended September 30, 2008 and 2007,respectively.  The amount payable to thislaw firm was $8,000 and $4,000 at September 30, 2008 and December 31,2007, respectively. This Board member also receives compensation in accordancewith the Company’s compensation program for non-employee directors.

 

# **Note 9.  Recent Accounting Pronouncements**

# ** **

InSeptember 2006, the Financial Accounting Standards Board (“FASB”) issuedSFAS No. 157,*Fair Value Measurements*,which defines fair value, establishes a framework for measuring fair value ingenerally accepted accounting principles, and expands disclosures about fairvalue measurements. This statement applies to other accounting pronouncementsthat require or permit fair value measurements, the FASB having previouslyconcluded in those accounting pronouncements that fair value is the relevantmeasurement attribute. Accordingly, this Statement does not require any newfair value measurements. SFAS No. 157 is effective for financialstatements issued for fiscal years beginning after November 15, 2007.However, on February 12, 2008, the FASB issued SFAS No. 157-2 whichdelays the effective date of SFAS No. 157 for all nonfinancial assets andnonfinancial liabilities, except those that are recognized or disclosed at fairvalue in the financial statements on a recurring basis (at least annually).SFAS No. 157-2 partially defers the effective date of SFAS No. 157 tofiscal years beginning after November 15, 2008, and interim periods withinthose fiscal years for items within the scope of this FASB Staff Position.Effective January 1, 2008, the Company adopted SFAS No. 157 forfinancial assets and liabilities recognized at fair value on a recurring basisexcept as it applies to those nonfinancial assets and nonfinancial liabilitiesas noted in SFAS No. 157-2. The partial adoption of SFAS No. 157 didnot have a material impact on the consolidated financial positions, results ofoperations 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*, (“SFAS No. 159”), topermit all entities to choose to elect, at specified election dates, to measureeligible financial instruments at fair value, to report unrealized gains andlosses on items for which the fair value option has been elected in earnings ateach subsequent reporting date, and recognize upfront costs and fees related tothose items in earnings as incurred and not deferred. An entity is prohibitedfrom retrospectively applying SFAS No. 159, unless it chooses earlyadoption. SFAS No. 159 is effective as of the beginning of the firstfiscal year that begins after November 15, 2007. Effective January 1,2008, the Company adopted SFAS No. 159. The adoption of SFAS No. 159did not have a material impact on the consolidated financial positions, resultsof operations or cash flows.

 

InJune 2007, the Emerging Issues Task Force reached a consensus on Issue No. 07-3,*Accounting for Nonrefundable AdvancePayments for Goods or Services Received to Be Used in Future Research andDevelopment Activities,*(“EITFNo. 07-3”). 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. EITF No. 07-3is effective for fiscal years beginning after December 15, 2007, andearlierapplication isnot permitted. Effective January 1, 2008, the Company adopted EITF No. 07-3.The adoption of EITF No. 07-3 did not have a material impact on theconsolidated financial positions, results of operations or cash flows.

 

In December 2007, the FASB issued SFAS No. 141(R), *Business Combinations*, (“SFAS No. 141(R)”). SFAS No. 141(R)establishes principles and requirements for how an acquirer recognizes andmeasures in its financial statements the identifiable assets acquired, theliabilities assumed, contractual contingencies and contingent consideration attheir fair value on the acquisition date, any controlling interest in theacquiree and the goodwill acquired. SFAS No. 141(R) also establishesdisclosure requirements to enable the evaluation of the nature and financialeffects of the business combination. SFAS No. 141(R) is effective forfiscal years beginning after December 15, 2008. The Company will assess the impact SFAS No. 141(R) willhave on acquisitions after December 31, 2008, at the time of any suchacquisition.

 

InMay 2008, the FASB issued SFAS No. 162, *TheHierarchy of Generally Accepted Accounting Principles,*(“SFAS No. 162”)*.* SFAS No. 162 identifies the sources of accountingprinciples and the framework for selecting the principles used in thepreparation of financial statements of nongovernmental entities that arepresented in conformity with generally accepted accounting principles in theUnited States. This statement will be effective 60 days following theSecurities and Exchange Commission’s approval of the Public Company AccountingOversight Board amendment to AU 411, *The Meaning of PresentFairly in Conformity With Generally Accepted Accounting Principles*.The Company does not expect the implementation of this standard will have amaterial impact on the consolidated financial statements.

 

13

----

Table of Contents

 

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

 

*Thefollowing discussion of our financial condition and results of operationsshould be read in conjunction with the condensed consolidated financialstatements and notes to those statements included elsewhere in this QuarterlyReport on Form 10-Q for the three and nine months ended September 30, 2008 and our audited consolidatedfinancial statements for the year ended December 31, 2007 included in ourAnnual 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 these terms, andother similar expressions. These forward-looking statements include statementsas to the source of our revenues, our ability to generate revenues, our abilityto sustain our growth rate and profitability, our expectation regarding theincrease in certain expenses, our cash needs, our capital requirements, ourmarket risk sensitivity, our business and product strategies, our anticipatedeffective tax rate, our intention to add integrated audio functionality to ourvideo decoders, industry trends and our anticipation that developments in ourtechnologies and new products will increase our target market 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 results, the demandfor digital video applications for the security surveillance,  automotiveand consumer markets, our ability to compete, our dependence on key and highlyskilled personnel, the ability to develop new products and to enhance ourexisting products, the continued seasonality of our business due to our targetmarkets and location of our customers, our ability to integrate businesses thatwe may acquire, 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 this Form 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 LCDdisplays, advanced TVs, multifunction LCD monitors, camcorders, DVD recordersand TV tuner cards. These applications receive analog video signals commonlygenerated by surveillance cameras, by consumer electronics devices such asset-top boxes, DVD recorders, VCRs and camcorders, and to a lesser extent byover-the-air TV broadcasts. We design application specific products that enablethe conversion of analog video sources to digital form and perform advanceddigital video processing to facilitate the display, storage and transport ofvideo content. We believe our product strategy to design application specificproducts allows us to better address varying customer requirements, fullyleverage our technology capabilities and achieve greater share within our targetmarkets. Our semiconductors are based on our proprietary architecture and mixedsignal technologies that we believe provide high video quality under a widerange of signal conditions, enable high levels of integration and are costeffective.

 

14

----

Table of Contents

 

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 designwins and convert these design wins into revenues. We generated revenues fromthe sale of over 25 different products in the quarter ended September 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 productsinclude products specifically designed for security surveillance systems, LCDdisplays primarily for the automotive market and video decoders used inconsumer and PC products. We also continue to sell video decoders that can beused across a variety of applications. We intend to continue to develop newgenerations of products for each of 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 the following applications:  digital video recorders, or DVRs, PC-basedDVRs, network video recorders, 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 interface directlywith certain types of LCD display and image enhancement functionality toimprove 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 the past, we do not expectto achieve similar growth rates in the future. We currently expect to increaseour expense levels in each of the next several quarters to support increasedresearch and development efforts. These expenditures may not result inincreased revenues or profitability in the future. In addition, our ability toincrease our revenues will depend on increased demand for digital videoapplications in the security surveillance, automotive and consumer and PCmarkets. The growth of our target markets is uncertain. In addition, the timingof orders by and shipments to our customers, as well as general trends in ourtarget markets and general economic conditions, can cause our revenue growth tobe 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 24 months 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, 

 

15

----

Table of Contents

 

which tends to extend the life cycles of our product. Conversely, if acompetitor secures the design win, it may be difficult for us to sell into thecustomer’s application for an extended period. Our sales cycle typically rangesfrom six to 24 months. Due to the length of our product development and salescycle, the majority of our revenues for any period is generally weighted towardproducts introduced for sale, meaning products for which we commenced placingorders with our manufacturing subcontractors, in the prior one or two years. Asa result, our present revenues are not necessarily representative of futuresales because our future sales are likely to be comprised of a different mix ofproducts, some of which are now in the development 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, which havehistorically been some of our largest customers, and to original designmanufacturers, or ODMs.  In 2007, we derived approximately 77% of ourrevenues from products sold to distributors and 23% from products sold to OEMsor ODMs. In the nine months ended September 30, 2008, we derivedapproximately 77% of our revenues from products sold to distributors and 23%from products sold to OEMs or ODMs. Our gross margins have nothistorically been significantly different between sales to distributors andsales to OEMs or ODMs through orders procured by independent salesrepresentatives. However, our operating profit on sales through orders procuredby independent sales representatives can be less due to the payment ofcommissions to sales representatives, which we record as sales and marketingexpense.

 

We received an aggregate of 80% and 84% of our revenues from our tenlargest customers in the three months ended September 30, 2008 and 2007,respectively.  In the three months ended September 30,2008, two of our customers accounted for 37% and 11% of our revenues, thelarger of which was a distributor.  Inthe three months ended September 30, 2007, three of our customers, two ofwhich are distributors, accounted for 24%, 12% and 11% of our revenues.  For the nine months ended September 30,2008, two of our customers accounted for 32% and 11% of our revenues, thelarger of which was a distributor.  Forthe nine months ended September 30, 2007, one of our customers, adistributor, accounted for 19% 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 nine months ended September 30, 2008and approximately 98% of our revenues for the three and nine months ended September 30,2007. The table below indicates the percentage of total revenue by geographiclocation for the periods indicated:

 
| ** **    | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **    | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **    | ** ** | **2008**                         | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
| China         |       | 41                               | %          | 26                              | %          | 35 | % | 21 | % |
| Taiwan        |       | 29                               |       | 41                              |       | 31 |   | 43 |   |
| South Korea   |       | 25                               |       | 28                              |       | 28 |   | 31 |   |
| Japan         |       | 3                                |       | 3                               |       | 4 |   | 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 September 30, 2008, 63 of our 158employees were located in our international offices. These offices provide marketingsupport to our customers. Our South Korea and Japan offices also performproduct development activities.

