** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, DC 20549**

 

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**FORM 10-Q**

** **
| **(Mark one)**                                                                                                                                                                       | ** ** | ** **                                                                                               |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------|
| **x**                                                                                                                                                                                     | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934**  |
| ** **                                                                                                                                                                                | ** ** | ** **                                                                                               |
| **For the  quarterly period ended September 30, 2006**                                                                                                                                    |
| ** **                                                                                                                                                                                | ** ** | ** **                                                                                               |
| **OR**                                                                                                                                                                                    |
| ** **                                                                                                                                                                                | ** ** | ** **                                                                                               |
| **o**                                                                                                                                                                                     | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                                                                                                                                                | ** ** | ** **                                                                                               |
| **For the  transition period from               to             ** |

** **

**Commission file number** 000-52014

 

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**Techwell, Inc.**

(Exact name 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)

 

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Indicate by check markwhether the Registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to filingrequirements for the past 90 days. YES **x** NO o

Indicate by check mark whetherthe registrant is a large accelerated filer, an accelerated filer or anon-accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Large Accelerated Filer o     Accelerated Filer****o      Non-Accelerated Filer******x**

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act). 

Yes o No **x**

Asof October 31, 2006, 20,298,897 shares of the Registrant’s common stock, $0.001par value, were outstanding.

 

 

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**TECHWELL, INC.**

**INDEX**
|                          | ** **                                                                                                             | ** ** | **Page** | ** ** |
|--------------------------|------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| PART I —  | FINANCIAL  INFORMATION                                                                                                 |       |     | 3          |   |   |
|                     |                                                                                                                   |       |     |       |   |   |
| Item 1.                  | Financial Statements  (Unaudited):                                                                                     |       |     | 3          |   |   |
|                     |                                                                                                                   |       |     |       |   |   |
|                     | Condensed Consolidated  Balance Sheets at September 30, 2006 and December 31, 2005                           |       |     | 3          |   |   |
|                     |                                                                                                                   |       |     |       |   |   |
|                     | Condensed  Consolidated Statements of Operations for the three and nine months ended  September 30, 2006 and 2005 |       |     | 4          |   |   |
|                     |                                                                                                                   |       |     |       |   |   |
|                     | Condensed  Consolidated Statements of Cash Flows for the nine months ended  September 30, 2006 and 2005      |       |     | 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                                                            |       |     | 24         |   |   |
|                     |                                                                                                                   |       |     |       |   |   |
| Item 4.                  | Controls and  Procedures                                                                                               |       |     | 25         |   |   |
|                     |                                                                                                                   |       |     |       |   |   |
| PART II — | OTHER INFORMATION                                                                                                      |       |     | 25         |   |   |
|                     |                                                                                                                   |       |     |       |   |   |
| Item 1.                  | Legal Proceedings                                                                                                      |       |     | 25         |   |   |
|                     |                                                                                                                   |       |     |       |   |   |
| Item  1A.                | Risk  Factors                                                                                                          |       |     | 25         |   |   |
|                     |                                                                                                                   |       |     |       |   |   |
| Item 2.                  | Unregistered  Sales of Equity Securities and Use of Proceeds                                                           |       |     | 37         |   |   |
|                     |                                                                                                                   |       |     |       |   |   |
| Item 3.                  | Defaults Upon  Senior Securities                                                                                       |       |     | 38         |   |   |
|                     |                                                                                                                   |       |     |       |   |   |
| Item 4.                  | Submission Of  Matters To A Vote Of Security Holders                                                                   |       |     | 38         |   |   |
|                     |                                                                                                                   |       |     |       |   |   |
| Item 5.                  | Other Information                                                                                                      |       |     | 38         |   |   |
|                     |                                                                                                                   |       |     |       |   |   |
| Item  6.                 | Exhibits                                                                                                               |       |     | 38         |   |   |
|                     |                                                                                                                   |       |     |       |   |   |
|                     | Signatures                                                                                                             |       |     | 39         |   |   |

 

2

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**PART I—FINANCIAL INFORMATION**

**Item 1.            Financial Statements**

**TECHWELL, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(Unaudited)**

**(Inthousands, except per share data)**
| ** **                                                                                                                                                                                                                                      | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                                      | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| ** **                                                                                                                                                                                                                                      | ** ** | ** **             | ** ** | ** **            | ** ** |
| **ASSETS**                                                                                                                                                                                                                                      | ** ** | ** **             | ** ** | ** **            | ** ** |
| Current assets:                                                                                                                                                                                                                                 |       |                   |       |                  |       |
| Cash and cash  equivalents                                                                                                                                                                                                                      |       | $                      | 17,389     |                  | $          | 15,982 |   |
| Short-term  investments                                                                                                                                                                                                                         |       | 31,365                 |       | 804                   |       |
| Total cash, cash  equivalents and short-term investments                                                                                                                                                                                        |       | 48,754                 |       | 16,786                |       |
| Accounts  receivable                                                                                                                                                                                                                            |       | 2,275                  |       | 3,052                 |       |
| Inventory                                                                                                                                                                                                                                       |       | 6,193                  |       | 3,113                 |       |
| Prepaid expenses  and other current assets                                                                                                                                                                                                      |       | 781                    |       | 2,224                 |       |
| Total current  assets                                                                                                                                                                                                                           |       | 58,003                 |       | 25,175                |       |
| Property and equipment,  net                                                                                                                                                                                                                    |       | 578                    |       | 434                   |       |
| Long-term investment                                                                                                                                                                                                                            |       | 989                    |       | —                |       |
| Other assets                                                                                                                                                                                                                                    |       | 57                     |       | 35                    |       |
| Total                                                                                                                                                                                                                                           |       | $                      | 59,627     |                  | $          | 25,644 |   |
|                                                                                                                                                                                                                                            |       |                   |       |                  |       |
| **LIABILITIES, REDEEMABLE  CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY (DEFICIT)**                                                                                                                                                |       |                   |       |                  |       |
| Current liabilities:                                                                                                                                                                                                                            |       |                   |       |                  |       |
| Accounts payable                                                                                                                                                                                                                                |       | $                      | 5,483      |                  | $          | 1,336 |   |
| Accrued  liabilities                                                                                                                                                                                                                            |       | 3,326                  |       | 2,687                 |       |
| Total current  liabilities                                                                                                                                                                                                                      |       | 8,809                  |       | 4,023                 |       |
| Deferred rent                                                                                                                                                                                                                                   |       | 13                     |       | 54                    |       |
| Total  liabilities                                                                                                                                                                                                                              |       | 8,822                  |       | 4,077                 |       |
|                                                                                                                                                                                                                                            |       |                   |       |                  |       |
| Redeemable convertible  preferred stock, $0.001 par value; 12,787,118 shares authorized, 12,777,118  shares outstanding, and $41,402 aggregate liquidation preference at  December 31, 2005                                                |       | —                 |       | 40,777                |       |
|                                                                                                                                                                                                                                            |       |                   |       |                  |       |
| Commitments and contingencies                                                                                                                                                                                                                   |       |                   |       |                  |       |
|                                                                                                                                                                                                                                            |       |                   |       |                  |       |
| Stockholders’ equity  (deficit):                                                                                                                                                                                                           |       |                   |       |                  |       |
| Preferred stock,  $0.001 par value; 10,000,000 shares authorized and no shares outstanding at  September 30, 2006                                                                                                                               |       | —                 |       | —                |       |
| Common stock,  $0.001 par value; 250,000,000 and 25,000,000 shares authorized at September 30,  2006 and December 31, 2005; 20,222,605 shares and 4,369,058 shares  outstanding at September 30, 2006 and December 31, 2005 |       | 20                     |       | 4                     |       |
| Additional  paid-in capital                                                                                                                                                                                                                     |       | 66,425                 |       | 5,355                 |       |
| Deferred  stock-based compensation                                                                                                                                                                                                              |       | (752                   | )          | (1,323                | )          |
| Accumulated  other comprehensive loss                                                                                                                                                                                                           |       | (14                    | )          | —                |       |
| Accumulated  deficit                                                                                                                                                                                                                            |       | (14,874                | )          | (23,246               | )          |
| Total  stockholders’ equity (deficit)                                                                                                                                                                                                      |       | 50,805                 |       | (19,210               | )          |
| Total                                                                                                                                                                                                                                           |       | $                      | 59,627     |                  | $          | 25,644 |   |

 

The accompanying notes are an integral part of thesecondensed consolidated financial statements.

3

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**TECHWELL, INC.**

**CONDENSED CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(Unaudited)**

**(Inthousands, except per share data)**
| ** **                                                      | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                      | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                      | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                            |       |                             |       |                            |       |   |   |   |   |
| Revenues                                                        |       | $                                | 15,101     |                            | $          | 9,877 |   | $ | 37,702 |   | $ | 25,259 |   |
|                                                            |       |                             |       |                            |       |   |   |   |   |
| Cost of revenues                                                |       | 6,374                            |       | 4,994                           |       | 16,112 |   | 12,444 |   |
|                                                            |       |                             |       |                            |       |   |   |   |   |
| Gross profit                                                    |       | 8,727                            |       | 4,883                           |       | 21,590 |   | 12,815 |   |
|                                                            |       |                             |       |                            |       |   |   |   |   |
| Operating expenses:                                             |       |                             |       |                            |       |   |   |   |   |
| Research and  development                                       |       | 2,033                            |       | 2,217                           |       | 6,984 |   | 6,118 |   |
| Selling, general  and administrative                            |       | 2,362                            |       | 1,396                           |       | 6,064 |   | 4,047 |   |
| Total operating  expenses                                       |       | 4,395                            |       | 3,613                           |       | 13,048 |   | 10,165 |   |
|                                                            |       |                             |       |                            |       |   |   |   |   |
| Income from operations                                          |       | 4,332                            |       | 1,270                           |       | 8,542 |   | 2,650 |   |
| Interest income                                                 |       | 617                              |       | 105                             |       | 1,024 |   | 248 |   |
|                                                            |       |                             |       |                            |       |   |   |   |   |
| Income before income  taxes                                     |       | 4,949                            |       | 1,375                           |       | 9,566 |   | 2,898 |   |
| Provision for income  taxes                                     |       | 440                              |       | 52                              |       | 1,194 |   | 120 |   |
|                                                            |       |                             |       |                            |       |   |   |   |   |
| Net income                                                      |       | $                                | 4,509      |                            | $          | 1,323 |   | $ | 8,372 |   | $ | 2,778 |   |
|                                                            |       |                             |       |                            |       |   |   |   |   |
| Basic net income per  share                                     |       | $                                | 0.22       |                            | $          | 0.33 |   | $ | 0.82 |   | $ | 0.71 |   |
| Diluted net income per  share                                   |       | $                                | 0.21       |                            | $          | 0.07 |   | $ | 0.42 |   | $ | 0.15 |   |
|                                                            |       |                             |       |                            |       |   |   |   |   |
| Weighed average shares  used in computing net income per share: |       |                             |       |                            |       |   |   |   |   |
| Basic                                                           |       | 20,093                           |       | 4,046                           |       | 10,213 |   | 3,902 |   |
| Diluted                                                         |       | 21,787                           |       | 18,572                          |       | 19,794 |   | 18,215 |   |

 

The accompanying notes are an integral part of thesecondensed consolidated financial statements.

4

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**TECHWELL, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

**(In thousands)**
| ** **                                                                         | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                         | ** ** | **September 30,**     | ** ** |
| ** **                                                                         | ** ** | **2006**                   | ** ** | **2005** | ** ** |
| **Cash flows from operating  activities:**                                         | ** ** | ** **                 | ** ** | ** ** | ** ** |
| Net income                                                                         |       | $                          | 8,372      |   | $ | 2,778 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                       |       |   |   |
| Depreciation and  amortization                                                     |       | 237                        |       | 144 |   |
| Stock-based  compensation                                                          |       | 1,788                      |       | 606 |   |
| Tax benefit from  employee equity incentive plans                                  |       | 190                        |       | — |   |
| Excess tax  benefits from stock-based compensation                                 |       | (22                        | )          | — |   |
| Changes in  assets and liabilities:                                                |       |                       |       |   |   |
| Accounts  receivable                                                               |       | 777                        |       | (1,494 | ) |
| Inventory                                                                          |       | (3,080                     | )          | (3,792 | ) |
| Prepaid expenses  and other current assets                                         |       | (359                       | )          | 530 |   |
| Other assets                                                                       |       | (22                        | )          | 12 |   |
| Accounts payable                                                                   |       | 4,024                      |       | 950 |   |
| Accrued  liabilities                                                               |       | 1,681                      |       | 1,471 |   |
| Restructuring  accrual                                                             |       | —                     |       | (103 | ) |
| Deferred rent                                                                      |       | (41                        | )          | 15 |   |
| Net cash  provided by operating activities                                         |       | 13,545                     |       | 1,117 |   |
| **Cash flows from investing  activities:**                                         | ** ** | ** **                 | ** ** | ** ** | ** ** |
| Purchase of  property and equipment                                                |       | (348                       | )          | (186 | ) |
| Change in  restricted cash                                                         |       | —                     |       | 100 |   |
| Purchase of  short-term investments                                                |       | (62,967                    | )          | — |   |
| Purchase of  long-term investment                                                  |       | (989                       | )          | — |   |
| Proceeds from  maturities of short-term investments                                |       | 32,392                     |       | 5,483 |   |
| Net cash  provided by (used in) investing activities                               |       | (31,912                    | )          | 5,397 |   |
| **Cash flows from financing  activities:**                                         | ** ** | ** **                 | ** ** | ** ** | ** ** |
| Proceeds from  initial public offering of common stock, net of offering costs      |       | 19,458                     |       | — |   |
| Proceeds from  the issuance of Series F redeemable convertible preferred stock     |       | —                     |       | 2,909 |   |
| Proceeds from  exercise of stock options                                           |       | 294                        |       | 228 |   |
| Excess tax  benefits from stock-based compensation                                 |       | 22                         |       | — |   |
| Collection of  notes receivable from stockholders                                  |       | —                     |       | 169 |   |
| Net cash  provided by financing activities                                         |       | 19,774                     |       | 3,306 |   |
| Net increase in cash  and cash equivalents                                         |       | 1,407                      |       | 9,820 |   |
| Cash and cash equivalents  at beginning of period                                  |       | 15,982                     |       | 2,069 |   |
| Cash and cash  equivalents at end of period                                        |       | $                          | 17,389     |   | $ | 11,889 |   |
| ** **                                                                         | ** ** | ** **                 | ** ** | ** ** | ** ** |
| **Supplemental cash flow  information—income taxes paid**                     |       | $                          | 695        |   | $ | 1 |   |
| ** **                                                                         | ** ** | ** **                 | ** ** | ** ** | ** ** |
| **Supplemental disclosure of  noncash investing and financing activities:**        | ** ** | ** **                 | ** ** | ** ** | ** ** |
| Deferred  stock-based compensation related to stock option grants                  |       | $                          | —     |   | $ | 949 |   |
| Reversal of  deferred stock-based compensation for cancellation of stock options   |       | $                          | 148        |   | $ | 464 |   |
| Change in  accrued offering costs                                                  |       | $                          | 94         |   | $ | — |   |
| Change in accrued  equipment costs                                                 |       | $                          | 33         |   | $ | — |   |
| Conversion of  redeemable convertible preferred stock to common stock              |       | $                          | 40,777     |   | $ | — |   |

 

The accompanying notes are an integral part of thesecondensed consolidated financial statements.