 

16

----

Table of Contents

 

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 and harmour 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 22% for the three months ended September 30,2008 compared to the three months ended September 30, 2007 and our netincome decreased to $2.5 million for the three months ended September 30,2008 from $5.4 million for the three months ended September 30, 2007primarily due to increased stock compensation and income tax expenses. Ourrevenues increased by 18% for the nine months ended September 30, 2008compared to the nine months ended September 30, 2007 and our net income decreasedto $6.3 million for the nine months ended September 30, 2008 from $10.5million for the nine months ended September 30, 2007 primarily due to anincrease in operating expenses and income tax expenses. We may not be able tomaintain our recent growth and profitability and our limited operating historymakes the prediction of future operating results very difficult. We believethat period-to-period comparisons of operating results should not be reliedupon 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, stock-basedcompensation and valuation of investments of which some of these investmentssuch as auction rate securities do not have observable market quotes. We baseour estimates on historical experience and on various other assumptions that webelieve to be reasonable under the circumstances, the results of which form thebasis for making the judgments we make about the carrying values of assets and liabilitiesthat are not readily apparent from other sources. Because these estimates canvary depending on the situation, 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 an arrangementexists, the price is fixed or determinable and collectibility is probable. Wedo not allow for price protection or stock rotation rights with any of ourdistributors. If we change our practice and allow stock rotation or priceprotection in the future, we would have to evaluate the consequences on thetiming 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.

 

*Fair Value Measurements.*  Effective January 1, 2008, we adoptedthe provisions of Statement of Financial Accounting Standards, or SFAS, No. 157,or SFAS No. 157, *Fair Value Measurements*,which defines fair value, 

 

17

----

Table of Contents

 

establishes a framework for measuring fair value and expandsdisclosures about fair value measurements required under other accountingpronouncements.  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 amaterial impact on our consolidated financial positions, results of operationsor cash flows.

 

*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-down units that are unlikely to be sold based upon a six months’ demandforecast. This evaluation may take into account matters including expected demand,anticipated sales price, product obsolescence and other factors. If actualfuture demand for our products is less than currently forecasted, additionalinventory adjustments may be required. Once a reserve is established, it ismaintained until the product to which it relates is sold or scrapped. If a unitthat has been written down is subsequently sold, the cost associated with therevenue from this unit is reduced to the extent of the write-down, resulting inan increase in gross profit.

 

*Accounting for Income Taxes.  *We account for income taxes under the provisions of SFAS No. 109,*Accounting for Income Taxes*, or SFAS No. 109. In applyingSFAS No. 109, we are required to estimate our current tax expense togetherwith assessing temporary differences resulting from differing treatments ofitems for tax and accounting purposes. These differences result in deferred taxassets and liabilities. We must assess the likelihood that our deferred taxassets will be recovered from future taxable income and to the extent webelieve that recovery is not likely, we must establish a valuation allowance.Significant management judgment is required to assess the likelihood that ourdeferred tax assets will be recovered from future taxable income. At September 30,2008, our total deferred tax assets were principally comprised of net operatingloss carryforwards, research and other credit carryforwards, stock-basedcompensation 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 thedeferred tax assets will be recovered from taxable income, we applied theguidance provided in SFAS No. 109 and considered both positive evidencethat indicates a valuation allowance is not needed and negative evidence thatindicates a valuation allowance is needed. As of September 30, 2008, webelieve that our continued and predictable strong earnings provide ampleevidence that no valuation allowance is required at this 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 tax authorities.

 

The total amountof our unrecognized tax benefits as of September 30, 2008 is approximately$0.7 million.   The totalunrecognized tax benefits as of September 30, 2008 increased byapproximately $0.1 million from the balance as of December 31, 2007.  Over the next twelve months, our existing taxpositions are not expected to generate material increase in total unrecognizedtax benefits.  We recognize interestrelated to unrecognized tax benefits in our income tax expense and penaltiesrelated to unrecognized tax benefits in our operating expenses. For the threeand nine months ended September 30, 2008, we recognized approximately$8,000 of interest and no penalties related to unrecognized tax benefits.

 

On October 3,2008 the Emergency Economic Stabilization Act of 2008 was signed into law. Aprovision in this legislation provided for the extension of the research anddevelopment tax credit for qualifying expenditures paid or incurred from January 1,2008 through December 31, 2009. As a result of this new legislation, weexpect to generate federal research and development tax credits for the yearended December 31, 2008. We will record a cumulative tax benefit duringthe fourth quarter of 2008.

 

*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.

 

18

----

Table of Contents

 

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 nine months ended September 30, 2008 and2007, 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. Forthe three and nine months ended September 30, 2007, we used the simplifiedcalculation of expected term described in Staff Accounting Bulletin No. 107and volatility was based on an average of the historical volatilities of thecommon stock of several entities with characteristics similar to us since ourstock had been actively traded for only a short period of time for the periodsthrough 2007. For the three and nine months ended September 30, 2008, weperformed a review of our assumptions using additional historical dataavailable to us. In the expected term assumption calculation, we started withour additional historical data as suggested by Staff Accounting Bulletin No. 107and adjusted the historical data for any changes in future expectations. Sincewe do not have any publicly traded options, we rely exclusively on historicalvolatility in the expected volatility assumption calculation. The risk-freerate is based on the U.S. Treasury yield curve in effect at the time of grantfor periods corresponding with the expected term of the option. The estimatedforfeiture rate is based on our historical forfeiture experience and isestimated at 10% for all periods presented.

 

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

 
| ** **              | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **              | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **              | ** ** | **2008**                         | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
| Expected term in years  |       | 4.28                             |       | 6.08                            |       | 4.28 |   | 6.08 |   |
| Risk-free interest rate |       | 2.79                             | %          | 4.78                            | %          | 2.57% – 2.86 | % | 4.60% - 4.78 | % |
| Expected volatility     |       | 51.0                             | %          | 67.0                            | %          | 51.0% - 64.0 | % | 67.0% - 70.6 | % |
| Dividend yield          |       | 0                                | %          | 0                               | %          | 0 | % | 0 | % |

 

Compensation expense for restricted stockawards is determined using the fair value of our stock on the date of the grantand 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).

 

19

----

Table of Contents

 

***Results of Operations***

*** ***

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** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                         | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| **Consolidated Statement of Operations Data:** | ** ** | **2008**                         | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
| Revenues                                                           |       | 100.0                            | %          | 100.0                           | %          | 100.0 | % | 100.0 | % |
| Cost of revenues*                                                  |       | 37.0                             |       | 40.0                            |       | 38.0 |   | 41.1 |   |
| Gross margin                                                       |       | 63.0                             |       | 60.0                            |       | 62.0 |   | 58.9 |   |
|                                                               |       |                             |       |                            |       |   |   |   |   |
| Operating expenses:                                                |       |                             |       |                            |       |   |   |   |   |
| Research and development*                                          |       | 24.0                             |       | 23.1                            |       | 23.9 |   | 19.8 |   |
| Selling, general and administrative*                               |       | 19.3                             |       | 20.7                            |       | 21.5 |   | 20.2 |   |
|                                                               |       |                             |       |                            |       |   |   |   |   |
| Total operating expenses                                           |       | 43.3                             |       | 43.8                            |       | 45.4 |   | 40 |   |
|                                                               |       |                             |       |                            |       |   |   |   |   |
| Income from operations                                             |       | 19.7                             |       | 16.2                            |       | 16.6 |   | 18.9 |   |
| Interest income                                                    |       | 2.7                              |       | 5.4                             |       | 3.5 |   | 5.2 |   |
|                                                               |       |                             |       |                            |       |   |   |   |   |
| Income before income taxes                                         |       | 22.4                             |       | 21.6                            |       | 20.1 |   | 24.1 |   |
| Income tax (benefit) provision                                     |       | 8.8                              |       | (14.2                           | )          | 7.9 |   | (0.2 | ) |
| Net Income                                                         |       | 13.6                             | %          | 35.8                            | %          | 12.2 | % | 24.3 | % |

 

----

(*)  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** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                          | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                          | ** ** | **2008**                         | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                |       |                             |       |                            |       |   |   |   |   |
| Cost of revenues                    |       | 0.7                              | %          | 0.5                             | %          | 0.7 | % | 0.4 | % |
| Research and development            |       | 4.9                              |       | 3.8                             |       | 4.8 |   | 3.3 |   |
| Selling, general and administrative |       | 4.5                              |       | 4.4                             |       | 5.1 |   | 3.8 |   |

 

***Revenuesby product line are as follows (in thousands):***

 
| ** **               | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **               | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **               | ** ** | **2008**                         | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
| Security Surveillance(1) |       | $                                | 14,409     |                            | $          | 10,247 |   | $ | 38,873 |   | $ | 28,250 |   |
| Video Decoders(2)        |       | 2,100                            |       | 3,320                           |       | 6,356 |   | 9,842 |   |
| LCD Display(3)           |       | 1,995                            |       | 1,293                           |       | 5,655 |   | 4,427 |   |
| Other(4)                 |       | 16                               |       | 262                             |       | 249 |   | 863 |   |
| Total                    |       | $                                | 18,520     |                            | $          | 15,122 |   | $ | 51,133 |   | $ | 43,382 |   |

 

----

| (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.                                                                                                                                                                                                |

 

20

----

Tableof Contents

 

**Comparisons of the Three Months Ended September 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.

 

Revenues were $18.5 million for the three months ended September 30,2008 and $15.1 million for the three months ended September 30, 2007, anincrease of 22%. Revenues from our security surveillance products increasedapproximately $4.2 million, or 41%, in the three months ended September 30,2008 compared to the three months ended September 30, 2007,primarily as a result of the increase in sales of our integratedfour-in-one-video decoder products. Revenues from of our LCDdisplay products increased by approximately $0.7 million, or 54%, in the threemonths ended September 30, 2008 compared to the three months ended September 30,2007,primarily as a result of continuing demand in the automotive market forvehicles with an in-car LCD display that utilizes our products. Revenuesfrom video decoder products decreased approximately $1.2 million, or 37%, inthe three months ended September 30, 2008 compared to the threemonths ended September 30, 2007, primarily as aresult of a decrease in demand for our decoders due to a lack of integratedaudio functionality. Additionally, sales of our video decoders have also beenimpacted by the shift of application specific products specifically designed forthe LCD display and security surveillance markets. Other revenues decreased$0.2 million, or 94%, in the three months ended September 30, 2008compared with the three months ended September 30, 2007, primarilyas a result of decreased sales of our PCI video decoder products.

 

*Gross Profit and Gross Margin.*    Gross profitis the difference between revenues and cost of revenues, and gross marginrepresents gross profit as a percentage of revenues. Cost of revenues, alsoknown as cost of goods sold, consists primarily of cost of processed siliconwafers, costs associated with assembly, test and shipping of our productionsemiconductors, cost of personnel and related expenses associated withsupporting our outsourced manufacturing activities and write-downs for excessand obsolete inventory.

 

Gross profit was $11.7 million for thethree months ended September 30, 2008 and $9.1 million for the threemonths ended September 30, 2007, an increase of 29%. Gross margin was 63% for the three monthsended September 30, 2008 increasing from 60% for the three months ended September 30,2007. The increase in gross profit wasprimarily due to an increase in revenue of $3.4 million or 22%. The increase ingross margin was primarily a result of reduced unit materialand production costs attributable to volume purchase discounts and the transition of our products to lowerprocess geometries during 2008.

 

We incurred stock-based compensation included in cost ofrevenues associated with outsourced manufacturing support and quality assurancepersonnel of $0.1 million for both the three months ended September 30,2008 and 2007, respectively.

 

*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 for the remainder of 2008 and into 2009as we increase our investment in developing new products.

 

Research and development expenses were $4.4 million, or 24%of revenues, for the three months ended September 30, 2008 and $3.5million or 23% of revenues for the three months ended September 30, 2007,an increase of 27%. This increase was primarily due to increasedcompensation-related expenses of approximately $0.9 million in salary andbenefits associated with additional headcount in the U.S. and in our Japansubsidiary to support product development efforts and an increase of $0.3million of stock-based compensation expense, partially offset by a decrease intape-out costs of $0.2 million.

 

We incurred stock-based compensation expense associated withresearch and development personnel of $0.9 million and $0.6 million in thethree months ended September 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 

 

21

----

Table of Contents

 

expenses, insurance and fees paid for professional services, travel,depreciation expenses and occupancy costs. Costs associated with audit and taxservices, corporate governance and compliance and financial reporting are alsoincluded in selling, general and administrative expenses.

 

Selling,general and administrative expenses were $3.6 million, or 19% ofrevenues, for the three months ended September 30, 2008 and $3.1 million,or 21% of revenues, for the three months ended September 30, 2007, anincrease in absolute dollars of 14%. The increase in expense wasprimarily due to increasedcompensation-related expenses of approximately $0.3 million associated withadditional headcount to support the expansion of our subsidiaries in China andJapan and $0.2 million in stock-based compensation expenses. We expectselling, general and administrative expenses to continue to increase in thefuture 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. We expect to continue to incur increasing administrative expenses associatedwith operating as a public company.

 

We incurred stock-based compensation expense associated withselling, general and administrative personnel of $0. 8 million and $0.7million in the three months ended September 30, 2008 and 2007,respectively.

 

*Interest Income.*    Interestincome was $0.5 million for the three months ended September 30, 2008 and$0.8 million for the three months ended September 30, 2007, a decrease of38%. The decrease was primarily due to lower rates of returns due to lowerinterest rates on cash, cash equivalent and investment balances. This wasslightly offset by an increase in cash, cash equivalent and investment balancesin the three month period ended September 30, 2008.

 

*Income Taxes.*    Our provision forincome taxes was $1.6 million for the three months ended September 30,2008. We recorded a benefit from income taxes of $2.2 million for the threemonths ended September 30, 2007. Our effective tax rate was 39% inthe three months ended September 30, 2008. The effective tax rate for bothperiods differed from the statutory federal income tax rate. In 2008, oureffective tax rate was greater than the statutory federal income tax rateprimarily due to non-deductible stock-based compensation expenses and stateincome taxes. In 2007, our effective tax rate was lower than the statutoryfederal income tax rate primarily due to a partial release of valuationallowances for net operating losses and other deferred tax assets.

 

**Comparisons of the Nine Months Ended September 30,2008 and 2007**

 

*Revenues.*    Revenueswere $51.1 million for the nine months ended September 30, 2008 and $43.4million for the nine months ended September 30, 2007, an increase of 18%. Revenuesfrom our security surveillance products increased approximately $10.6 million,or 38%, in the nine months ended September 30, 2008 compared to the ninemonths ended September 30, 2007, primarily as a result of the increase insales of our integrated four-in-one security surveillance products. Revenuesfrom of our LCD display products increased by $1.2 million, or 28%, in the ninemonths ended September 30, 2008 compared to the nine months ended September 30,2007 primarily as a result of  anincrease in demand in the automotive market for vehicles with an in-car LCDdisplay that utilize our products. Revenues from video decoder productsdecreased approximately $3.5 million, or 35%, in the nine months ended September 30,2008 compared to the nine months ended September 30, 2007, primarily as aresult of a decrease in demand for our decoders due to a lack of integratedaudio functionality. Additionally, sales of our video decoders have also beenimpacted by the shift to application specific products specifically designedfor the LCD display and security surveillance markets. Other revenues decreasedby $0.6 million, or 71%, in the nine months ended September 30, 2008 ascompared with the nine months ended September 30, 2007, primarily as aresult of decreased sales of our PCI video decoder products.

 

*Gross Profit and Gross Margin.*    Gross profit was $31.7 million for thenine months ended September 30, 2008 and $25.6 million for the nine monthsended September 30, 2007, an increase of 24%. Gross margin was 62% for the nine months ended September 30, 2008increasing from 59% for the nine months ended September 30, 2007. Theincrease in gross profit was primarily due to an increase in revenue of $7.8million or 18%. The increase in gross margin was primarily a result of reducedunit material and production costs inthe nine months ended September 30, 2008 compared to the same period in2007 attributable to volume purchase discounts and the transition of our products to lower process geometries during2008.

 

We incurred stock-based compensation includedin cost of revenues associated with outsourced manufacturing support andquality assurance personnel of $0.4 million and $0.2 million in the ninemonths ended September 30, 2008 and 2007, respectively.

 

22

----

Table of Contents

 

*Research andDevelopment.*    Research and development expenses were$12.2 million, or 24% of revenues, for the nine months ended September 30,2008 and $8.6 million, or 20% of revenues, for the nine months ended September 30,2007, an increase in absolute dollars of 42%. The increase in expenseswas primarily due to increased compensation-relatedexpenses of approximately $2.7 million in salary and benefits associated with additionalheadcount in the U.S. and in our Japan subsidiary to support productdevelopment efforts and $1.0 million in stock-based compensation.

 

We incurred stock-based compensation expenseassociated with research and development personnel of $2.5 million and$1.4 million in the nine months ended September 30, 2008 and 2007,respectively. The increase in stock-based compensation expenses was primarilydue to the granting of restricted stock awards to new employees.

 

*Selling, General andAdministrative*.    Selling, general and administrative expenses were$11.0 million, or 22% of revenues, for the nine months ended September 30,2008 and $8.8 million, or 20% of revenues, for the nine months ended September 30,2007, an increase in absolute dollars of 26%. The increase in expense wasprimarily due to increasedcompensation-related expenses of approximately $1.2 million associated withadditional headcount to support the expansion of our subsidiaries in China andJapan and $1.0 million in stock-based compensation expenses. We expectselling, general and administrative expenses to continue to increase in thefuture 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. We expect to continue to incur increasing administrative expenses associatedwith operating as a public company.