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**TECHWELL, INC.**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited)

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

***The Company***

Techwell, Inc.(“Techwell” or the “Company”) was incorporated in California on March 7, 1997and reincorporated in Delaware on March 30, 2006.  As a result of the reincorporation, thecondensed consolidated financial statements have been adjusted to giveretroactive effect to the establishment of par value for Techwell’s common stock.  The Company is a fabless semiconductorcompany that designs, markets and sells mixed signal integrated circuits formultiple video applications in the consumer, security surveillance andautomotive markets.

TheCompany has branch offices in South Korea and Taiwan and recently established asubsidiary in China.  The South Koreaoffice is primarily involved in product development and is also involved intechnical sales support.  The Chinaoffice and the Taiwan office primarily provide sales and marketing support.

***Basis ofPresentation***

The accompanying condensed consolidated financialstatements of the Company have been prepared without audit in accordance withthe rules and regulations of the Securities and Exchange Commission.  The balance sheet at December 31, 2005 has been derived from the auditedfinancial statements as of and 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 itsRegistration Statement on Form S-1, as amended, declared effectiveby the Securities and Exchange Commission on June 21, 2006.

In the opinion of management, the accompanyingunaudited condensed consolidated financial statements reflect all adjustments(consisting only of normal recurring adjustments) necessary to summarize fairlythe Company’s financial position, results of operations and cash flows for theinterim periods presented. The operating results for the three months endedSeptember 30, 2006 are not necessarily indicative of the results that maybe expected for the year ending December 31, 2006 or for any other futureperiod.

***Principlesof Consolidation and Year End***

The condensed consolidated financial statementsinclude the accounts of the Company and its subsidiary. All significant intercompanybalances and transactions have been eliminated in consolidation. The Companyreports 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 differ from theseestimates.

***Certain Significant Risks and Uncertainties***

The Company operates in a dynamic high technologyindustry and changes in any of the following areas could have a materialadverse effect on the Company’s financial position and results of operations:unpredictable volume and timing of customer orders, which are not fixed bycontract; loss of one or more of its customers; decrease in the overall averageselling prices of its products; changes in the relative sales mix of itsproducts; changes in its cost of finished goods; the availability, pricing andtimeliness of delivery of other components used in the Company’scustomers’products; the Company’s customers’ sales outlook, purchasing patterns andinventory adjustments based on consumer demands and general economicconditions; product obsolescence and the Company’s ability to manage producttransitions; the Company’s ability to 

6

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** **

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.

***Accumulated Other ComprehensiveLoss***

Accumulated other comprehensive loss consists of netunrealized losses on available-for-sale investments.  The change in unrealized losses oninvestments, net of tax, in the three and nine months ended September 30, 2006was $1,000 and $14,000, respectively. There were no unrealized gains or losses on investments in the three andnine months ended September 30, 2005.

***CommonStock and Conversion of Redeemable Convertible Preferred Stock***

In June 2006, the Company completed its initial publicoffering (“IPO”) and issued 2,540,225 shares of its common stock at a price of$9.00 per share. The Company received approximately $17.5 million in cash, netof underwriting discounts, commissions and other offering costs. Simultaneouslywith the closing of the IPO, each outstanding share of redeemable convertiblepreferred stock was automatically converted into one share of commonstock.  In July 2006, the Companyreceived aggregate proceeds of $1.1 million, net of underwriting discounts andcommissions, from the sale of an additional 130,000 shares following theunderwriters’ partial exercise of their over-allotment option received inconnection with the Company’s initial public offering in June 2006.

****RecentAccounting Pronouncements****

InJune 2006, the Financial Accounting Standards Board (“FASB”) issued InterpretationNo. 48 (“FIN No. 48”), **Accounting for Uncertainty in Income Taxes**.This interpretation clarifies the accounting for uncertainty in income taxesrecognized in an enterprise’s financial statements in accordance with FASBStatement No. 109, **Accounting for Income Taxes. **FIN No. 48 prescribes arecognition threshold and measurement attribute for the financial statementrecognition and measurement of a tax position taken or expected to be taken ina tax return. FIN No. 48 also provides guidance on derecognition,classification, interest and penalties, accounting in interim periods,disclosure, and transition. FIN No. 48 is effective for fiscal years beginningafter December 15, 2006. The Company is evaluating the potential impact of FINNo. 48 on its results of operations and financial position.

OnSeptember 13, 2006, the Securities and Exchange Commission issued StaffAccounting Bulletin No. 108 (“SAB No. 108”), *Consideringthe Effects of Prior Year Misstatements when Quantifying Misstatements in CurrentYear Financial Statements*, which provides interpretive guidance onthe consideration of the effects of prior year misstatements in quantifyingcurrent year misstatements for the purpose of a materiality assessment. SABNo.108 is effective for annual financial statements for the first fiscal yearending after November 15, 2006. However, early application is encouraged in anyreport for an interim period of the first fiscal year ending after November 15,2006, filed after the publication of this guidance. The Company is evaluatingthe potential impact of SAB No.108 on its results of operations and financialposition.

In September 2006, the FASB issued SFAS No. 157, *Fair Value Measurements*. SFAS No. 157 defines fair value,establishes a framework for measuring fair value in generally acceptedaccounting principles, and expands disclosures about fair value measurements.This Statement applies under 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 issued forfiscal years beginning after November 15, 2007, and interim periods withinthose fiscal years. This Statement is required to be adopted by the Company inthe first quarter of its fiscal year 2008. The Company is evaluating thepotential impact of SFAS No. 157 on its results of operations and financialposition.

7

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** **

 

**Note 2. ****Stock-Based Compensation**

The Company has equity incentive plans (“Plans”) underwhich it may grant stock options, restricted stock, stock units and stockappreciation rights to employees, consultants and directors.  At September 30, 2006, the total number ofshares available for issuance under the Plans is 1,841,876.  Options granted under the Plans have acontractual term up to ten years, generally vest over four years at the rate of25 percent on the one-year anniversary of the vesting commencement dateand ratably each month thereafter and are exercisable under conditionsdetermined by the Board as permissible under the terms of the Plans.

Effective January 1, 2006, the Company adoptedStatement of Financial Accounting Standards No. 123 (revised 2004), *Share-Based Payment*, (“SFAS 123(R)”) whichrequires 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 adoption of SFAS 123(R), the Company accounted forstock-based compensation awards issued to its employees using theintrinsic value measurement provisions of Accounting Principles Board OpinionNo. 25 (“APB Opinion No. 25”), *Accountingfor Stock Issued to Employees*. In March 2005, the Securities and Exchange Commission (“SEC”) issuedStaff Accounting Bulletin No. 107 (“SAB No. 107”) relating to SFAS 123(R).The Company has applied the provisions of SAB No. 107 in its adoption of SFAS123(R).

The Company adopted SFAS 123(R) using the prospectivetransition method. Under this method, SFAS 123(R) is applied to new awards andto awards modified, repurchased or cancelled after the adoption date of January1, 2006.  Compensation cost previouslyrecorded under APB Opinion No. 25 for awards outstanding at the adoption date,such as unvested options, will continue to be recognized as the optionsvest.  Accordingly, for the three andnine months ended September 30, 2006, stock based compensation expense includescompensation cost related to estimated fair values of awards granted after thedate of adoption of SFAS 123(R) and compensation costs related to unvestedawards at the date of adoption based on the intrinsic values as previouslyrecorded under APB Opinion No. 25.

The following table summarizes the distribution ofstock-based compensation expense (in thousands):
| ** **                              | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                              | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                              | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Cost of revenues                        |       | $                                | 35         |                            | $          | 8 |   | $ | 72 |   | $ | 26 |   |
| Research and  development               |       | 174                              |       | 109                             |       | 909 |   | 315 |   |
| Selling, general  and administrative    |       | 342                              |       | (21                             | )          | 807 |   | 265 |   |
| Related tax  effect                     |       | (34                              | )          | —                          |       | (60 | ) | — |   |
| Total stock-based  compensation expense |       | $                                | 517        |                            | $          | 96 |   | $ | 1,728 |   | $ | 606 |   |

 

Thefair value of options granted after January 1, 2006 is estimated on the grantdate using the Black-Scholes option valuation model.  This valuation model for stock compensationexpense requires the Company to make assumptions and judgments about thevariables used in the calculation including the expected term (weighted averageperiod of time that the options granted are expected to be outstanding), thevolatility of Techwell’s common stock, an assumed risk free interest rate andthe estimated forfeiture rate of unvested stock options. To the extent actualresults differ from the estimates, the difference will be recorded as acumulative adjustment in the period estimates are revised. No compensation costis recorded for options that do not vest. Since the Company’s stock has not been actively traded in the past, theCompany uses the simplified calculation of expected term described in SAB No.107 and volatility is based on an average of the historical volatilities of thecommon stock of several entities with characteristics similar to those of theCompany.  The risk-free rate is based onthe U.S. Treasury yield curve in effect at the time of grant for periodscorresponding with the expected term of the option.  The estimated forfeiture rate is based on theCompany’s historical experience and is estimated at 10%.   The Company uses the straight-line methodfor expense attribution for options granted after January 1, 2006, and valuedin accordance with SFAS 123(R).

8

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** **

Thefollowing assumptions are used to value stock options granted after adoption ofSFAS 123(R):

|                          | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  |
|--------------------------|------------|----------------------------------|------------|----------------------------------|
| ** **               | ** ** | **September 30, 2006** | ** ** | **September 30, 2006** |
|                     |       |                             |       |                             |
| Expected term in  years  |       | 6.08                             |       | 6.08                             |
| Risk-free  interest rate |       | 4.85                             | %          | 4.55% - 5.0%                     |
| Expected  volatility     |       | 72.6                             | %          | 72.6% - 74.1%                    |
| Dividend yield           |       | 0                                | %          | 0%                               |

 

Thetotal compensation cost attributable to activities capitalized in inventory wasnot significant in the three and nine months ended September 30, 2006.

Under the provisions of APB Opinion No. 25, theCompany recognized deferred stock-based compensation based on the excess of thedeemed fair value of the underlying stock over the stock option exercise priceat the date of grant.  From April 2005through December 2005, the Company granted options with exercise pricesequal to the fair value of the common stock determined by the board ofdirectors at the time of the grants. Techwell subsequently obtained valuationsfrom an unrelated valuation specialist that were used to establishretroactively the fair value of its common stock. This retroactive fair valueexceeded the fair value established by the board of directors at the time ofthe grants. As a result, the Company recorded deferred stock-basedcompensation.  For options granted in earlier periods, the fair value ofthe common stock was originally based on estimates made by theboardof directors at the date of each grant. The Company did not obtain valuationsby a valuation specialist. Subsequent to the grant date, when the Companyprepared its financial statements, it performed retrospective valuations of itscommon stock using the probability-weighted expected return method. The Companyused the values determined to record retroactively stock compensation based onthe difference between the subsequently determined fair value and the exerciseprice.  For options granted prior toJanuary 1, 2006, the Company uses the multiple grant approach for expense attribution,which results in substantially higher amounts of amortization in earlier yearsas opposed to the straight-line method, which results in equal amortizationover the vesting period of the options. Under the multiple grant approach,forfeitures of unvested options resulting from employee terminations result inthe reversal of previously expensed stock compensation associated with theunvested options during the period in which the forfeiture occurs. Stock-basedcompensation expense from vested options is not reversed.