 

We incurred stock-based compensation expenseassociated with selling, general and administrative personnel of $2.6 millionand $1.6 million the nine months ended September 30, 2008 and 2007,respectively. The increase in stock-based compensation expenses was primarily dueto the granting of restricted stock awards to new employees.

 

*Interest Income.*    Interestincome was $1.8 million for the nine months ended September 30, 2008 and$2.2 million for the nine months ended September 30, 2007, adecrease of 19%. The decrease was due to lower rates of returns due tolower interest rates offset by higher cash, cash equivalent and investmentbalances during the nine month period ended September 30, 2008.

 

*Income Taxes.*    Ourprovision for income taxes was $4.1 million for the nine months ended September 30,2008 and a tax benefit of $80,000 for the nine months ended September 30,2007. Our effective tax rate increased to approximately 39% in the nine monthsended September 30, 2008 from a zero percent effective tax rate in thenine months ended September 30, 2007. The effective tax rate for bothperiods differed from the statutory federal income tax rate. In 2008, oureffective tax rate was greater than the statutory federal income tax rateprimarily due to non-deductible stock-based compensation expenses and stateincome taxes. In 2007, our effective tax rate was lower than the statutoryfederal income tax rate primarily due to a partial release of valuationallowances for net operating losses and other deferred tax assets.

 

***Liquidity and Capital Resources***

*** ***

Since our inception, we have financed our growthprimarily with proceeds from the issuance of preferred stock and common stockand cash flows from operations. Our cash, cash equivalents and short andlong-term investments were $77.3 million as of September 30, 2008 comparedto $65.4 million as of September 30, 2007.

 

Net cash provided by operating activities was $10.7million in the nine months ended September 30, 2008. The net cash providedby our operating activities in the nine months ended September 30, 2008was primarily due to our net income of $6.2 million, an increase inaccounts payables of $0.4 million primarily due to the timing of payments, aswell as non-cash charges from stock-based compensation expenses of $5.4 millionand depreciation and amortization expenses of $0.5 million. These werepartially offset by increases in inventory of $1.3 million, accounts receivableof $0.3 million, both of which are attributable to the growth in our revenueand other prepaid and other assets of $0.3 million.

 

Net cash provided by operating activities was$11.1 million in the nine months ended September 30, 2007. The net cashprovided by our operating activities in the nine months ended September 30,2007 was primarily due to our net income of $10.5 million and an increase toincome taxes payable of $1.5 million, a decrease in our accounts receivable of$0.8 million attributable to the timing of customer collections and an increasein deferred rent of $0.2 million. These were offset by an increase in deferredincome taxes of $5.1 million, a decrease in accrued liabilities of 

 

23

----

Table of Contents

 

$0.8 million primarily attributable to a reduction in the liability foremployees bonuses which were accrued throughout the year and paid subsequent toyear-end and a decrease in accounts payable of $0.4 million. We incurrednon-cash expenses of $3.2 million for stock-based compensation expense and $0.3million in depreciation expense in the nine months ended September 30,2007. We also recognized a tax benefit of $0.9 million attributable to ouremployee equity incentive plans.

 

Net cash provided by our investing activities was$7.4 million in the nine months ended September 30, 2008 due to thematurities of our investments of $54.1 million offset by purchases ofshort and long-term investments of $46.4 million and capital expenditures of$0.4 million.

 

Net cash used in our investing activities was$2.9 million in the nine months ended September 30, 2007 reflectingpurchases of short and long-term investments of $77.2 million and capitalpurchases of $0.8 million offset by maturities of short and long-terminvestments of $75.1 million.

 

Net cash used in financing activities of $0.6million in the nine months ended September 30, 2008 primarily consisted ofrepurchases of common stock upon release of restricted stock awards offset byproceeds from the exercise of stock options.

 

Net cash provided by financing activities of $0.5million in the nine months ended September 30, 2007 consisted of proceedsfrom the exercise of stock options.

 

We believe our existing cash and cash equivalentsand investments balances, as well as cash expected to be generated fromoperating activities, will be sufficient to meet our anticipated cash needs forat least the next 12 months.

 

At September 30, 2008, we held approximately$6.6 million of investments, classified as long-term assets, with an auctionreset feature, which are referred to as “auction rate securities”, whoseunderlying assets are generally student loans which are substantially backed bythe federal government. The carrying value of our investment in these auctionrate securities has been valued lower than their par value of $7.1 million asof September 30, 2008. We have deemed this loss in fair value as temporaryas we currently have the ability and intent to hold these investments untilrecovery of the auction process or until maturity. The loss in fair value wasrecorded as an unrealized loss reported in a separate component of stockholders’equity and included in accumulated other comprehensive loss. Our holdings ofauction rate securities decreased from $11.6 million at December 31, 2007due to successful sales of several auction rate securities at the carryingvalue in the first quarter of 2008. In February and March of 2008,auctions failed for our auction rate securities, and there is no assurance thatsuccessful auctions on the other auction rate securities in our investmentportfolio will continue to succeed. Our ability to liquidate our investment andfully recover the carrying value of our investment in the near term may belimited or not exist and as a result we have classified these investments aslong-term. An auction failure means that the parties wishing to sell securitiescould not. All of our auction rate securities were rated AAA at the time ofpurchase, the highest rating, by a rating agency. If the issuers of thesesecurities are unable to successfully close future auctions and their creditratings deteriorate, we may in the future be required to record an impairmentcharge on these investments. In October 2008, we received an offer fromone of our investment providers, which currently holds our ARSs and from whomwe had purchased the securities, to sell at par value the ARSs back to theinvestment provider by 2010. We are in the process of evaluating the offer andthe impact to our consolidated financial statements. We are continuing toevaluate the credit quality, classification and valuation of our auction ratesecurities, but based on our expected operating cash flows, and our othersources of cash, we do not anticipate the potential lack of liquidity on these investmentswill affect our ability to execute our current business plan.

 

Our long-term future capital requirements willdepend on many factors, including our level of revenues, the timing and extentof spending to support our product development efforts, the expansion of salesand marketing activities, the timing of our introductions of new products, thecosts to ensure access to adequate manufacturing capacity, the continuingmarket acceptance of our products and our ability to liquidate our auction ratesecurities in a timely manner. We could be required, or could elect, to seekadditional funding through public or private equity or debt financing andadditional funds may not be available on terms acceptable to us or at all.

 

***Off-Balance SheetArrangements***

 

As of September 30, 2008, we have no off-balance sheetarrangements as defined in Item 303(a)(4) of Regulation S-Kpromulgated under the Securities Act of 1933, as amended.

 

24

----

Table of Contents

 

***ContractualObligations***

 

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

 
| ** **                | ** ** | **Payment Due by Period** | ** ** |
|---------------------------|------------|------------------------------------------|------------|
| ** **                | ** ** | **Total**                                | ** ** | **Less than 1  year** | ** ** | **1-3 years** | ** ** | **4-5 years** | ** ** |
|                      |       |                                     |       |   |   |   |   |   |   |
| Minimum lease commitments |       | $                                        | 1,887      |   | $ | 618 |   | $ | 1,174 |   | $ | 95 |   |
| Purchase commitments      |       | 2,095                                    |       | 2,095 |   | — |   | — |   |
| Total commitments         |       | $                                        | 3,982      |   | $ | 2,713 |   | $ | 1,174 |   | $ | 95 |   |

 

***Recent Accounting Pronouncements***

 

In September 2006, the Financial AccountingStandards Board, or FASB, issued SFAS No. 157,*Fair Value Measurements*, which defines fair value,establishes a framework for measuring fair value in generally acceptedaccounting principles, and expands disclosures about fair value measurements.This statement applies to other accounting pronouncements that require orpermit fair value measurements, the FASB having previously concluded in thoseaccounting 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, we adopted SFAS No. 157 for financial assets and liabilitiesrecognized at fair value on a recurring basis except as it applies to thosenonfinancial 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.

 

In February 2007, the FASB issued SFAS No. 159,*The Fair Value Option for Financial Assets andFinancial Liabilities – including an Amendment of FASB Statement No. 115*,or SFAS No. 159,  to permit allentities to choose to elect, at specified election dates, to measure eligiblefinancial instruments at fair value, to report unrealized gains and losses onitems for which the fair value option has been elected in earnings at eachsubsequent reporting date, and recognize upfront costs and fees related tothose items in earnings as incurred and not deferred. An entity is prohibitedfrom retrospectively applying SFAS No. 159, unless it chooses earlyadoption. SFAS No. 159 is effective as of the beginning of the firstfiscal year that begins after November 15, 2007. Effective January 1,2008, we 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.

 

In June 2007, the Emerging Issues Task Forcereached a consensus on Issue No. 07-3, *Accountingfor Nonrefundable Advance Payments for Goods or Services Received to Be Used inFuture Research and Development Activities,*or EITF No. 07-3. Nonrefundable advance payments for goodsor services that will be used or rendered for future research and developmentactivities should be deferred and capitalized. Such amounts should berecognized as an expense as the related goods are delivered or the services areperformed, or when the goods or services are no longer expected to be provided.EITF No. 07-3 is effective for fiscal years beginning after December 15,2007, and earlier application is not permitted. Effective January 1, 2008,we adopted EITF No. 07-3. The adoption of EITF No. 07-3 did not havea material impact on the consolidated financial positions, results ofoperations or cash flows.