SFAS 123(R) requires thecash flows resulting from the tax benefits for tax deductions resulting fromthe exercise of stock options in excess of the compensation expense recordedfor those options (excess tax benefits) to be classified as cash from financingactivities. The Company recorded excess tax benefits of $22,000 in the threeand nine months ended September 30, 2006.

The following table summarizes stock option activityduring the nine months ended September 30, 2006 under all stock option plans:
| ** **                                 | ** ** | **Number  of  Shares** | ** ** | **Weighted-  Average  Exercise  Price per  Share** | ** ** | **Weighted-  Average  Remaining  Contractual  Term  (in years)** | ** ** | **Aggregate  Intrinsic  Value**(in 000’s) | ** ** |
|--------------------------------------------|------------|------------------------|------------|---------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| Options  outstanding at December 31, 2005  |       | 2,417,728              |       | $                                                       | 1.22       |                                                                  |       |                                                |       |   |
| Options granted                            |       | 697,000                |       | $                                                       | 9.88       |                                                                  |       |                                                |       |   |
| Options exercised                          |       | (406,204               | )          | $                                                       | 0.72       |                                                                  |       |                                                |       |   |
| Options cancelled                          |       | (189,138               | )          | $                                                       | 2.38       |                                                                  |       |                                                |       |   |
| Options  outstanding at September 30, 2006 |       | 2,519,386              |       | $                                                       | 3.61       |                                                                  | 7.47       |                                                | $          | 28,653 |   |
|                                       |       |                   |       |                                                    |       |                                                                  |       |                                                |       |
| Options exercisable at  September 30, 2006 |       | 1,127,823              |       | $                                                       | 0.80       |                                                                  | 5.60       |                                                | $          | 15,993 |   |

 

9

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** **

**The fair value of options accounted for in accordance withSFAS 123(R) and vested in the nine months ended September 30, 2006 is$672,000.  The weighted-average fairvalue of options granted in the nine months ended September 30, 2006 is$6.88.   Total compensation cost ofoptions granted but not yet vested as of September 30, 2006 was $4.1 million,which is expected to be recognized over the weighted-average period of1.75 years.**

** **

*AdjustmentsDuring the Quarter Ended March 31, 2006*

Subsequentto the issuance of the 2005 financial statements, management determined that ithad underestimated the fair value of its common stock at the time of its stockoption grants in November and December 2005. As a consequence, at December 31,2005 deferred stock-based compensation, additional paid-in capital andoperating expenses were understated by $422,000, $466,000 and $44,000,respectively, for employee stock options, and additional paid-in capital andoperating expenses were understated by $3,000 for nonemployee stock options. Inaddition, management found that variable accounting had been incorrectly usedfor certain foreign employee stock options resulting in overstatements ofdeferred stock-based compensation, additional paid-in capital and operatingexpenses by $78,000, $127,000 and $49,000, respectively. The aggregate impactof these adjustments as of December 31, 2005 is an understatement of deferredstock-based compensation, additional paid-in capital and operating expenses of$344,000, $342,000 and $2,000, respectively. Management has determined that theimpact of these errors on the 2005 annual financial statements and on thefourth quarter of 2005 is not material using the guidance of SEC SAB No. 99, *Assessing Materiality*. Accordingly, the cumulativeadjustment to correct these errors was recorded in the financial statements forthe quarter ended March 31, 2006. Management does not believe the correction ofthese errors is material to the financial statements for the three months endedMarch 31, 2006 or for the nine months ended September 30, 2006 and does notbelieve that it will be material to the 2006 annual financial statements.

**Note 3.  Net Income Per Share**

The Companycalculates net income per share in accordance with SFAS No. 128, *Earnings Per Share.*  Under SFAS No. 128, basic net income pershare is computed by dividing net income for the period by the weighted averagenumber of common stock shares outstanding during the period excluding sharessubject to repurchase. Diluted net income per share is computed by dividing thenet income for the period by the weighted average number of common and dilutivepotential common equivalent shares outstanding during the period.  Dilutive potential common equivalent sharesconsist of convertible preferred stock, common stock options and common stocksubject to repurchase.

A reconciliation of shares used in the calculation ofbasic and diluted net income per share is as follows (in thousands):
| ** **                                                                          | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                          | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                                          | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                                |       |                             |       |                            |       |   |   |   |   |
| Weighted average  common shares outstanding                                         |       | 20,162                           |       | 4,104                           |       | 10,290 |   | 3,933 |   |
| Weighted average  shares subject to repurchase                                      |       | (69                              | )          | (58                             | )          | (77 | ) | (31 | ) |
| Shares used to  calculate basic net income per share                                |       | 20,093                           |       | 4,046                           |       | 10,213 |   | 3,902 |   |
| Effect of  dilutive securities:                                                     |       |                             |       |                            |       |   |   |   |   |
| Convertible preferred stock                                                         |       | —                           |       | 12,777                          |       | 7,866 |   | 12,639 |   |
| Common stock options and unvested common shares  subject to repurchase or cancelled |       | 1,694                            |       | 1,749                           |       | 1,715 |   | 1,674 |   |
| Dilutive  potential common stock                                                    |       | 1,694                            |       | 14,526                          |       | 9,581 |   | 14,313 |   |
| Shares used to  calculate dilutive net income per share                             |       | 21,787                           |       | 18,572                          |       | 19,794 |   | 18,215 |   |

 

The completion of the Company’s IPO in June 2006resulted in the conversion to common stock of all outstanding shares ofconvertible preferred stock.  As aconsequence, the shares used to calculate basic net income per share haveincreased by the weighted average impact of the 12,777,118 shares of commonstock issued on conversion of 

10

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** **

# theconvertible preferred stock and the 2,540,225 shares of common stock issued inthe IPO and 130,000 shares of common stock issued in July 2006 following theunderwriters’ partial exercise of their over-allotment option related to theIPO. For periods prior to the IPO, the weighted shares used to calculatediluted net income per share include the effect of the convertible preferredstock.

 

# **Note 4. Investments**

Short-terminvestments at September 30, 2006 are consideredavailable-for-sale and consist of corporate bonds, U.S. government agencysecurities and auction rate securities. Long-term investment at September 30,2006 is also considered available-for-sale and consists of a corporate bond.These securities are carried at fair market value based on market quotes.Unrealized gains and losses, net of tax, are reported as a separate componentof stockholders’ equity and included in “Accumulated other comprehensive loss”.  Realized gains and losses are recorded basedon the specific identification method and are not significant in any periodpresented.

**Note 5.  Detailsof Certain Balance Sheet Components**

**Inventory**(inthousands):

|                 | ** ** | **September 30, 2006** | ** ** | **December 31, 2005** | ** ** |
|-----------------|------------|----------------------------------|------------|---------------------------------|------------|
| Finished goods  |       | $                                | 2,461      |                            | $          | 1,306 |   |
| Work in process |       | 3,732                            |       | 1,807                           |       |
|            |       | $                                | 6,193      |                            | $          | 3,113 |   |

 

**Property and equipment, net**(inthousands):

|                                                 | ** ** | **September 30, 2006** | ** ** | **December 31, 2005** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| Equipment and  software                         |       | $                                | 1,123      |                            | $          | 891 |   |
| Furniture and  fixtures                         |       | 310                              |       | 273                             |       |
| Leasehold  improvements                         |       | 143                              |       | 91                              |       |
|                                            |       | 1,576                            |       | 1,255                           |       |
| Less accumulated  depreciation and amortization |       | (998                             | )          |                            | (821       | ) |   |
|                                            |       | $                                | 578        |                            | $          | 434 |   |
|                                                 |            |                                  |            |                                 |            |  |  |  |  |

 

**Accrued liabilities**(inthousands):

|                                             | ** ** | **September 30, 2006** | ** ** | **December 31, 2005** | ** ** |
|---------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| Accrued  compensation                       |       | $                                | 1,560      |                            | $          | 551 |   |
| Accrued  inventory purchases                |       | 617                              |       | 239                             |       |
| Accounting and  legal professional services |       | 245                              |       | 1,274                           |       |
| Exercise of  unvested stock options         |       | 122                              |       | 159                             |       |
| Income taxes  payable                       |       | 418                              |       | 135                             |       |
| Other                                       |       | 364                              |       | 329                             |       |
|                                        |       | $                                | 3,326      |                            | $          | 2,687 |   |

 

**Note 6.  SegmentInformation**

Asdefined by the requirements of SFAS No. 131, *DisclosureAbout Segments of an Enterprise and Related Information,* the Companycurrently operates in one reportable segment, the designing, marketing andselling of mixed signal integrated circuits for multiple video applications inthe consumer, security surveillance and automotive markets. The Company’s chiefoperating decision maker is its chief executive officer.  Enterprise-wide information is provided inaccordance with SFAS No. 131. Geographical revenue information is based on thecustomer’s ship-to location. Long-lived assets consist of property, plant andequipment.  Property, plant and equipmentinformation is based on the physical location of the assets at the end of eachreporting period.

11

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The percentage of total revenues by geographic areaare as follows:
| ** **      | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **      | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **      | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| South Korea     |       | 26                               | %          | 41                              | %          | 30 | % | 42 | % |
| Taiwan          |       | 48                               | %          | 38                              | %          | 45 | % | 41 | % |
| China/Hong Kong |       | 21                               | %          | 16                              | %          | 20 | % | 12 | % |
| Japan           |       | 4                                | %          | 4                               | %          | 3 | % | 3 | % |
| United States   |       | 1                                | %          | 1                               | %          | 1 | % | 1 | % |
| Other           |       | —                           |       | —                          |       | 1 | % | 1 | % |
| Total           |       | 100                              | %          | 100                             | %          | 100 | % | 100 | % |

 

Revenues by product line are as follows (in thousands):
| ** **                | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Security  Surveillance(1) |       | $                                | 7,333      |                            | $          | 4,009 |   | $ | 17,996 |   | $ | 8,798 |   |
| Video  Decoders(2)        |       | 5,667                            |       | 4,332                           |       | 14,764 |   | 11,969 |   |
| LCD Display(3)            |       | 2,001                            |       | 1,228                           |       | 4,281 |   | 3,719 |   |
| Other(4)                  |       | 100                              |       | 308                             |       | 661 |   | 773 |   |
| Total                     |       | $                                | 15,101     |                            | $          | 9,877 |   | $ | 37,702 |   | $ | 25,259 |   |

 

----

(1)    Consistsof application specific products designed for use in security surveillancesystems.

(2)    Consistsof general-purpose video decoders designed for use in the consumer, securitysurveillance and automotive markets. Revenues from general purpose videodecoders used in security surveillance systems and LCD displays are reported underthe video decoder product line and not the security surveillance or LCD displayproduct lines.

(3)    Consistsof application specific products designed for use in LCD displays.

(4)    Consistsof early generation mixed signal semiconductors for digital video applicationsand a PCI video decoder product.

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

| Country       | ** ** | **September 30, 2006** | ** ** | **December 31, 2005** | ** ** |
|---------------|------------|----------------------------------|------------|---------------------------------|------------|
| United States |       | $                                | 489        |                            | $          | 306 |   |
| Taiwan        |       | 70                               |       | 91                              |       |
| South Korea   |       | 14                               |       | 37                              |       |
| China         |       | 5                                |       | —                          |       |
| Total         |       | $                                | 578        |                            | $          | 434 |   |

 

12

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The revenues and accounts receivable from customersrepresenting 10% or more of total revenues and accounts receivable are asfollows:
| ** **   | ** ** | **Accounts Receivable at** | ** ** | **Revenues**          | ** ** |
|--------------|------------|--------------------------------------|------------|-----------------------|------------|
| ** **   | ** ** | **September 30,**               | ** ** | **December 31,** | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
| **Customer** | ** ** | **2006**                             | ** ** | **2005**              | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
| A            |       | *                                    | %          | 15                    | %          | * | % | * | % | * | % | 10 | % |
| B            |       | *                                    |       | *                     |       | 16 |   | 12 |   | 14 |   | 10 |   |
| C            |       | 16                                   |       | *                     |       | * |   | * |   | * |   | * |   |
| D            |       | *                                    |       | *                     |       | 17 |   | * |   | 14 |   | * |   |
| E            |       | 22                                   |       | *                     |       | * |   | * |   | * |   | 12 |   |
| F            |       | *                                    |       | 18                    |       | * |   | * |   | * |   | * |   |
| G            |       | 12                                   |       | 12                    |       | * |   | * |   | * |   | * |   |
| H            |       | 12                                   |       | 11                    |       | 11 |   | * |   | * |   | * |   |

 

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*   less than 10%

# **Note 7.  Related Party Transactions**

Onemember of the Company’s board of directors is a partner in a law firm thatprovides services to the Company. The Company incurred fees of $21,000 and$54,000 to this law firm for legal services in three months ended September 30,2006 and 2005, respectively. The Company incurred fees of $101,000 and $179,000to this law firm for legal services in the nine months ended September 30, 2006and 2005, respectively.  The amountpayable to this law firm was $10,000 at September 30, 2006 and $53,000 atDecember 31, 2005.

# **Note 8.  Provision for Income Taxes**

The Company’s effective tax rate is based on theestimated annual effective tax rate in accordance with SFAS No. 109, *Accounting for Income Taxes*.  A provision for income taxes of $440,000 and$52,000 was recorded in the three months ended September 30, 2006 and 2005,respectively.  A provision for incometaxes of $1,194,000 and $120,000 was recorded in the nine months endedSeptember 30, 2006 and 2005, respectively.  The effective tax rate differed from the statutory federal income taxrate because the Company utilized prior net operating losses to offset profitsmade in the current period.