 

In December 2007, the FASB issued SFAS No. 141(R),*Business Combinations*, or SFAS No. 141(R).SFAS No. 141(R) establishes principles and requirements for how anacquirer recognizes and measures in its financial statements the identifiableassets acquired, the liabilities assumed, contractual contingencies andcontingent consideration at their fair value on the acquisition date, anycontrolling interest in the acquiree and the goodwill acquired. SFAS No. 141(R) alsoestablishes disclosure requirements to enable the evaluation of the nature andfinancial effects of the business combination. SFAS No. 141(R) iseffective for fiscal years beginning after 

 

25

----

Table of Contents

 

December 15,2008. We will assess the impact SFAS No. 141(R) will have onacquisitions after December 31, 2008, at the time of any such acquisition.

 

In May 2008, the FASB issued SFAS No. 162,“*The Hierarchy of Generally Accepted AccountingPrinciples,*” or SFAS No. 162. SFAS No. 162 identifies thesources of accounting principles and the framework for selecting the principlesused in the preparation of financial statements of nongovernmental entitiesthat are presented in conformity with generally accepted accounting principlesin the United States. This statement will be effective 60 days following theSecurities and Exchange Commission’s approval of the Public Company AccountingOversight Board amendment to AU 411, *The Meaning of PresentFairly in Conformity With Generally Accepted Accounting Principles*.We do not expect the implementation of this standard will have a materialimpact on the consolidated financial statements.

 

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

 

The primary objectives of our investmentactivity are to preserve principal, provide liquidity and maximize incomewithout significantly increasing the risk. Some of the securities we invest inare subject to market risk. This means that a change in prevailing interestrates may cause the principal amount of the investment to fluctuate. Tominimize this risk, we maintain our portfolio of cash equivalents, short andlong-term investments in demand accounts, money market funds, commercial paper,corporate bonds, U.S. government agency securities and auction rate securitieswhich are investment grade securities with a maximum dollar weighted maturityof two years or less. The risk associated with fluctuating interest rates islimited to our investment portfolio, and we believe that a 10% change ininterest rates would not have a significant impact on our interest income.

 

At September 30, 2008, we held approximately$6.6 million of investments, classified as long-term assets, with an auctionreset feature, which are referred to as “auction rate securities”, whoseunderlying assets are generally student loans which are substantially backed bythe federal government. The carrying value of our investment in these auctionrate securities has been valued lower than their par value of $7.1 million asof September 30, 2008. We have deemed this loss in fair value as temporaryas we currently have the ability and intent to hold these investments untilrecovery of the auction process or until maturity. The loss in fair value wasrecorded as an unrealized loss reported in a separate component of stockholders’equity and included 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 were rated AAA at the time of purchase, the highest rating, bya rating agency. If the issuers of these securities are unable to successfullyclose future auctions and their credit ratings deteriorate, we may in thefuture be required to record an impairment charge on these investments. InOctober 2008, we received an offer from one of our investment providers,which currently holds our ARSs and from whom we had purchased the securities,to sell at par value the ARSs back to the investment provider by 2010. We are continuingto evaluate the credit quality, classification and valuation of our auctionrate securities, but based onour expected operating cash flows, and our other sources of cash, we do notanticipate the potential lack of liquidity on these investments will affect ourability to execute our current business plan.

 

To date, our international customeragreements have been denominated solely in U.S. dollars, and accordingly, wehave not been exposed to foreign currency exchange rate fluctuations fromcustomer agreements, and do not currently engage in foreign currency hedgingtransactions. However, the functional currency of our operations in Taiwan,South Korea, Japan and China is the U.S. dollar and our local accounts are maintainedin the local currency in Taiwan, South Korea, Japan and China, respectively,and thus we are subject to foreign currency exchange rate fluctuationsassociated with remeasurement to U.S. dollars. Such fluctuations have not beensignificant historically and we believe that a 10% change in exchange rateswould not have a significant impact on our operating expenses.

 

**ITEM 4. Controls andProcedures**

 

(a) ***  Evaluation of disclosure controls and procedures.***  We maintain “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”),that are designed to ensure that information required to be disclosed by us inreports that we file or submit 

 

26

----

Table of Contents

 

under the Exchange Act is recorded, processed, summarized, and reportedwithin the time periods specified in Securities and Exchange Commission rules andforms, and that such information is accumulated and communicated to ourmanagement, including our chief executive officer and chief financial officer,as appropriate, to allow timely decisions regarding required disclosure. Indesigning and evaluating our disclosure controls and procedures, managementrecognized that disclosure controls and procedures, no matter how wellconceived and operated, can provide only reasonable, not absolute, assurancethat the objectives of the disclosure controls and procedures are met. Ourdisclosure controls and procedures have been designed to meet the reasonableassurance standards. Additionally, in designing disclosure controls andprocedures, our management necessarily was required to apply its judgment inevaluating the cost-benefit relationship of possible disclosure controls andprocedures. The design of any disclosure controls and procedures also is basedin part upon certain assumptions about the likelihood of future events, andthere can be no assurance that any design will succeed in achieving its statedgoals under all potential future conditions.

 

Based on the evaluation as of the end of theperiod covered by this Quarterly Report on Form 10-Q, our chief executiveofficer and chief financial officer have concluded that, as of such date, ourdisclosure controls and 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 on Form 10-Qthat has materially affected, or is reasonably likely to materially affect, ourinternal control over financial reporting.

 

**PART II—OTHERINFORMATION**

 

**ITEM1.****                 ****Legal Proceedings**

 

We are currently not a party to any 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 not meritorious,could result in the expenditure of significant financial and managerialresources.

 

**ITEM1A.****              ****Risk Factors**

 

If any of the following risks actually occur,our business, results of operations and financial condition could suffersignificantly.

 

**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 aredifficult to predict, have in the past fluctuated, and may in the futurefluctuate from quarter to quarter. It is possible that our operating results insome quarters will be below market expectations. This would likely cause themarket price of our common stock to decline. Our quarterly operating results areaffected by a number of factors, including:

 

·                  unpredictablevolume and timing of customer orders, which are not fixed by contract but varyon a purchase order basis;

·                  uncertain demandin the automotive market for LCD display products;

·                  the loss of oneor more of our customers, causing a significant reduction or postponement oforders from these customers;

·                  decreases in theoverall average selling prices of our products;

·                  changes in therelative sales mix of our products;

·                  changes in ourcost of finished goods;

·                  theavailability, pricing and timeliness of delivery of other components used inour customers’ products;

·                  our customers’sales outlook, purchasing patterns and inventory adjustments based on demandsand general economic conditions;

·                  product obsolescenceand our ability to manage product transitions;

 

27

----

Table of Contents

 

·                  our ability tosuccessfully develop, introduce and sell new or enhanced products in a timelymanner;

·                  the timing ofnew product announcements or introductions by us or by our competitors; and

·                  fluctuations inour effective tax rate.

 

We base our planned operating expenses inpart on our expectations of future revenue, and a significant portion of ourexpenses is relatively fixed in the short term. We have limited historicalfinancial data from which to predict future sales for our products. As aresult, it is difficult for us to forecast our future revenue and budget ouroperating expenses accordingly. If revenue for a particular quarter is lowerthan we expect, we likely will be unable to proportionately reduce ouroperating expenses for that quarter, which would harm our operating results forthat 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 secondquarter of 2005. We incurred significant net losses prior to that quarter. Tosustain or increase profitability, we will need to generate and sustainsubstantially higher revenue while maintaining reasonable cost and expenselevels. We currently expect to increase expense levels in each of the nextseveral quarters to support increased research and development efforts. Theseexpenditures may not result in increased revenue or customer growth. Becausemany of our expenses are fixed in the short term, or are incurred in advance ofanticipated sales, we may not be able to decrease our expenses in a timelymanner to offset any shortfall of sales. We also believe our future effectivetax rate will increase over our historical annual effective tax rate that hasbeen less than 10% of our pre-tax income since our inception, which will harmour financial results and negatively impact our profitability. We may not beable to sustain or increase profitability on a quarterly or an annual basis.This may, in turn, cause the price of our common stock to decline.

 

***If the growth ofdemand for digital video applications for the security surveillance,automotive, consumer and PC markets does not continue, our ability to increaseour revenue could suffer.***

 

Our ability to increase our revenue willdepend on increased demand for digital video applications in the securitysurveillance, automotive, consumer and PC markets. If our target markets do notgrow as rapidly or to the extent we anticipate, our business could suffer. Thegrowth of our target markets is uncertain 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

·                  the availability,at a reasonable price, of components required by such products, such as LCDpanels.

 

***Fluctuations in demand for ourproducts may harm our financial results and are difficult to forecast.***

 

Current uncertainty in global economicconditions pose a risk to the overall economy as consumers and businesses maydelay or postpone purchases in response to tighter credit and negativefinancial news, which could negatively affect demand for our products.Consequently, demand could be different from our expectations due to factorsincluding:

 

·                  changes inbusiness and economic conditions, including conditions in the credit marketthat could affect consumer confidence;

·                  customeracceptance of our products;

·                  changes incustomer order patterns including order cancellations;

·                  and changes inthe level of inventory at customers.