InNovember 2005, the FASB issued FSP No. FAS 123(R)-3 which describes analternative transition method for calculating the tax effects of stock-basedcompensation pursuant to SFAS 123(R). The alternative transition methodincludes simplified methods to establish the beginning balance of theadditional paid-in capital pool (APIC pool) related to the tax effects ofemployee stock-based compensation, and to determine the subsequent impacton the APIC pool and the statement of cash flows of the tax effects of employeestock-based compensation awards that are outstanding upon adoption ofSFAS 123(R).

**Note 9.  Commitments and Contingencies**

On September 26, 2005, we filed an administrativeaction on behalf of an original equipment manufacturer (OEM) in South Koreaagainst Alogics Co., Ltd. (Alogics), a semiconductor company in South Korea,seeking a determination that the OEM’s product offering which incorporates ourTW2834 product does not infringe a patent held by Alogics.   OnFebruary 13, 2006, the South Korean Intellectual PropertyTribunal rendered a decision in the action determining that the OEM’sproduct offering which incorporates our TW2834 product does not infringe thepatent held by Alogics.  On March 10, 2006, Alogics filed an appealwith the Korean Patent Court (KPC).  All arguments have been presented inthis action and we are awaiting a final determination.  We do not believethe resolution of this matter will result in a material adverse impact on ourfinancial position, results of operations or cash flows.  However, anadverse determination could result in further legal action against us ina Korea district court.

# **Note 10.  Subsequent Event**

On November 6, 2006, theCompany signed a new lease agreement for its current headquarter facility thatwill accommodate its principal administrative, sales, marketing, support andresearch and development functions. Under the new lease agreement beginning onJanuary 1, 2007, the Company will continue occupying approximately 27,900square feet of space in San Jose, California with the lease expiring onDecember 31, 2011.

13

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

*The following discussion of our financialcondition and results of operations should be read in conjunction with thecondensed consolidated financial statements and notes to those statementsincluded elsewhere in this Quarterly Report on Form 10-Q as ofSeptember 30, 2006 and our audited financial statements for the year-endedDecember 31, 2005 included in our Registration Statement on Form S-1previously filed with the SEC.*

*This report contains forward-lookingstatements that involve risks and uncertainties.  These statements relateto future periods, future events or our future operating or financial plans orperformance.  These statements can often be identified by the use offorward-looking terminology such as “expects,” “believes,” “intends,”“anticipates,” “estimates,” “plans,” “may,” or “will,” or the negative of theseterms, and other similar expressions.  These forward-looking statementsinclude statements as to the source of our revenues, our ability to generaterevenues, our ability to sustain our growth rate and profitability, ourexpectation regarding the increase in certain expenses, our cash needs, ourcapital requirements, and our market risk sensitivity.*

*These forward-looking statements reflectour current views with respect to future events are based on assumptions andare subject to risks and uncertainties.  These risks and uncertaintiescould cause actual results to differ materially from those projected andinclude, but are not limited to, fluctuations in our revenue and operatingresults, the demand for digital video applications for the consumer, securitysurveillance and automotive markets, our ability to compete, our dependence onkey and highly skilled personnel, the ability to develop new products and toenhance our existing products, our ability to integrate businesses that we mayacquire, our ability to estimate and predict customer demand,**economicvolatility in either domestic or foreign markets, our reliance on independentfoundries and subcontractors for the manufacture, assembly and testing of ourproducts, our ability to protect our intellectual property, the cyclical natureof the semiconductor industry, our ability to raise capital, the potentialvolatility of our stock, and the risks set forth under Item 1A. “RiskFactors.”  Given these risks and uncertainties, you should not place unduereliance on these forward-looking statements.  Except as required byfederal securities laws, we undertake no obligation to update anyforward-looking statements for any reason, even if new information becomesavailable or other events occur in the future.*

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

*Techwell is our registeredtrademark.  We also refer to trademarks of other corporations andorganizations in this Form 10-Q.*

***Overview***

We area fabless semiconductor company that designs, markets and sells mixed signalintegrated circuits for multiple video applications in the consumer, securitysurveillance and automotive markets. We target video applications based ondigital technologies that receive and process analog video signals. These videoapplications include advanced TVs, multifunction LCD monitors, DVD recorders,camcorders, security surveillance systems and in-car displays. Theseapplications receive analog video signals commonly generated by over-the-air TVbroadcasts, by consumer electronics devices such as set-top boxes, DVD players,VCRs and camcorders and by surveillance cameras. We design both general purposeand application specific products that enable the conversion of analog videosources to digital form and perform advanced digital video processing tofacilitate the display, storage and transport of video content. We believe thisproduct strategy allows us to better address varying customer requirements,fully leverage our technology capabilities and achieve greater share within ourtarget markets. Our semiconductors are based on our proprietary architectureand mixed signal technologies that we believe provide high video quality undera wide range of signal conditions, enable high levels of integration and arecost effective.

Wecommenced operations in 1997. From 1997 to 1999, we were primarily involved indeveloping our technology. We shipped our first generation video decoder in1999. Since 1999, our business has experienced significant growth primarily asa result of our ability to develop new products, obtain design wins and convertthesedesign wins into revenues. We generated revenues fromthe sale of over 20 different products in the three months endingSeptember 30, 2006.

Wehave three principal semiconductor product lines: video decoder products,security surveillance products and liquid crystal display, or LCD, products.Our video decoder products, which we view as general purpose products, arehigh-performance mixed signal semiconductors that decode analog TV broadcastsignals, including National Television Systems Committee, or NTSC, phase alternationline, or PAL, and sequential color with memory, or SECAM, and popular analogvideo signals, including composite, S-Video, component and Syndicate of Radioand Television Manufacturers, or SCART, into a standard digital format. Oursecurity surveillance products integrate important functions required todisplay, store and transport analog video signals from security surveillancecameras. In March 2006, we introduced two new security 

14

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surveillanceproducts, each of which includes four video decoders and a system controller ona single semiconductor. We also introduced in March 2006 a semiconductor in theCODEC segment for digital video decoder applications designed specifically forthe security surveillance market. Our LCD display products integrate importantfunctions required to display analog TV broadcast, popular analog video, highdefinition video and PC graphics signals on an LCD display. In January 2006, weannounced the introduction of three new LCD display processors designed for theautomotive end market. These new products are designed to provide advancedimage processing, an integrated programmable timing controller and multipleanalog and digital video inputs. Our other products include early generation mixedsignal semiconductors for digital video applications and a PCI video decoderproduct, which is a video decoder that utilizes peripheral componentinterconnect, or PCI, technology for personal computer applications.

Althoughour revenues have grown rapidly in a short period of time, we do not expect toachieve similar growth rates in the future. We currently expect to increase ourexpense levels in each of the next several quarters to support increased researchand development and sales and marketing efforts. These expenditures may notresult in increased revenue or profitability in the future. In addition, ourability to increase our revenues will depend on increased demand for digitalvideo applications in the consumer, security surveillance and automotivemarkets. 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, can cause our revenue growth to be inconsistent.

Weundertake significant product development efforts well in advance of aproduct’s release, and in advance of receiving purchase orders from ourcustomers. Our product development efforts, which are focused on developing newdesigns with broad demand and potential for future derivative products,typically take from six months to two years until production begins, dependingon the product’s complexity. If we secure a design win, the system designer islikely to continue to use the same or enhanced versions of our product across anumber of their models, which tends to extend the life cycles of our product.Conversely, if a competitor secures the design win, it may be difficult for usto sell into the customer’s application for an extended period. Our sales cycletypically ranges from six to 12 months. Due to the length of our productdevelopment and sales cycle, the majority of our revenues for any period isgenerally weighted toward products introduced for sale, meaning products forwhich we commenced placing orders with our manufacturing subcontractors, in theprior one or two years. As a result, our present revenues are not necessarilyrepresentative of future sales because our future sales are likely to becomprised of a different mix of products, some of which are now in thedevelopment stage.

As afabless semiconductor company, we outsource all of our manufacturing, assemblyand test functions to third-party vendors primarily located in Taiwan. Thisbusiness model enables us to reduce our capital expenditures and fixed costs,while focusing our engineering and design resources on our core strength, thedesign of mixed signal semiconductors for digital video applications. Webelieve this model also reduces the impact on our business of potential endmarket seasonality, cyclicality and fluctuations in demand.

Wesell our products to distributors that fulfill third-party orders for ourproducts. We also sell directly, using independent sales representatives, toOEMs such as Samsung and LG Electronics, which have historically been some ofour largest customers, and to original design manufacturers, or ODMs. In thethree months ended September 30, 2006, we derived approximately 82% of ourrevenues from products sold to distributors and 18% from products sold to OEMsor ODMs.  In the nine months endedSeptember 30, 2006, we derived approximately 79% of our revenues fromproductssold to distributors and 21% from products sold to OEMs or ODMs.  In 2005, we derived 65% of our revenues fromproducts sold to distributors and 35% from products sold to OEMs or ODMs. Ourgross margins have not historically been significantly different between salesto distributors and sales to OEMs or ODMs through orders procured byindependent sales representatives. However, our operating profit on salesthrough orders procured by independent sales representatives can be less due tothe payment of commissions to sales representatives which we record as salesand marketing expense.

Wereceived an aggregate of 81% and 73% of our revenues from our ten largestcustomers in the three months ended September 30, 2006 and 2005, respectively.For the three months ended September 30, 2006, three of our customers accountedfor 17%, 16%, and 11%, respectively, of our revenues. For the three monthsended September 30, 2005, one of our customers accounted for 12% of ourrevenues.  For the nine months endedSeptember 30, 2006, two of our customers each accounted for 14% of ourrevenues. For the nine months ended September 30, 2005, three of our customersaccounted for 12%, 10% and 10%, respectively, of our revenues.

Wederive substantially all of our revenues from sales to foreign customers,particularly in Asia. In the three months ended September 30, 2006,approximately 99% of our revenues were from sales in Asia, including 48% inTaiwan, 26% in 

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South Korea, 21%in China and 4% in Japan. In the three months ended September 30, 2005,approximately 99% of our revenues were from sales in Asia, includingapproximately 38% in Taiwan, 41% in South Korea, 16% in China and 4% inJapan.  In the nine months endedSeptember 30, 2006, approximately 98% of our revenues were from sales in Asia,including approximately 45% in Taiwan, 30% in South Korea, 20% in China and 3%in Japan. In the nine months ended September 30, 2005, approximately 98% of ourrevenues were from sales in Asia, including approximately 41% in Taiwan, 42% inSouth Korea, 12% in China and 3% in Japan. We believe that a substantialmajority of our revenues will continue to come from customers located in Asia,where most of the consumer electronic devices that use our integrated circuits,or ICs, are manufactured. As a result of this regional customer concentration,we may be subject to economic and political events and other developments thatimpact our customers in Asia. However, all of our sales, substantially all ofour cost of revenues and a majority of our operating expenses are denominatedin U.S. dollars. As a consequence, we believe that our overall exposure toforeign exchange risk is low.

Wehave two international branches, one in South Korea and one in Taiwan and werecently established a subsidiary in China. As of September 30, 2006, 37 of our95 employees were located in our international subsidiary and two internationalbranches. Our South Korea branch is primarily involved in product developmentand is also involved in technical sales support. Our China subsidiary and ourTaiwan branch provide sales and marketing support.

It isdifficult for us to forecast the demand for our products, in part because ofthe highly complex supply chain between us and the end markets that incorporateour products. Demand for new features changes rapidly. Distributors and ODMsadd an additional layer of complexity. We must, therefore, forecast demand notonly from our direct customers, but also from other participants in thismulti-level distribution channel. Because of our lengthy product developmentcycle, it is critical for us to anticipate changes in demand for our variousproduct features and the applications they serve, to allow sufficient time forproduct design. Our failure to accurately forecast demand can lead to productshortages that can impede production by our customers and harm our relationshipwith these customers. Conversely, our failure to forecast declining demand orshifts in product mix can result in excess or obsolete inventory.

Generally,the average selling price of our products will decline over the life of theproduct. Our experience to date is that the decline has not had a materialeffect on our gross margins, as price reductions have been mitigated by lowerper unit costs associated with both high unit volume and the transition of ourproducts to smaller process geometries. Our video decoder and LCD displayproducts that are sold into consumer applications are subject to theseasonality connected with the consumer market. As a result, we expect revenuesfrom these products to be lower in the first calendar quarter of the year.

Ourrevenues increased by 53% for the three months ended September 30, 2006compared to the three months ended September 30, 2005 and net income increasedto $4.5 million for the three months ended September 30, 2006 from $1.3 millionfor the three months ended September 30, 2005. Our revenues increased by 49%for the nine months ended September 30, 2006 compared to the nine months endedSeptember 30, 2005 and net income increased to $8.4 million for the nine monthsended September 30, 2006 from $2.8 million for the three months ended September30, 2005. However, we had an accumulated deficit of $14.9 million as ofSeptember 30, 2006 and we may not be able to maintain our recent growth andprofitability. Our limited operating history makes the prediction of futureoperating results very difficult. We believe that period-to-period comparisonsof operating results should not be relied upon as predictive of futureperformance.

**CriticalAccounting Policies**

Ourdiscussion and analysis of our financial condition and results of operationsare based upon our condensed consolidated financial statements, which have beenprepared in accordance with accounting principles generally accepted in theUnited States. The preparation of these financial statements requires us tomake estimates and judgments that affect the reported amount of assets,liabilities, revenues and expenses and related disclosure of contingent assetsand liabilities. We evaluate our estimates on an on-going basis, includingthose related to inventory valuations, income taxes, warranty obligations andstock-based compensation. We base our estimates on historical experience and onvarious other assumptions that we believe to be reasonable under thecircumstances, the results of which form the basis for making the judgments wemake about the carrying values of assets and liabilities that are not readilyapparent from other sources. Because these estimates can vary depending on thesituation, actual results may differ from the estimates.

Webelieve the following critical accounting policies affect our more significantjudgments used in the preparation of our condensed consolidated financialstatements.

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*Revenue Recognition.  *Revenues from product sales are recognized uponshipment, provided title and risk of loss has passed to the customer, whenpersuasive evidence of an arrangement exists, the price is fixed ordeterminable and collectibility is probable. We do not allow for priceprotection or stock rotation rights with any of our distributors.

*Warranty.  *Weoffer a one-year product replacement warranty against any defective product. Weaccrue for estimated returns of defective products at the time revenue isrecognized, based on the rate of return for the prior 12 months. As aconsequence of standardized manufacturing processes and product testing procedures,returns of defective product are infrequent and the quantities have not beensignificant. Accordingly, historical warranty costs have not been significantin the fiscal periods presented.

*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 andobsolescence and write-off units that are unlikely to be sold based upon a sixmonths’ demand forecast. This evaluation may take into account matters includingexpected demand, anticipated sales price, product obsolescence and otherfactors. If actual future demand for our products is less than currentlyforecasted, additional inventory adjustments may be required. Once a reserve isestablished, it is maintained until the product to which it relates is sold orscrapped. If a unit that has been written down or off is subsequently sold, thecost associated with the revenue from this unit is reduced to the extent of thewrite off, resulting in an increase in gross profit.

*Accounting for Income Taxes.  *We account for incometaxes under the provisions of SFAS, No. 109, *Accountingfor Income Taxes*. In applying SFAS No. 109, we are required toestimate our current tax expense together with assessing temporary differencesresulting from differing treatments of items for tax and accounting purposes.These differences result in deferred tax assets and liabilities. Significantmanagement judgment is required to assess the likelihood that our deferred taxassets will be recovered from future taxable income. As of December 31, 2005,our total deferred tax assets were principally comprised of net operating losscarryforwards, research and other credit carryforwards and expense accruals. Asof December 31, 2005, based on the available objective evidence, we believed itis more likely than not that our deferred tax assets will not be realizable. Webased this belief primarily on the fact that, despite our pre-tax income forthe year ended December 31, 2005, we have incurred cumulative pre-tax losses inall prior years. Accordingly, we provided a full valuation allowance againstour net deferred tax assets as of December 31, 2005. Should sufficientpositive, objectively verifiable evidence of the realization of our netdeferred tax assets exist at a future date, we would reverse any remainingvaluation allowance to the extent supported by estimates of future taxableincome at that time.

As ofDecember 31, 2005, we had approximately $14.9 million of federal and $9.2million of state net operating loss carryforwards available to offset futuretaxable income. If not utilized, these carryforwards will expire beginning in2020 for federal tax purposes and in 2012 for state tax purposes. We also haveresearch and other tax credit carryforwards of approximately $0.8 million forboth federal and state income tax purposes. If not utilized, the federalcarryforwards will expire in various amounts beginning in 2012. The state taxcredits can be carried forward indefinitely.

In thefuture we expect, as we have historically experienced, that substantially allof our revenues will come from foreign locations. As such, we are transferringcertain functions to our foreign operations that are geographically closer toour suppliers and customers. Some of these activities may include order entry,purchasing and billing functions. We have not yet decided where to relocatethese functions as we are continuing to evaluate the locations in which it willbe most efficient to conduct these operating activities. However, we do notcurrently anticipate any material changes in personnel or facilities. Ourforeign locations are in tax jurisdictions with income tax rates lower than theUnited States statutory income tax rates. Consequently, we believe that ourfuture effective income tax rate will eventually be less than the United Statesstatutory income tax rates because we do not intend to remit these earningsfrom our foreign subsidiary back to the United States. Our future effectiveincome tax rate will be subject to many variables, including the absoluteamount and future geographic distribution of our pre-tax income, our ability tosuccessfully transfer our operating activities to our foreign operations andthe amount and timing of intercompany payments from our foreign operationssubject to United States income taxes related to the transfer of certain rightsand functions. As a result of any of these factors, our future effective incometax rate is likely to fluctuate significantly over the next few years.

*Stock-Based Compensation.  *Effective January 1, 2006, we adopted SFAS No. 123(revised 2004), *Share-Based Payment*,or SFAS 123(R), which requires that we measure compensation expense for allshare-based payment awards made to employees and directors, including employeestock options, based on estimated fair values and recognize that expense overthe required service period. Prior to adoption of SFAS 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 25.

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Weadopted SFAS 123(R) using the prospective transition method. Under this method,SFAS 123(R) is applied to new awards and to awards modified, repurchased orcancelled after January 1, 2006. Compensation cost previously recorded underOpinion 25 for unvested options will continue to be recognized as the requiredservices are rendered. Accordingly, for the three and nine months ended September30, 2006, stock based compensation expense includes compensation costs relatedto estimated fair values of awards granted after the date of adoption of SFAS123(R) and compensation costs related to unvested awards at the date ofadoption based on the intrinsic values as previously recorded under Opinion 25.

Foroptions granted after January 1, 2006, and valued in accordance with SFAS123(R), we use the straight-line method for expense attribution. For optionsgranted prior to January 1, 2006, we use the multiple grant approach forexpense attribution, which results in substantially higher amounts ofamortization in earlier years as opposed to the straight-line method, whichresults in equal amortization over the vesting period of the options.

Uponadoption of SFAS 123(R), we were required to estimate the number of outstandingoptions that are not expected to vest. In subsequent periods, if actualforfeitures differ from these estimates, we will revise our estimates. Nocompensation cost is recognized for options that do not vest. Under themultiple grant approach, forfeitures of unvested options resulting fromemployee terminations result in the reversal of previously expensed stockcompensation associated with the unvested options during the period in whichthe termination occurred. Stock compensation expense from vested options is notreversed.

Weestimated the fair value of options granted after January 1, 2006 using theBlack-Scholes option valuation model. This valuation model requires us to makeassumptions and judgments about the variables used in the calculation. Thesevariables and assumptions include the weighted average period of time that theoptions granted are expected to be outstanding, the volatility of our commonstock, the risk free interest rate and the estimated rate of forfeitures ofunvested stock options. If actual results differ from our estimates, we willrecord the difference as a cumulative adjustment in the period we revise ourestimates. Since our stock has not been activelytraded in thepast, we used the simplified calculation of expected term described in theSecurities and Exchange Commission Staff Accounting Bulletin No. 107 and weestimated our stock’s volatility based on an average of the historicalvolatilities of the common stock of several entities with characteristicssimilar to us. The risk-free interest rate is based on U.S. Treasurysecurities. We estimated expected forfeiture rate based on our historicalexperience.

Thefollowing assumptions are used to value stock options granted after adoption ofSFAS 123(R):

|                         | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|-------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **              | ** ** | **September 30, 2006** | ** ** | **September 30, 2006** | ** ** |
| ** **              | ** ** | ** **                       | ** ** | ** **                       | ** ** |
| Expected term in years  |       | 6.08                             |       | 6.08                             |       |
| Risk-free interest rate |       | 4.85                             | %          | 4.55% - 5.0                      | %          |
| Expected volatility     |       | 72.6                             | %          | 72.6% - 74.1                     | %          |
| Dividend yield          |       | 0                                | %          | 0                                | %          |

 

Weaccount for stock-based compensation awards issued to our employees prior toour adoption of SFAS 123(R) on January 1, 2006 using the intrinsicvalue measurement provisions of Opinion 25. Accordingly, we have recordedcompensation expense for stock options granted with exercise prices less thanthe fair value of the underlying common stock at the option grant date.  From April 2005 through December 2005,the Company granted options with exercise prices equal to the fair value of thecommon stock determined by the board of directors at the time of the grants.Techwell subsequently obtained valuations from an unrelated valuationspecialist, that were used to establish retroactively the fair value of itscommon stock. This retroactive fair value exceeded the fair value establishedby the board of directors at the time of the grants. As a result, the Companyrecorded deferred stock-based compensation.  For options granted inearlier periods, the fair value of the common stock was originally based onestimates made by the board of directors at the date of each grant. The Companydid not obtain valuations by a valuation specialist. Subsequent to the grantdate, when the Company prepared its financial statements, it performedretrospective valuations of its common stock using the probability-weightedexpected return method. The Company used the values determined to recordretroactively stock compensation based on the difference between thesubsequently determined fair value and the exercise price.

Underthe provisions of APB Opinion 25, we determine our amortization expensefollowing the multiple grant approach, which results in substantially higheramounts of amortization in earlier years as opposed to the single grantapproach, which results in equal amortization over the vesting period of theoptions. Under the multiple grant method, the amortization in any given periodis significantly impacted by the number and timing of grants within the periodand the 

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amount by whichthe estimated fair value of our stock exceeds the exercise price of the optionand, to a lesser extent, from the amortization of options granted in previousperiods. Forfeitures of unvested options resulting from employee terminations resultin the reversal of previously expensed stock compensation associated with theunvested options during the period in which the forfeiture occurs. Stockcompensation expense from vested options is not reversed.

Stock-based compensation expense is allocated among cost ofrevenues, research and development expenses and selling, general andadministrative expenses, respectively, based upon the employee’s job function.**We expect to continue to recognizesubstantial amounts of stock-based compensation expense relating to ouremployee stock options in future periods primarily as a result of our adoptionof SFAS 123(R).

***Resultsof Operations***

The followingtable is derived from our selected financial data and sets forth our historicaloperating results as a percentage of revenues for the periods indicated:
| ** **                                                         | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| **Consolidated Statement of Operations Data:** | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenues                                                           |       | 100.0                                                | %          | 100.0                                               | %          | 100.0 | % | 100.0 | % |
| Cost of  revenues*                                                 |       | 42.2                                                 |       | 50.6                                                |       | 42.7 |   | 49.3 |   |
| Gross margin                                                       |       | 57.8                                                 |       | 49.4                                                |       | 57.3 |   | 50.7 |   |
|                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| Operating  expenses:                                               |       |                                                 |       |                                                |       |   |   |   |   |
| Research and development*                                          |       | 13.5                                                 |       | 22.4                                                |       | 18.5 |   | 24.2 |   |
| Selling, general and administrative*                               |       | 15.6                                                 |       | 14.1                                                |       | 16.1 |   | 16.0 |   |
|                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| Total operating expenses                                           |       | 29.1                                                 |       | 36.5                                                |       | 34.6 |   | 40.2 |   |
|                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| Income from  operations                                            |       | 28.7                                                 |       | 12.9                                                |       | 22.7 |   | 10.5 |   |
| Interest income                                                    |       | 4.1                                                  |       | 1.0                                                 |       | 2.7 |   | 1.0 |   |
|                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| Income before  income taxes                                        |       | 32.8                                                 |       | 13.9                                                |       | 25.4 |   | 11.5 |   |
| Provision for  income taxes                                        |       | 2.9                                                  |       | 0.5                                                 |       | 3.2 |   | 0.5 |   |
| Net Income                                                         |       | 29.9                                                 | %          | 13.4                                                | %          | 22.2 | % | 11.0 | % |

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(*)    Percentagesinclude stock-based compensation. The table below indicates the percentage ofstock-based compensation attributed to each item as a percentage of revenuesfor the periods indicated:
| ** **                           | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                           | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                           | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Costs and  expenses:                 |       |                             |       |                            |       |   |   |   |   |
| Cost of revenues                     |       | 0.2                              | %          | 0.1                             | %          | 0.2 | % | 0.1 | % |
| Research and  development            |       | 1.2                              |       | 1.1                             |       | 2.4 |   | 1.2 |   |
| Selling, general and  administrative |       | 2.3                              |       | (0.2                            | )          | 2.1 |   | 1.0 |   |

** **

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***Revenues by product line are as follows (inthousands):***
| ** **                | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Security  Surveillance(1) |       | $                                | 7,333      |                            | $          | 4,009 |   | $ | 17,996 |   | $ | 8,798 |   |
| Video  Decoders(2)        |       | 5,667                            |       | 4,332                           |       | 14,764 |   | 11,969 |   |
| LCD Display(3)            |       | 2,001                            |       | 1,228                           |       | 4,281 |   | 3,719 |   |
| Other(4)                  |       | 100                              |       | 308                             |       | 661 |   | 773 |   |
| Total                     |       | $                                | 15,101     |                            | $          | 9,877 |   | $ | 37,702 |   | $ | 25,259 |   |

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(1)    Consistsof application specific products designed for use in security surveillancesystems.

(2)    Consistsof general-purpose video decoders designed for use in the consumer, securitysurveillance and automotive markets. Revenues from general purpose videodecoders used in security surveillance systems and LCD displays are reportedunder the video decoder product line and not the security surveillance or LCDdisplay product lines.

(3)    Consistsof application specific products designed for use in LCD displays.

(4)    Consistsof early generation mixed signal semiconductors for digital video applicationsand a PCI video decoder product.

**Comparisons of the Three Months Ended September 30, 2006 and2005**

*Revenues.*    Our revenuesconsist of sales of our mixed signal integrated circuits for digital videoapplications.  We have three principalproduct lines:  video decoder, securitysurveillance and LCD display.  All of oursales are denominated in U.S. dollars.