 

***Our success depends on our abilityto develop and introduce new products, which we may not be able to do in atimely manner, as product development in smaller wafer fabrication geometries becomesmore complex and costly.***

 

The development of new products is highly complex,and we have experienced some delays in bringing new products to the market inthe past. As our products integrate new, more advanced functions, they becomemore complex and increasingly difficult to design. In addition, in our effortto decrease cost, we intend to design new 

 

28

----

Table of Contents

 

productsin smaller fabrication geometries, some of which we may have no priorexperience of success. In the past, we have experienced some difficulties inshifting to smaller geometry process technologies.

 

Completing these projects is extremely challenging, time-consumingand expensive, and we can give no assurance that we will succeed or succeed ina timely and cost-effective manner. Product development delays may result fromunanticipated engineering complexities, changing market or competitive productrequirements or specifications, difficulties in overcoming resourcelimitations, the inability to license third-party technology or other factors.If we are unable to develop products successfully, in a timely andcost-effective manner, our business, financial condition and results ofoperations could suffer.

 

***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 andsell may be subject to rapid declines in average selling prices. From time totime, we have had to reduce our prices significantly to meet customerrequirements, and we may be required to reduce our prices in the future. Thiswould cause our gross margins to decline which in turn may negatively impactour operating results. Our financial results will suffer if we are unable tooffset any reductions in our average selling prices by increasing our salesvolumes, reducing our costs or developing new or enhanced products on a timelybasis with higher selling prices 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 extremelycompetitive and are characterized by rapid technological change, continuouslyevolving customer requirements and declining average selling prices. We may notbe able to compete successfully against current or potential competitors. If wedo not compete successfully, our market share and revenue may decline. Wecompete with large semiconductor manufacturers and designers. Most of ourcurrent and potential competitors have longer operating histories,significantly greater resources and name recognition and a larger base ofcustomers than we do. This may allow them to respond more quickly than we canto new or emerging technologies or changes in customer requirements. Inaddition, these competitors may have greater credibility with our existing andpotential customers. 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.

 

***The demand for ourproducts is affected by general economic conditions, which could impact ourbusiness.***

 

The United States and international economieshave recently experienced a period of economic downturn. The timing ofsustained economic recovery, if any, is uncertain. In addition, terrorist actsand similar events, turmoil in the Middle East or war in general, couldcontribute to a slowdown of the market demand for our products. If the economycontinues to slow down as a result of the recent economic, political and socialturmoil, or if there are further terrorist attacks in the United States orelsewhere, we may experience decreases in the demand for our products, whichmay harm our operating results. Our business has been adversely affected byprevious economic downturns. For example, during the global economic downturnin 2002 to 2003, demand for many semiconductor and consumer electronicsproducts suffered as consumers delayed purchasing decisions or changed orreduced their discretionary spending. As a result, demand for our productssuffered and we had to implement restructuring initiatives to align ourcorporate spending with a slower than anticipated revenue growth during thattimeframe.

 

***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 inlarge part upon our ability to attract and retain highly skilled managerial,engineering and sales and marketing personnel. The loss of any key employees orthe inability to attract or retain qualified personnel, including engineers andsales and marketing personnel, could delay the development and introduction of,and harm our ability to sell, our products and harm the market’s perception ofus. We believe that our future success is highly dependent on the contributionsof Fumihiro 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.

 

29

----

Table of Contents

 

***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 ourexisting products with improved technologies to meet rapidly evolving customerrequirements. We need to design products for customers who continually requirehigher performance and functionality at lower costs. We must, therefore,continue to cost-effectively add features that enhance performance andfunctionality to our products. The development process for these advancementsis lengthy and requires us to accurately anticipate market trends. Our failureto accurately anticipate market trends in a timely manner will harm the marketacceptance of our products and the sales of our products. For example, wewere excluded from certain customer qualification processes in the past due tothe lack of integrated audio functionality in our general purpose decoders. Aspart of 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 isuncertain and can be time-consuming, costly and complex. There is a risk thatthese developments and enhancements will be late, fail to meet customer ormarket specifications or not be competitive with products from our competitorsthat offer comparable or superior performance and functionality. Any newproducts or product enhancements may not be accepted in new or existingmarkets. Our business will suffer if we fail to develop and introduce newproducts or product enhancements on 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 toachieve design wins for our products, especially our new products and productenhancements. Once a customer designs a semiconductor into a product, it islikely to continue to use the same semiconductor or enhanced versions of thatsemiconductor from the same supplier across a number 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 designedto decode analog broadcast TV signals into digital images. In February 2009,transmission of broadcast TV signals will no longer be permitted in analog andall signals must be in a digital format. We are in the process of developing mixed signal and digital technologyto decode digital signals. However, transmission of digital video involves acombination of emerging technologies. The complexities of these technologiesand the variability in implementations between manufacturers may cause ourdevelopment of semiconductors to be costly and time-consuming. We may neverobtain the benefits of our investment in developing this technology. Thecomplexities of digital broadcast technologies may also cause some of thesemiconductors we are developing to ultimately work incorrectly for reasonsthat may be either related or unrelated to our products, or not beinteroperable with other key products. Delays or difficulties in integratingour semiconductors into digital broadcast TV products or the failure ofproducts incorporating digital broadcast TV to achieve broad market acceptancecould have an adverse effect on our business.

 

***A significant portion of ourproducts are sold into the consumer and security surveillance markets, and ifsales of our semiconductors into these markets decline or do not increase, orif we do not increase our sales into the automotive market, our business andfinancial results could suffer.***

 

We sell semiconductors targeted for the securitysurveillance, automotive, consumer and PC markets. For the year ended December 31,2007 more than 85% of our sales were derived from the sale of our productsdesigned for the consumer and security surveillance markets. If sales ofsemiconductors into these markets decline or do not increase, or if demandslows in these markets generally, our operating results would suffer. Inaddition, we have increased our focus on the automotive market and devotedsubstantial resources to the development of semiconductors for digital videoapplications that address this market. If we are not successful in selling our

 

30

----

Tableof Contents

 

semiconductorsinto this market, we may not recover the costs associated with our efforts inthis area and our operating results could suffer.

 

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

 

Our business is subject to seasonality as aresult of our target markets and the location of our customers. We sell asignificant number of our semiconductors into the consumer market. Ourcustomers who manufacture products for the consumer market experienceseasonality in the sales of their products, which in turn may affect the timingand volume of orders for our semiconductors. Because the consumer market fordigital video applications is characterized by this seasonality, our operatingresults may vary significantly from quarter to quarter. For example, wegenerally experience lower sales in the first calendar quarter with our videodecoder and LCD display products as a result of the seasonality associated withthe consumer markets. In addition, a significant number of our semiconductorsare sold to customers located in Asia, primarily to customers located inregions who observe the Lunar New Year holiday, also referred to as Chinese NewYear. Typically, our foreign offices and those of our customers are closed fora week or more during the extended holiday period. For the three and ninemonths ended September 30, 2008, over 94% of our revenues was attributableto customers located in regions that observe the Lunar New Year holiday. As aresult, we typically experience fluctuations in our first calendar quarter duein part to a slowing of business activity around the period of the Lunar NewYear holiday. These sales fluctuations 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 purchaseorders rather than long-term purchase commitments. In addition, our customersmay cancel purchase orders or defer the shipments of our products. Wemanufacture our products according to our estimates of customer demand. Thisprocess requires us to make multiple demand forecast assumptions, each of whichmay introduce error into our estimates. If we overestimate customer demand, wemay manufacture products that we may not be able to sell. As a result, we wouldhave excess inventory, which would increase our losses. Conversely, if we underestimatecustomer demand or if sufficient manufacturing capacity were unavailable, wewould forego revenue opportunities, lose market share and damage our customerrelationships.

 

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

 

Our revenues increased approximately 109% in2005 from 2004 and approximately 49% in 2006 from 2005. We do not expect toachieve similar growth rates in future periods. For example, our revenuesincreased approximately 11% in 2007 from 2006 and 18% in the nine months ended September 30,2008 compared to the nine months ended September 30, 2007. You should notrely on the results of any prior quarterly or annual periods as an indicationof our future operating performance. If we are unable to maintain adequate revenuegrowth, our stock price may decline and we may not have adequate financialresources to execute our 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. Acquisitionspresent a number of potential risks and challenges that could, if not met,disrupt our business operations, increase our operating costs and reduce thevalue to us of the acquired company. Even if we are successful, we may not beable to integrate the acquired businesses, products or technologies into ourexisting business and products. Furthermore, potential acquisitions andinvestments, whether or not consummated, may divert our management’s attentionand require considerable cash outlays at the expense of our existingoperations. In addition, to complete future acquisitions, we may issue equitysecurities, incur debt, assume contingent liabilities or have amortizationexpenses and write-downs of acquired assets, which could adversely affect ourprofitability.