Revenues were $15.1 million for the three months endedSeptember 30, 2006 and $9.9 million for the three months ended September 30,2005, an increase of 53%.  Revenues fromour security surveillance products increased approximately $3.3 million, or83%, in the three months ended September 30, 2006 compared to the three monthsended September 30, 2005, primarily as a result of the increase in sales of ourfour-in-one video decoders and our recently introduced integrated securitysurveillance products.  Revenues fromvideo decoder products increased approximately $1.3 million, or 31%, in thethree months ended September 30, 2006 compared to the three months endedSeptember 30, 2005, primarily as a result of a generalincrease in demand from the markets for products such as multi-functionmonitors and DVD recorders,offset by a shift in sales from general-purpose videodecoders to application specific products specifically designed for thesecurity surveillance market. Revenues from our LCD display products increased by $0.8 million, or63%, in the three months ended September 30, 2006 compared to the three monthsended September 30, 2005, primarily as a result of a continuing ramp ofcustomer projects begun from earlier design wins in the automotive market.  Other revenues decreased $0.2 million, or68%, in the three months ended September 30, 2006 as compared with the threemonths ended September 30, 2005, primarily as a result of decreased sales ofour PCI video decoder products.

*Gross Profit and Gross Margin.*  Gross profit is thedifference between revenues and cost of revenues, and gross margin representsgross profit as a percentage of revenues. Cost of revenues, also known as costof goods sold, consists primarily of cost of processed silicon wafers, costsassociated with assembly, test and shipping of our production integratedcircuits, or ICs, cost of personnel and related expenses associated withsupporting our outsourced manufacturing activities and write-downs for excessand obsolete inventory.

Gross profit was $8.7 million for thethree months ended September 30, 2006 and $4.9 million for the three monthsended September 30, 2005, an increase of 79%. Gross margin was 58% for thethree months ended September 30, 2006 increasing from 49% for the three monthsended September 30, 2005.  The increase in gross margin was primarily aresult of reduced materials andproduction costs in the third quarter of 2006 compared to the third quarter of2005.  

We incurred stock-based compensation included in cost ofrevenues associated with outsourced manufacturing support and quality assurancepersonnel of less than $0.1 million in both the three months endedSeptember 30, 2006 and 2005.

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*Research and Development.*    Research anddevelopment expenses consist primarily of compensation and associated costs ofemployees engaged in research and development, contractor costs, tape outcosts, development testing and evaluation costs, occupancy costs anddepreciation expense.  Before releasingnew products, we incur charges for mask sets, prototype wafers and mask setrevisions, which we refer to as tape-out costs. Tape-out costs cause our research and development expenses to fluctuatebecause they are not incurred uniformly every quarter.  We expect our research and development coststo increase in absolute dollars in 2006 as we increase our investment indeveloping new products.

Research and development expenses were $2.0 million, or 14%of revenues, for the three months ended September 30, 2006 and $2.2 million or22% of revenues for the three months ended September 30, 2005.  This decrease is primarily attributable totape-out related expenses which decreased by approximately $0.3 million as theyare not incurred uniformly every quarter.  Approximately $0.4 million of tape-out related expense were planned forbut not incurred for the three months ended September 30, 2006.  We anticipate incurring these expenses in thefourth quarter of 2006.  The decrease intape-out related expenses was partially offset by an increase in compensationexpense due in part to the increase in engineering headcount and increasedexpenses associated with our Korea branch.

We incurred stock-based compensation expense associated withresearch and development personnel of $0.2 million and $0.1 million in thethree months ended September 30, 2006 and 2005, respectively.

*Selling, General and Administrative.*    Selling,general and administrative expenses consist primarily of compensationand associated costs for marketing, selling and administrative personnel, salescommissions to independent sales representatives, contractor compensation,public relations, promotional and other marketing expenses, insuranceand fees paid for professional services, travel, depreciationexpenses and occupancy costs. Costs associated with audit and taxservices, corporate governance and compliance and financial reporting are alsoselling, general and administrative expenses.

Selling, general and administrative expenses were $2.4million, or 16% of revenues, for the three months ended September 30, 2006and $1.4 million or 14% of revenues for the three months ended September 30,2005.  The increase in expense inabsolute dollars was due primarily to increased compensation and consultingrelated expenses of $0.5 million to support increasing customer interest in ourproducts and the growth of our business, an increase in professional servicesexpense of $0.2 million for audit and legal services associated with the growthin our business, an increase in insurance and administrative fees of $0.2million associated with being a public company. These increases in expense wereoffset in part by a decrease of $0.1 million in commission expense for salesrepresentatives reflecting a larger proportion of sales to distributors in theperiod.  We expect selling, general andadministrative expenses to continue to increase in the future in support of ouranticipated growth as we hire additional personnel, expand our sales andmarketing efforts and pay increased sales commissions based on a projectedincrease in sales volume.  Administrativeexpenses will also increase to cover additional costs associated with operatingas a public company, such as improvements to our information technologyinfrastructure and increased costs associated with our efforts to comply withthe Sarbanes-Oxley Act of 2002.

We incurred stock-based compensation expense associated withselling, general and administrative personnel of $0.3 million in the threemonths ended September 30, 2006.  Weincurred a net credit to stock-based compensation of less than $0.1 million inthe three months ended September 30, 2005 as the forfeiture of anunvested stock option resulting from an employee termination resulted in thereversal of previously expensed stock compensation associated with the unvestedstock option during the quarter which was greater than stock-based compensationexpense in the quarter.  

*Interest Income.*    Interestincome was $0.6 million for the three months ended September 30, 2006 and $0.1million for the three months ended September 30, 2005.  The increase was due to higher cash, cashequivalent and short-term investment balances as a result of our initial publicoffering and higher interest rates in the three months ended September 30, 2006compared to the same period in the prior year.

*Income Taxes.*    Ourprovision for income taxes was $0.4 million for the three months endedSeptember 30, 2006 and $0.1 million for the three months ended September 30,2005.  The effective tax rate for bothperiods differed from the statutory federal income tax rate primarily becausewe utilized prior net operating losses to offset profits.

**Comparisons of the Nine Months Ended September 30, 2006 and2005**

*Revenues.*   Revenues were $37.7million for the nine months ended September 30, 2006 and $25.3 million for thenine months ended September 30, 2005, an increase of 49%.  Revenues from our security surveillanceproducts increased approximately $9.2 million, or 105%, in the nine monthsended September 30, 2006 compared to the nine months ended 

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September30, 2005, primarily as a result of the increase in sales of our four-in-onevideo decoder and higher integrated security surveillance products.  Revenues from video decoder productsincreased approximately $2.8 million, or 23%, in the nine months endedSeptember 30, 2006 compared to the nine months ended September 30, 2005,primarily as a result of a general increase in demand in the consumer marketsthat our video decoders serve, offset by a shift in sales from general-purpose videodecoders to application specific products designed specifically for thesecurity surveillance market.  Revenues fromour LCD display products increased by $0.6 million, or 15%, in the nine monthsended September 30, 2006 compared to the nine months ended September 30, 2005,primarily as a result of increased demand in the automotive market.  Other revenues decreased $0.1 million, or15%, in the nine months ended September 30, 2006 as compared with the ninemonths ended September 30, 2005, primarily as a result of decreased sales ofour PCI video decoder products.

*GrossProfit and Gross Margin.*  Gross profit was $21.6 million for the nine months endedSeptember 30, 2006 and $12.8 million for the nine months ended September30, 2005, an increase of 68%.  Gross margin was 57% for the nine monthsended September 30, 2006 increasing from 51% for the nine months endedSeptember 30, 2005.  The increase in gross margin was primarily aresult of reduced materialscosts and production costs in the nine months ended September 30, 2006compared to the same period in 2005.  Ourgross margin in the nine months ended September 30, 2005 wasadversely impacted by the decline in the average selling price of our LCDdisplay products arising from discounts granted on a large order from a singlecustomer.

We incurred stock-based compensation included in cost ofrevenues associated with outsourced manufacturing support and quality assurancepersonnel of less than $0.1 million in both the nine months endedSeptember 30, 2006 and 2005.

*Research and Development.*  Research and developmentexpenses were $7.0 million, or 19% of revenues, for the nine months endedSeptember 30, 2006 and $6.1 million or 24% of revenues for the nine monthsended September 30, 2005.  Compensationrelated expenses increased by approximately $1.3 million due to the increase inengineering headcount and increased expenses associated with our Korea branch.These increases in expenses were partially offset by a decrease of $0.6 millionin tape out expenses. Approximately $0.4 million of tape-out related expensewere planned for but not incurred for the three months ended September 30,2006.  We anticipate incurring theseexpenses in the fourth quarter of 2006.  

We incurred stock-based compensation expense associated withresearch and development personnel of $0.9 million and $0.3 million in thenine months ended September 30, 2006 and 2005, respectively.  Stock-based compensation expense increased by$0.6 million for the nine months ended September 30, 2006 primarily as a resultof stock options granted in the first quarter of 2006 to certain consultants ascompensation for product development services of $0.5 million.

*Selling, General and Administrative*.  Selling,general and administrative expenses were $6.1 million, or 16% ofrevenues, for the nine months ended September 30, 2006 and $4.0 million or 16%of revenues for the nine months ended September 30, 2005.  The increase in expense in absolutedollars was due primarily to increased compensation and consultingrelated expenses of $0.9 million to support increasing customer interest in ourproducts and the growth of our business, an increase in professionalservices expense of $0.7 million for audit and legal services associated withthe growth in our business, an increase in insurance and administrativefees of $0.2 million associated with being a public company and an increasein  expenses of $0.2 million associatedwith our foreign branches and our subsidiary in China. These increases inexpense were offset in part by a decrease of $0.2 million in commission expensefor sales representatives reflecting greater sales to distributors.

We incurred stock-based compensation expense associated withselling, general and administrative personnel of $0.8 million and $0.3 millionthe nine months ended September 30, 2006 and 2005, respectively. This increaseis due primarily as a result of stock options granted to certain consultantsand new employees as we continued to staff our sales team to support increasingcustomer interest in our products and our administrative team to meet therequirements of Sarbanes-Oxley Act of 2002.

*Interest Income.*    Interestincome was $1.0 million for the nine months ended September 30, 2006 and $0.2million for the nine months ended September 30, 2005.  The increase was due to higher cash, cashequivalent and short-term investment balances as a result of our initial publicoffering and higher interest rates in the nine months ended September 30, 2006compared to the same period in the prior year.

*Income Taxes.*    Ourprovision for income taxes was $1.2 million for the nine months ended September30, 2006 and $0.1 million for the nine months ended September 30, 2005.  The effective tax rate for both periodsdiffered from the statutory federal income tax rate primarily because weutilized prior net operating losses to offset profits.

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***Liquidityand Capital Resources***

Sinceour inception, we have financed our growth primarily with proceeds from theissuance of preferred stock and common stock. As of September 30, 2006, we had cash, cash equivalents and short-terminvestments of $48.8 million. We maintain our cash, cash equivalents andshort-term investments with high credit-quality financial institutions.  As of September 30, 2006, we had totalworking capital of $49.2 million. Our primary capital requirements are to fundworking capital needs.

Netcash provided by operating activities was $13.5 million in the nine monthsended September 30, 2006.  The net cashprovided by our operating activities in the nine months ended September 30,2006 was primarily due to our net income of $8.4 million and an increase inaccounts payable and accrued liabilities of $5.7 million associated withincreasing customer demand as a result of new product introductions andincreased sales of existing products and a decrease in accounts receivable of$0.8 million attributable to the timing of customer collections.  These were offset in part by an increase ininventory of $3.1 million in response to increasing customer demand and anincrease in prepaid expenses of $0.4 million. We incurred non-cash expenses of$1.8 million for stock-based compensation expenses and $0.2 million indepreciation expenses in the nine months ended September 30, 2006.

Netcash provided by operating activities was $1.1 million in the nine months endedSeptember 30, 2005.  The net cashprovided by our operating activities in the nine months ended September 30,2005 was primarily due to our net income of $2.8 million and an increase inaccounts payable and accrued liabilities of $2.4 million and prepaid expensesand other current assets of $0.5 million which was offset by increases ininventory of $3.8 million and accounts receivable of $1.5 million.  The increases in inventory and accountsreceivable and accounts payable were associated with the increase in revenuesduring the period as a result of new product introductions and increased salesof existing products.  We incurrednon-cash expenses of $0.6 million for stock-based compensation expenses and$0.1 million in depreciation expenses in the nine months ended September 30,2005.

Net cash used in our investing activities was $31.9million in the nine months ended September 30, 2006 reflecting purchases ofshort-term and long-term investments of $64.0 million and capital purchases of$0.3 million offset by maturities of short-term investments of $32.4million.  Net cash provided by investingactivities was $5.4 million in the nine months ended September 30, 2005reflecting maturities of short-term investments and restricted cash of $5.6million offset by capital purchases of $0.2 million.

Net cash provided by financing activities was $19.8million in the nine months ended September 30, 2006.  The net cash provided by financing activitiesin the nine months ended September 30, 2006 primarily consisted of proceedsfrom our initial stock offering net of underwriting discounts, commissions andoffering costs of $19.5 million and proceeds from the exercise of stock optionsof $0.3 million.

Netcash provided by our financing activities was $3.3 million in the ninemonths ended September 30, 2005. Net cash provided by our financing activitiesconsisted of proceeds of $2.9 million from the issuance of Series Fredeemable convertible preferred stock, $0.2 million from the exercise ofcommon stock options and $0.2 million from collections of stockholders’notes receivable.