 

31

----

Table of Contents

 

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

 

Our future effective tax rates will befavorably or unfavorably affected by the absolute amount and future geographicdistribution of our pre-tax income, our ability to take advantage of theavailable tax planning strategies and the availability of tax credits. Prior toSeptember 30, 2007, we determined that it was not more likely than notthat our deferred tax assets would be recovered from future taxable income.Therefore we provided a valuation allowance for our deferred tax assets. At September 30,2007, we assessed the recoverability of our deferred tax assets. As a result ofthis assessment, we released the valuation allowance recorded against ourdeferred tax assets of approximately $5.5 million. Our effective tax rate forthe years ended 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 significantgrowth and expansion, which has placed, and any future expansion will continueto place, a significant strain on our management, personnel, systems and financialresources. We have hired additional employees to support an increase inresearch and development as well as increase our sales and marketing efforts,which resulted in increasing our headcount from 96 employees at the end of 2006to 142 employees at the end of 2007. To manage our growth successfully, webelieve we must effectively:

 

·                  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 substantialmanagerial and financial resources and may increase our operating costs eventhough these efforts may not be successful. If we are unable to manage ourgrowth effectively, we may not be able to take advantage of marketopportunities, develop new products, satisfy customer requirements, execute ourbusiness 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 incompleting the development and introduction of new products and productenhancements, and we could experience delays in the future that may render ournew or enhanced products, when introduced, obsolete and unmarketable. Inaddition, it is often difficult for semiconductor foundries to achievesatisfactory product yields. Product yields depend on both our product designand the manufacturing process technology unique to the semiconductor foundry.Since low yields may result from either design or process difficulties,identifying yield problems can only occur well into the production cycle aftera product that can be physically analyzed and tested exists. Poor yields fromour foundry could cause us to sell our products at lower gross margins andtherefore harm our financial results.

 

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

 

Although we test our products, they arecomplex and may contain defects and errors. In the past, we have encountereddefects and errors in our products. For example, in 2003 we were unable to sellcertain products to a customer for whom these products were specifically designedas a result of our failure to produce a product that met this customer’sspecifications. We believe this customer secured the product from anothervendor. Delivery of products with defects or reliability, quality orcompatibility problems may damage our reputation and our ability to retainexisting customers and attract new customers. In addition, product defects anderrors could result in additional development costs, diversion of technicalresources, delayed product shipments, increased product returns and 

 

32

----

Table of Contents

 

product liability claims against us, which may not be fully covered byinsurance. Any of these could harm our business.

 

***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 orassembly facilities and have very limited in-house testing facilities.Therefore, we must rely on third-party vendors to manufacture, assemble andtest the products we design. We currently rely on Taiwan SemiconductorManufacturing Corporation, or TSMC, to produce the majority of oursemiconductors. We rely on Advanced Semiconductor Engineering, Inc., orASE, to assemble, package and test many of our products. If these vendors donot provide us with high-quality products, services and production and testcapacity in a timely manner, or if one or more of these vendors terminates itsrelationship with us, we may be unable to obtain satisfactory replacements tofulfill customer orders on a timely basis, our relationships with our customerscould suffer and our sales could decrease. Other significant risks associatedwith relying on these third-party vendors include:

 

·                  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;

·                  increasedexposure to 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 supplycontracts with any of our third-party vendors. Therefore, they are notobligated to perform services or supply products to us for any specific period,in any specific quantities or at any specific price, except as may be providedin a particular purchase order. Neither TSMC nor ASE has provided contractualassurances to us that adequate capacity will be available for us to meet futuredemand for our products. These third party vendors may allocate capacity to theproduction of other companies’ products while reducing deliveries to us onshort notice. In particular, other customers that are larger and betterfinanced than we are or that have long-term agreements with TSMC or ASE maycause either or both of them to reallocate capacity to those customers,decreasing the capacity available 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 whichrelies on third-party manufacturers or foundries to manufacture oursemiconductors. We are reliant on these foundries for the manufacture of our productsas well as providing services to assist us in getting our products intoproduction. As a result of the complexity in manufacturing our semiconductors,it is difficult to determine if a new foundry will be able to successfullyproduce our products. We may not be able to enter into a relationship with anew foundry that produces satisfactory yields on a cost-effective basis. If weneed another foundry because of increased demand, or the inability to obtaintimely and adequate deliveries from our current provider, we might not be ableto cost-effectively and quickly retain other vendors to satisfy ourrequirements. Any failure to successfully integrate a new foundry couldnegatively impact our sales 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 attributableto sales to customers in Asia was approximately 98% for both the nine monthsended September 30, 2008 and 2007. We expect that revenues from customersin Asia will continue to account for substantially all of our revenues. All oursales currently are denominated in U.S. dollars. As a result, an increase inthe value of the U.S. dollar relative to foreign currencies could make ourproducts less competitive in international markets.

 

33

----

Table of Contents

 

Currently, we maintain international salesoffices in Asia, and we rely on a network of third-party sales representativesto sell our products internationally. We have also established offices inChina, Japan, Taiwan and South Korea, which serve various aspects of ourbusiness. Moreover, we have in the past relied on, and expect to continue torely on, suppliers, manufacturers and subcontractors primarily located inTaiwan. Accordingly, we are subject to several risks and challenges, any ofwhich could harm our business and financial results. These risks and challengesinclude:

 

·                  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, exportlicenses and 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 constantlyevolving technologies, we have experienced a lengthy sales cycle for some ofour semiconductors, particularly those designed for digital video applicationsin the automotive market. Our sales cycle typically ranges from six to 24months. We may experience a delay between the time we increase expenditures forresearch and development, sales and marketing efforts and inventory and thetime we generate revenue, if any, from these expenditures. In addition, becausewe do not have long-term commitments from our customers, we must repeat oursales process on a continual basis even for current customers looking topurchase a new product. As a result, our business could be harmed if a customerreduces or delays its orders, chooses not to release products incorporating oursemiconductors or elects not to purchase a new product or product enhancementsfrom us.

 

***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 productsprimarily through a limited number of******distributors, most of which are located in Asia. Thisdistribution channel has been characterized by rapid change and consolidations.Distributors have accounted for a significant portion of our revenues in thepast. Sales to our distributors represented approximately 77% of our revenuesin 2007 and 77% of our revenues in the nine months ended September 30,2008.

 

Our operating results and financial conditioncould be significantly disrupted by the loss of one or more of our currentdistributors and sales representatives, volume pricing discounts, ordercancellations, delays in shipment by one of our major distributors or salesrepresentatives or the failure of our distributors or sales representatives tosuccessfully sell our products.

 

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

 

We seek to protect our proprietary designprocesses, documentation and other written materials primarily under tradesecret and copyright laws. We also typically require employees and consultantswith access to our proprietary information to execute confidentialityagreements. The steps taken by us to protect our proprietary information maynot be adequate to prevent misappropriation of our technology. In addition, ourproprietary rights may not be 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;

 

34

----

Table of Contents

 

·                  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 orother misappropriation of our proprietary technologies could enable thirdparties to benefit from our technologies without compensating us for doing so.For example, if the foundry that manufactures our semiconductors loses controlof our intellectual property, it would be more difficult for us to takeremedial measures since it is located in Taiwan, which does not have the sameprotection for intellectual property as is provided in the United States. Anyinability to adequately protect our proprietary rights could harm our abilityto compete, generate revenue 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 secretlaws and contractual restrictions to protect the technology in thesemiconductors we currently manufacture and market, our success and ability tocompete in the future may also depend to a significant degree upon obtaining patentprotection for our proprietary technology. As of December 31, 2007, we hadthree issued patents in the United States and five patent applications pendingin the United States and three applications pending in foreign jurisdictions.These patents and patent applications cover aspects of the technology in thesemiconductors we currently manufacture and market, including a patent for ourvideo decoding architecture. Patents that we currently own do not cover all ofthe semiconductors that we presently manufacture and market. Our patentapplications may not result in issued patents, and even if they result inissued patents, the patents may not have claims of the scope we seek. Inaddition, any issued patents may be challenged, invalidated or declared unenforceable.The term of any issued patents would be 20 years from its filing date and ifour applications are pending for a long time period, we may have acorrespondingly shorter term for any patent that may issue. Our issued patentshave expiration dates ranging from September 2, 2019 to March 27,2020. Our present and future patents may provide only limited protection forour technology and may not be sufficient to provide us with competitiveadvantages. For example, competitors could be successful in challenging anyissued patents or, alternatively, could develop similar or more advantageoustechnologies on their own or design around our patents. Also, patent protectionin certain foreign countries may not be available or may be limited in scopeand any patents obtained may not be as readily enforceable as in the UnitedStates, making it difficult for us to effectively protect our intellectualproperty from misuse or infringement by anyone in these countries. Ourinability to obtain and enforce our intellectual property rights in somecountries may harm our business. In addition, given the costs of obtainingpatent protection, we may choose not to protect certain innovations that laterturn out to be important to 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 frequentlitigation regarding patent and other intellectual property rights. Forexample, during 2005 and 2006, we were a party to an administrative proceedingin front of the intellectual property tribunal in South Korea in which anotherparty unsuccessfully sought a determination that our TW2824 and TW2834 productsinfringed a South Korean patent allegedly held by that party. We have certainindemnification obligations to customers under our contract developmentprojects with respect to any infringement of third-party patents andintellectual property rights by our products. If a lawsuit were to be filedagainst us in connection with claims of infringement, our business would beharmed.

 

Questions of infringement in the digitalvideo applications market involve highly technical and subjective analyses.Litigation may be necessary in the future to enforce any patents we may receiveand other intellectual property rights, to protect our trade secrets, todetermine the validity and scope of the proprietary rights of others or todefend against claims of infringement or invalidity, and we may not prevail inany future litigation. Litigation, whether or not determined in our favor orsettled, could be costly, could harm our reputation, could cause our customersto use our competitors’ products and could divert the efforts and attention ofour management and technical personnel from normal business operations. Inaddition, adverse determinations in litigation could result in the loss of ourproprietary rights, subject us to significant liabilities, require us to seeklicenses from third parties or prevent us from licensing our technology orselling our products, any of which could seriously harm our business.

 

35

----

Table of Contents

 

***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 the State of Washington and in Taiwan. Our assembly andtesting vendors’ facilities are primarily located in Taiwan. In addition, ourheadquarters are located in Northern California. The risk of an earthquake orextreme weather in the Pacific Rim region or an earthquake in NorthernCalifornia or Washington State is significant due to the proximity of majorearthquake fault lines. In September 1999, a major earthquake in Taiwanaffected the facilities of TSMC and ASE, our primary assembly vendor, as wellas other providers of foundry, packaging and test services. As a result ofthese natural disasters, these contractors suffered power outages anddisruptions that impaired their production capacity. In March 2002 and June 2003,additional earthquakes occurred in Taiwan. In 2005, several typhoons alsodisrupted the operations of TSMC and ASE. As a result of these naturaldisasters, these contractors suffered power outages and disruptions thatimpaired their production capacity. The occurrence of earthquakes orother natural disasters could result in the disruption of our foundry orassembly and test capacity. We may not be able to obtain alternate capacity onfavorable terms, if at all, which could harm our operating results.

 

***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-term investments for general corporate purposes, includingworking capital and capital expenditures. We may also use a portion of ourcash, cash equivalents, short-term and long-term investments to acquire orinvest in complementary technologies, businesses or other assets. We have notreserved or allocated our cash, cash equivalents, short-term and long-terminvestments for any specific purpose, and we cannot state with certainty howour management will use our cash, cash equivalents, short-term and long-terminvestments. Accordingly, our management has considerable discretion inapplying our cash, cash equivalents, short-term and long-term investments andmay use our cash, cash equivalents, short-term and long-term investments forpurposes that do not result in any increase in our results of operations ormarket value. Until the cash, cash equivalents, short-term and long-terminvestments are used, they may be placed in investments that do not produceincome 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 cyclicaland subject to rapid change and evolving industry standards and, from time totime, has experienced significant downturns. These downturns are characterizedby decreases in product demand, excess customer inventories and acceleratederosion of prices. These factors have caused and could cause substantialfluctuations in our net revenue and in our operating results. Any downturns inthe semiconductor industry may be severe and prolonged, and any failure of thisindustry to fully recover from downturns could harm our business. Thesemiconductor industry also periodically experiences increased demand andproduction capacity constraints, which may affect our ability to ship products.Accordingly, our operating results have varied and may vary significantly as aresult of the general conditions in the semiconductor industry, which couldcause our stock price to decline.

 

***The recent financial crisis couldnegatively affect our business, results of operations, and financial condition.***

 

The recent financial crises affecting thebanking system and financial markets and the going concern threats toinvestment banks and other financial institutions have resulted in a tighteningin the credit markets, a low level of liquidity in many financial markets, andextreme volatility in credit and equity markets. There could be a number offollow on effects from the credit crisis on our business, including insolvencyof key suppliers resulting in product delays; inability of customers to obtaincredit to finance purchases of our products and/or customer insolvencies.

 

36

----

Table of Contents

 

***Our operating results may beadversely affected by unfavorable economic, political and market conditions.***

 

Our results could be impacted by adverseeconomic, social, political and physical/infrastructure conditions in thecountries in which we, our customers or our suppliers operate, includingsecurity risks, natural disasters, infrastructure disruptions, health concernsand fluctuations in currency exchange rates.

 

**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 hasexperienced wide fluctuations due to the factors discussed in this risk factorssection and elsewhere in this Quarterly Report on Form 10-Q. For example,in the three months ended September 30, 2008, the closing price of ourstock ranged from a low of $9.17 on September 29, 2008 to a high of $12.44on July 16, 2008. In addition, the stock market in general has, and TheNASDAQ Global Market and technology companies in particular have, experiencedextreme price and volume fluctuations. These trading prices and valuations maynot be sustainable. These broad market and industry factors may decrease themarket price of our common stock, regardless of our actual operatingperformance. In addition, in the past, following periods of volatility in theoverall market and the market price of a company’s securities, securities classaction litigation has often been instituted against companies that experiencedsuch volatility. This litigation, if instituted against us, regardless of itsoutcome, could result in substantial costs and a diversion of our management’sattention and 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 isinfluenced by the research and reports that industry or securities analystspublish about us or our business. If one or more of the analysts who cover usdowngrade our stock, our stock price would likely decline. If one or more ofthese analysts cease coverage of our company or fail to regularly publishreports on us, we could lose visibility in the financial markets, which in turncould cause our stock price 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 cashequivalents and our investments will be sufficient to meet our anticipated cashneeds for at least the next 12 months. The timing and amount of our workingcapital and capital expenditure requirements may vary significantly dependingon 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 tosatisfy our liquidity requirements, we may seek to sell additional equitysecurities or debt securities or obtain debt financing. The sale of additionalequity securities or convertible debt securities would result in additionaldilution to our stockholders. Additional debt would result in increasedexpenses and could result in covenants that would restrict our operations. Wehave not made arrangements to obtain additional financing and there is noassurance that financing, if required, will be available in amounts or on termsacceptable 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 thepublic market, or the perception that these sales could occur, could cause themarket price of our common stock to decline. At September 30, 2008, we had21,217,791 shares of common stock outstanding. A substantial portion of theseshares of common stock are entitled to rights to cause us to register the saleof those shares under the Securities Act. Registration of these shares underthe Securities Act would 

 

37

----

Table of Contents

 

result in these shares, other than shares purchased by our affiliates,becoming freely tradable without restriction under the Securities Actimmediately upon the effectiveness of the registration.

 

Some of our officers and directors haveentered into 10b5-1 trading plans, which generally provide for pre-determinedsales of stock by these officers. The sales of stock by our officers anddirectors, even if made pursuant to these 10b5-1 trading plans, may cause ourstock price to fall.

 

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

 

Our directors, executive officers and theiraffiliated entities beneficially own a significant percentage of ouroutstanding common stock. These stockholders, if they acted together, couldexert substantial control over matters requiring approval by our stockholders,including electing directors and approving mergers or other businesscombination transactions. This concentration of ownership may also discourage,delay or prevent a change in control of our company, which could deprive ourstockholders of an opportunity to receive a premium for their stock as part ofa sale of our company and might reduce our stock price. These actions may betaken even if they are opposed by our other stockholders.

 

***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 ofincorporation, as amended and restated, may have the effect of delaying orpreventing a change of control or changes in our management. These provisionsinclude 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 inDelaware, we are governed by the provisions of Section 203 of the DelawareGeneral Corporation Law. These provisions may prohibit or restrict largestockholders, in particular those owning 15% or more of our outstanding votingstock, from merging or combining with us. These provisions in our certificateof incorporation and bylaws and under Delaware law could discourage potentialtakeover attempts and could reduce the price that investors might be willing topay for shares of our common stock in the future and result in our market pricebeing lower than it would without these provisions.

 

38

----

Table of Contents

 

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

 

As a public company, we have incurred andwill continue to incur significant legal, accounting and other expenses that wedid not incur as a private company. In addition, the Sarbanes-Oxley Act of2002, as well as new rules subsequently implemented by the SEC and NASDAQ,have required changes in corporate governance practices of public companies. Weexpect these new rules and regulations to increase our legal and financialcompliance costs and to make some activities more time-consuming and costly.For example, as a result of becoming a public company, we have added anindependent director, created additional board committees and adopted policiesregarding internal controls and disclosure controls and procedures. Inaddition, we have incurred and will continue to incur costs associated with ourpublic company 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.

 

**ITEM 2.****  Unregistered Sales of Equity Securities and Use of Proceeds**

 

Not applicable.

 

**ITEM 3.****  Defaults Upon Senior Securities**

 

Not applicable.

 

**ITEM 4.****  Submission of Matters to a Vote of Security Holders**

 

Not applicable.

 

**ITEM 5.****  Other Information**

 

Not applicable.

 

**ITEM 6.****  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. |
|-----|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

39

----

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: November 6, 2008 |                                                                                 |
|------------------------------|--------------------------------------------------------------------------------------|
|                         |                                                                                 |
|                         |                                                                                 |
|                         | /s/ Fumihiro Kozato                                                                  |
|                         | Fumihiro Kozato                                                                      |
|                         | President and Chief Executive  Officer                                               |
|                         |                                                                                 |
| Dated: November 6, 2008 |                                                                                 |
|                         |                                                                                 |
|                         |                                                                                 |
|                         | /s/ Mark Voll                                                                        |
|                         | Mark Voll  Vice President of Finance and Administration  and Chief Financial Officer |

 

40

----