Weconsider all highly liquid investments purchased with a remaining maturity ofthree months or less at the date of purchase to be cash equivalents. Cash andcash equivalents consist of demand accounts, money market funds and commercialpaper. Short-term investments consist of corporate bonds, U.S. governmentagency securities and auction rate securities.

Webelieve our existing cash, cash equivalents and short and long-terminvestments, as well as cash that we expect to generate from operatingactivities, will be sufficient to meet our anticipated cash needs for at leastthe next 12 months.

Our long-term future capital requirements will depend on manyfactors, including our level of revenues, the timing and extent of spending tosupport our product development efforts, the expansion of sales and marketing activities,the timing of our introductions of new products, the costs to ensure access toadequate manufacturing capacity and the continuing market acceptance of ourproducts. We could be required, or could elect, to seek additional fundingthrough public or private equity or debt financing and additional funds may notbe available on terms acceptable to us or at all. The failure to raise capitalwhen needed could have a material, adverse effect on our business and financialcondition.

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***Off-Balance Sheet Arrangements***

As of September 30, 2006, we have no off-balance sheetarrangements as defined in Item 303(a) (4) of the Securities and ExchangeCommission’s Regulation S-K.

** *Contractual Obligations***

At December 31, 2005, we had a total commitment of$2.6 million.  The following tableidentifies our commitments to settle contractual obligations as of September30, 2006:

|                            | ** ** | **Payment Due by Period** | ** ** |
|----------------------------|------------|------------------------------------------|------------|
| ** **                 | ** ** | **Total**                                | ** ** | **Less than  1 year** | ** ** | **1-3 years** | ** ** | **4-5 years** | ** ** |
|                       |       |                                     |       |   |   |   |   |   |   |
| Minimum Lease  Commitments |       | $                                        | 566        |   | $ | 383 |   | $ | 183 |   | $ | — |   |
| Purchase  Commitments      |       | 1,740                                    |       | 1,740 |   | — |   | — |   |
| Total Commitments          |       | $                                        | 2,306      |   | $ | 2,123 |   | $ | 183 |   | $ | — |   |

 

****RecentAccounting Pronouncements****

InJune 2006, the Financial Accounting Standards Board (“FASB”) issuedInterpretation No. 48 (“FIN No. 48”), **Accounting for Uncertainty in Income Taxes**.This interpretation clarifies the accounting for uncertainty in income taxesrecognized in an enterprise’s financial statements in accordance with FASBStatement No. 109, **Accounting for Income Taxes. **FIN No. 48 prescribes arecognition threshold and measurement attribute for the financial statementrecognition and measurement of a tax position taken or expected to be taken ina tax return. FIN No. 48 also provides guidance on derecognition,classification, interest and penalties, accounting in interim periods,disclosure, and transition. FIN No. 48 is effective for fiscal years beginningafter December 15, 2006.  We areevaluating the potential impact of FIN No. 48 on our results of operations andfinancial position.

OnSeptember 13, 2006, the Securities and Exchange Commission issued StaffAccounting Bulletin No. 108 (“SAB No. 108”), *Considering the Effects of Prior Year Misstatementswhen Quantifying Misstatements in Current Year Financial Statements*,which provides interpretive guidance on the consideration of the effects ofprior year misstatements in quantifying current year misstatements for thepurpose of a materiality assessment. SAB No.108 is effective for annualfinancial statements for the first fiscal year ending after November 15, 2006.However, early application is encouraged in any report for an interim period ofthe first fiscal year ending after November 15, 2006, filed after thepublication of this guidance. We are evaluating the potential impact of SABNo.108 on our results of operations and financial position.

InSeptember 2006, the FASB issued SFAS No. 157, *Fair ValueMeasurements*. SFAS No. 157 defines fair value, establishes aframework for measuring fair value in generally accepted accounting principles,and expands disclosures about fair value measurements. This statement appliesunder other accounting pronouncements that require or permit fair valuemeasurements, the FASB having previously concluded in those accountingpronouncements that fair value is the relevant measurement attribute.Accordingly, this Statement does not require any new fair value measurements.SFAS No. 157 is effective for financial statements issued for fiscal yearsbeginning after November 15, 2007, and interim periods within those fiscalyears. We are required to adopt this statement in our first fiscal quarter of2008. We are evaluating the potential impact of SFAS No. 157 on our results ofoperations and financial position.

# **ITEM3.         ****Quantitative andQualitative Disclosures about Market Risk**

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

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To date, our international customer agreements havebeen denominated solely in U.S. dollars, and accordingly, we have not beenexposed to foreign currency exchange rate fluctuations from customeragreements, and do not currently engage in foreign currency hedgingtransactions. However, the functional currency of our operations in Taiwan,South Korea and China is the U.S. dollar and our local accounts are maintainedin the local currency in Taiwan, South Korea and China, respectively, and thuswe are subject to foreign currency exchange rate fluctuations associated withremeasurement to U.S. dollars. Such fluctuations have not been significanthistorically and we believe that a 10% change in exchange rates would not havea significant impact on our interest income.

**ITEM 4.          Controls****and Procedures**

(a) ***Evaluationof disclosure controls and procedures.*** We maintain “disclosurecontrols and procedures,” as such term is defined in Rule 13a-15(e) under theSecurities Exchange Act of 1934 (the “Exchange Act”), that are designed toensure that information required to be disclosed by us in reports that we fileor submit under the Exchange Act is recorded, processed, summarized, andreported within the time periods specified in Securities and ExchangeCommission rules and forms, and that such information is accumulated andcommunicated to our management, including our Chief Executive Officer and ChiefFinancial Officer, as appropriate, to allow timely decisions regarding requireddisclosure. In designing and evaluating our disclosure controls and procedures,management recognized that disclosure controls and procedures, no matter howwell conceived and operated, can provide only reasonable, not absolute,assurance that the objectives of the disclosure controls and procedures aremet. Our disclosure controls and procedures have been designed to meet thereasonable assurance standards. Additionally, in designing disclosure controlsand procedures, our management necessarily was required to apply its judgmentin evaluating 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 their evaluation as of the end of the period coveredby this quarterly report on Form 10-Q, our Chief Executive Officer and ChiefFinancial Officer have concluded that, as of such date, our disclosure controlsand procedures were effective at the reasonable assurance level.

(b) ***Changesin internal control over financial reporting.*** There was nochange in our internal control over financial reporting (as defined in Rule13a-15(f) under the Exchange Act) that occurred during the period covered bythis quarterly report that has materially affected, or is reasonably likely tomaterially affect, our internal control over financial reporting.

**PART II—OTHER INFORMATION**

**ITEM 1.****          Legal Proceedings**

OnSeptember 26, 2005, we filed an administrative action on behalf of an originalequipment manufacturer (OEM) in South Korea against Alogics Co., Ltd.(Alogics), a semiconductor company in South Korea, seeking a determination thatthe OEM’s product offering which incorporates our TW2834 product does notinfringe a patent held by Alogics.   On February 13, 2006, the SouthKorean Intellectual Property Tribunal rendered a decision in theaction determining that the OEM’s product offering which incorporates ourTW2834 product does not infringe the patent held by Alogics.  OnMarch 10, 2006, Alogics filed an appeal with the Korean Patent Court(KPC).  All arguments have been presented in this action and we areawaiting a final determination.  We do not believe the resolution of thismatter will result in a material adverse impact on our financial position,results of operations or cash flows.  However, an adverse determinationcould result in further legal action against us in a Korea districtcourt.

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

**ITEM 1A.**       RiskFactors

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

**Risks Related to Our Business**

***Fluctuations in our revenue and operating results on aquarterly basis could cause the market price of our common stock to decline.***

Our revenue andoperating results are difficult to predict, have in the past fluctuated, andmay in the future fluctuate from quarter to quarter. It is possible that ouroperating results in some quarters will be below market expectations. Thiswould likely cause the market price of our common stock to decline. Ourquarterly operating results are affected by a number of factors, including:

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

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·                  uncertain demandin the consumer 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 consumerdemands and general economic conditions;

·                  productobsolescence and our ability to manage product transitions;

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

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

We base ourplanned operating expenses in part on our expectations of future revenue, and asignificant portion of our expenses is relatively fixed in the short term. Wehave limited historical financial data from which to predict future sales forour products. As a result, it is difficult for us to forecast our futurerevenue and budget our operating expenses accordingly. If revenue for aparticular quarter is lower than we expect, we likely will be unable toproportionately reduce our operating expenses for that quarter, which would harmour operating results for that quarter.

***We have a history of losses, have only recently becomeprofitable and may not sustain or increase profitability in the future whichmay cause the market price of our common stock to decline.***

We first becameprofitable in the second quarter of 2005. We incurred significant net lossesprior to that quarter. As of September 30, 2006, we had an accumulated deficitof approximately $14.9 million. To sustain or increase profitability, we willneed to generate and sustain substantially higher revenue while maintainingreasonable cost and expense levels. We currently expect to increase expenselevels in each of the next several quarters to support increased research anddevelopment and sales and marketing efforts. These expenditures may not resultin increased revenue or customer growth. Because many of our expenses are fixedin the short term, or are incurred in advance of anticipated sales, we may notbe able to decrease our expenses in a timely manner to offset any shortfall ofsales. We may not be able to sustain or increase profitability on a quarterlyor an annual basis. This may, in turn, cause the price of our common stock todecline.

***If the growth of demand for digital video applications forthe consumer, security surveillance and automotive markets does not continue,our ability to increase our revenue could suffer.***

Our ability toincrease our revenue will depend on increased demand for digital videoapplications in the consumer, security surveillance and automotive markets. Ifour target markets do not grow as rapidly or to the extent we anticipate, ourbusiness could suffer. The growth of our target markets is uncertain and willdepend in particular upon:

·                  consumer confidence and the continuedincrease of consumer spending levels;

·                  the pace at which new digital videoapplications are adopted;

·                  a continued reduction in the costs ofproducts in these markets; and

·                  the availability, at a reasonable price,of components required by such products, such as liquid crystal display, orLCD, panels.

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***The average selling prices of our semiconductor products maybe subject to rapid price declines which could harm our revenue and grossprofits.***

The semiconductorproducts we develop and sell may be subject to rapid declines in averageselling prices. From time to time, we have had to reduce our pricessignificantly to meet customer requirements, and we may be required to reduceour prices in the future. This would cause our gross margins to decline whichin turn may negatively impact our operating results. Our financial results willsuffer if we are unable to offset any reductions in our average selling pricesby increasing our sales volumes, reducing our costs or developing new orenhanced products on a timely basis with higher selling prices or grossmargins.

***We face intense competition and may not be able to competeeffectively, which could reduce our market share and decrease our net revenueand profitability.***

The markets inwhich we operate are extremely competitive and are characterized by rapidtechnological change, continuously evolving customer requirements and decliningaverage selling prices. We may not be able to compete successfully againstcurrent or potential competitors. If we do not compete successfully, our marketshare and revenue may decline. We compete with large semiconductormanufacturers and designers. Most of our current and potential competitors havelonger operating histories, significantly greater resources and namerecognition and a larger base of customers than we do. This may allow them torespond more quickly than we can to new or emerging technologies or changes incustomer requirements. In addition, these competitors may have greatercredibility with our existing and potential customers. Many of our current andpotential customers have their own internally developed semiconductor solutionsand may choose not to purchase products from third party suppliers like us.

***We depend on key and highly skilled personnel to operate ourbusiness, and if we are unable to retain our current personnel and hireadditional personnel, our ability to develop and market our products could beharmed.***

We believe ourfuture success will depend in large part upon our ability to attract and retainhighly skilled managerial, engineering and sales and marketing personnel. Theloss of any key employees or the inability to attract or retain qualifiedpersonnel, including engineers and sales and marketing personnel, could delaythe development and introduction of, and harm our ability to sell, our productsand harm the market’s perception of us. We believe that our future success ishighly dependent on the contributions of Fumihiro Kozato, our president andchief executive officer, and Dr. Feng Kuo, our chief technical officer. We donot have long-term employment contracts with these or any other key personnel,and their knowledge of our business and industry would be extremely difficultto replace.

Several members ofour board of directors and management team recently joined us. For example,Mark Voll, our chief financial officer, joined us in November 2005. Because ofthese recent changes, our management has not worked together as a group for anextended period of time and may not work together as effectively to execute ourrevenue goals, implement our strategies and manage our operations as they wouldif they had worked together for a longer period of time. If our management teamis unable to accomplish our business objectives, our ability to grow ourbusiness and successfully meet operational challenges could be impaired.

***If we fail to develop new products and enhance our existingproducts in order to react to rapid technological change and market demands,our business will suffer.***

We must developnew products and enhance our existing products with improved technologies tomeet rapidly evolving customer requirements. We need to design products forcustomers who continually require higher performance and functionality at lowercosts. We must, therefore, continue to cost-effectively add features thatenhance performance and functionality to our products. The development processfor these advancements is lengthy and requires us to accurately anticipatemarket trends. Our failure to accurately anticipate market trends in a timelymanner will harm the market acceptance of our products and the sales of ourproducts.

Developing andenhancing these products is uncertain and can be time-consuming, costly andcomplex. There is a risk that these developments and enhancements will be late,fail to meet customer or market specifications or not be competitive withproducts from our competitors that offer comparable or superior performance andfunctionality. Any new products or product enhancements may not be accepted innew or existing markets. Our business will suffer if we fail to develop andintroduce new products or product enhancements on a cost-effective basis.

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***If we fail to achieve initial design wins for our products,we may lose the opportunity for sales for a significant period of time to customersand be unable to recoup our investments in our products.***

We expendconsiderable resources in order to achieve design wins for our products,especially our new products and product enhancements. Once a customer designs asemiconductor into a product, it is likely to continue to use the samesemiconductor or enhanced versions of that semiconductor from the same supplieracross a number of similar and successor products for a lengthy period of timedue to the significant costs associated with qualifying a new supplier andpotentially redesigning the product to incorporate a different semiconductor.If we fail to achieve an initial design win in a customer’s qualificationprocess, we may lose the opportunity for significant sales to that customer fora number of its products and for a lengthy period of time. This may cause us tobe unable to recoup our investments in our products, which would harm ourbusiness.

***If we fail to develop, in a timely manner, or at all,technologies that address the demands of a shift from analog broadcast TV todigital broadcast TV, our operating results could suffer.***

Our semiconductorsare principally designed to decode analog broadcast TV signals into digitalimages. We believe the transmission of broadcast TV signals will over timeshift from analog signals to digital signals. We are in the process ofdeveloping mixed signal and digital technology to decode digital signals.However, transmission ofdigital video involves a combinationof emerging technologies. The complexities of these technologies and thevariability in implementations between manufacturers may cause our developmentof semiconductors to be costly and time-consuming. We may never obtain thebenefits of our investment in developing this technology. The complexities ofdigital broadcast technologies may also cause some of the semiconductors we aredeveloping to ultimately work incorrectly for reasons that may be eitherrelated or unrelated to our products, or not be interoperable with other keyproducts. Delays or difficulties in integrating our semiconductors into digitalbroadcast TV products or the failure of products incorporating digitalbroadcast TV to achieve broad market acceptance could have an adverse effect onour business.

***A significant portion of our products are sold into theconsumer and security surveillance markets, and if sales of our semiconductorsinto these markets decline or do not increase, or if we do not increase oursales into the automotive market, our business and financial results couldsuffer.***

We sellsemiconductors targeted for the consumer, security surveillance and automotivemarkets. We believe that for the year ended December 31, 2005 more than 80% ofour sales were derived from the sale of our products designed for the consumerand security surveillance markets. If sales of semiconductors into thesemarkets decline or do not increase, or if demand slows in these marketsgenerally, our operating results would suffer. In addition, we have increasedour focus on the automotive market and devoted substantial resources to thedevelopment of semiconductors for digital video applications that address thismarket. If we are not successful in selling our semiconductors into thismarket, we may not recover the costs associated with our efforts in this areaand our operating results could suffer.

***Our customers in the consumer market experience seasonality,which is likely to cause our revenues to fluctuate.***

A significantnumber of our semiconductors are sold for use in 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. These sales fluctuations are expected to continue.

***We manufacture our products based on our estimates ofcustomer demand, and if our estimates are incorrect our financial results couldbe negatively impacted.***

Our sales are madeon the basis of purchase orders rather than long-term purchase commitments. Inaddition, our customers may cancel purchase orders or defer the shipments ofour products. We manufacture our products according to our estimates of customerdemand. This process requires us to make multiple demand forecast assumptions,each of which may introduce error into our estimates. If we overestimatecustomer demand, we may manufacture products that we may not be able to sell.As a result, we would have excess inventory, which would increase our losses.Conversely, if we underestimate customer demand or if sufficient manufacturingcapacity were unavailable, we would forego revenue opportunities, lose marketshare and damage our customer relationships.

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***We do not expect to sustain the growth rate of our recentrevenues******.***

Our revenuesincreased approximately 110% in 2005 from 2004. We do not expect to achievesimilar growth rates in future periods. You should not rely on the results ofany prior quarterly or annual periods as an indication of our future operatingperformance. If we are unable to maintain adequate revenue growth, our stockprice may decline and we may not have adequate financial resources to executeour business objectives.

***We may pursue acquisitions or investments in complementarytechnologies and businesses, which could harm our operating results and maydisrupt our business.***

In the future, wemay pursue acquisitions of, or investments in, complementary technologies andbusinesses. Acquisitions present a number of potential risks and challengesthat could, if not met, disrupt our business operations, increase our operatingcosts and reduce the value to us of the acquired company. Even if we aresuccessful, we may not be able to integrate the acquired businesses, productsor technologies into our existing business and products. Furthermore, potentialacquisitions and investments, whether or not consummated, may divert ourmanagement’s attention and require considerable cash outlays at the expense ofour existing operations. In addition, to complete future acquisitions, we mayissue equity securities, incur debt, assume contingent liabilities or haveamortization expenses and write-downs of acquired assets, which could adverselyaffect our profitability.

***Changesin our tax rates will affect our future results.***

Our futureeffective tax rates will be favorably or unfavorably affected by the absoluteamount and future geographic distribution of our pre-tax income, our ability tosuccessfully transfer our operating activities to our foreign operations andthe amount and timing of intercompany payments from our foreign operationssubject to United States income taxes related to the transfer of certain rightsand functions. In addition, we are subject to the examination of our income taxreturns by the Internal Revenue Service and other tax authorities. The outcomesof these examinations, if they occur, could harm our net income and financialcondition.

***Future transactions may limit our abilityto use our net operating loss carryforwards.***

As of December 31,2005, we had federal and state tax net operating loss carryforwards ofapproximately $14.9 million and $9.2 million, respectively. These net operatingloss carryforwards may be used to offset future taxable income and therebyreduce our U.S. federal income taxes otherwise payable. Section 382 of theInternal Revenue Code of 1986, as amended, or the Code, imposes an annual limiton the ability of a corporation that undergoes an ‘‘ownership change’’ to use itsnet operating loss carry forwards to reduce its tax liability. Due in part toequity financings, we experienced ‘‘ownership changes’’ as defined in Section382 of the Code. Accordingly, our use of the net operating loss carryforwardsand credit carryforwards is limited by the annual limitations described inSections 382 and 383 of the Code.

***We may not be able to manage our future growth effectively,and we may need to incur significant expenditures to address the additionaloperational and control requirements of our growth.***

We areexperiencing a period of significant growth and expansion, which has placed,and any future expansion will continue to place, a significant strain on ourmanagement, personnel, systems and financial resources. We plan to hire additionalemployees to support an increase in research and development as well asincrease our sales and marketing efforts. To manage our growth successfully andhandle the responsibilities of being a public company, we believe we musteffectively:

·                  hire, train, integrate and manageadditional qualified engineers for research and development activities, salesand marketing personnel and financial and information technology personnel;

·                  continue to enhance our customerresource management and manufacturing management systems;

·                  implement additional and improveexisting administrative, financial and operations systems, procedures andcontrols, including the requirements of the Sarbanes-Oxley Act of 2002;

·                  expand and upgrade our technologicalcapabilities; and

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·                  manage multiple relationships with ourcustomers, distributors, suppliers and other third parties.

Our efforts mayrequire substantial managerial and financial resources and may increase ouroperating costs even though these efforts may not be successful. If we areunable to manage our growth effectively, we may not be able to take advantageof market opportunities, develop new products, satisfy customer requirements,execute our business plan or respond to competitive pressures.

***We may experience unforeseen delays, expenses or lower thanexpected product yields for our semiconductors manufactured by our third partyvendors, which could increase our costs and prevent us from recognizing thebenefits of new technologies we develop.***

We occasionallyhave experienced delays in completing the development and introduction of newproducts and product enhancements, and we could experience delays in the futurethat may render our new or enhanced products, when introduced, obsolete andunmarketable. In addition, it is often difficult for semiconductor foundries toachieve satisfactory product yields. Product yields depend on both our productdesign and the manufacturing process technology unique to the semiconductorfoundry. Since low yields may result from either design or processdifficulties, identifying yield problems can only occur well into theproduction cycle after a product that can be physically analyzed and testedexists. Poor yields from our foundry could cause us to sell our products atlower gross margins and therefore harm our financial results.

***Defects in our products could increase ourcosts, cause customer claims and delay our product shipments.***

Although we testour products, they are complex and may contain defects and errors. In the past,we have encountered defects and errors in our products. For example, in 2003 wewere unable to sell certain products to a customer for whom these products werespecifically designed as a result of our failure to produce a product that metthis customer’s specifications. We believe this customer secured the productfrom another vendor. Delivery of products with defects or reliability, qualityor compatibility 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 productliability claims against us, which may not be fully covered by insurance. Anyof these could harm our business.

***We rely on a limited number of independent subcontractorsfor the manufacture, assembly and testing of our semiconductors, and thefailure of any of these third-party vendors to deliver products or otherwiseperform as requested could damage our relationships with our customers,decrease our sales and limit our growth.***

We do not have ourown manufacturing or assembly facilities and have very limited in-house testingfacilities. Therefore, we must rely on third-party vendors to manufacture,assemble and test the products we design. We currently rely on TaiwanSemiconductor Manufacturing Corporation, or TSMC, to produce all of oursemiconductors. We rely on Advanced Semiconductor Engineering, Inc., or ASE, toassemble, package and test many of our products. If these vendors do notprovide 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

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·                  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 donot have long-term supply contracts with any of our third-party vendors.Therefore, they are not obligated to perform services or supply products to usfor any specific period, in any specific quantities or at any specific price,except as may be provided in a particular purchase order. Neither TSMC nor ASEhas provided contractual assurances to us that adequate capacity will beavailable for us to meet future demand for our products. These third partyvendors may allocate capacity to the production of other companies’ productswhile reducing deliveries to us on short notice. In particular, other customersthat are larger and better financed than we are or that have long-term agreementswith TSMC or ASE may cause either or both of them to reallocate capacity tothose customers, decreasing the capacity available to us.

***We plan to retain additional foundries to manufacture oursemiconductors, which could disrupt our current manufacturing process andnegatively impact our sales volumes and net revenue.***

As a result of thecomplexity in manufacturing our semiconductors, it is difficult to retain andrely on a new foundry. 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.

***We may experience difficulties in transitioning to smallergeometry process technologies or in achieving higher levels of designintegration, which may result in reduced manufacturing yields, delays inproduct deliveries and increased expenses.***

To reduce costsand maintain our gross margins, we intend to transition our semiconductors toincreasingly smaller geometries and achieve higher levels of designintegration. This transition requires us to modify the manufacturing processesfor our products and to redesign some products, which may result in delays inproduct deliveries. We periodically evaluate the benefits, on aproduct-by-product basis, of migrating to smaller geometry process technologiesto reduce our costs. In the past, we have experienced some difficulties inshifting to smaller geometry process technologies and new manufacturing processes,which resulted in reduced manufacturing yields, delays in product deliveriesand increased expenses. We may face similar difficulties, delays and expensesin the future. If our foundry, or we, experience significant delays in thesetransitions or fail to efficiently implement these transitions, our business,financial condition and results of operations could suffer.

***Our business depends on international customers, suppliersand operations in Asia, and as a result we are subject to regulatory,operational, financial and political risks, which could adversely affect ourfinancial results.***

The percentage ofour revenues attributable to sales to customers in Asia was 99% in the threemonths ended September 30, 2006 and 2005 and 98% in the nine months ended September30, 2006 and 2005. We expect that revenues from customers in Asia will continueto account for substantially all of our revenues. Currently, we maintaininternational sales offices in Asia, and we rely on a network of third-partysales representatives to sell our products internationally. We have alsoestablished offices in China, Taiwan and South Korea, which serve variousaspects of our business. Moreover, we have in the past relied on, and expect tocontinue to rely on, suppliers, manufacturers and subcontractors located inAsia, including Taiwan. Accordingly, we are subject to several risks andchallenges, any of which could harm our business and financial results. Theserisks and challenges include:

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

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

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

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

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·                  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 can be lengthy, which couldresult in uncertainty and delays in generating revenue.***

Because ourproducts are based on constantly evolving technologies, we have experienced alengthy sales cycle for some of our semiconductors, particularly those designedfor digital video applications in the automotive market. Our sales cycletypically ranges from six to 12 months. We may experience a delay between the timewe increase expenditures for research and development, sales and marketingefforts and inventory and the time we generate revenue, if any, from theseexpenditures. In addition, because we do not have long-term commitments fromour customers, we must repeat our sales process on a continual basis even forcurrent customers looking to purchase a new product. As a result, our businesscould be harmed if a customer reduces or delays its orders, chooses not torelease products incorporating our semiconductors or elects not to purchase anew product or product enhancements from us.

***We primarily sell our semiconductors through distributors,and if our relationships with one or more of those distributors were toterminate, our operating results may be harmed.***

We market and distribute our products primarily throughdistributors. This distribution channel has been characterized by rapid changeand consolidations. Distributors have accounted for a significant portion ofour revenues in the past. Sales to our distributors represented approximately65% of our revenues in 2005 and approximately 79% of our revenues in the ninemonths ended September 30, 2006.

Our operating results and financial condition could besignificantly disrupted by the loss of one or more of our current distributorsand sales representatives, volume pricing discounts, order cancellations,delays in shipment by one of our major distributors or sales representatives orthe failure of our distributors or sales representatives to successfully sellour products.

***We rely primarily upon copyright and trade secret laws andcontractual restrictions to protect our proprietary rights, and, if theserights are not sufficiently protected, our ability to compete and generaterevenue could suffer.***

We seek to protectour proprietary design processes, documentation and other written materialsprimarily under trade secret and copyright laws. We also typically requireemployees and consultants with access to our proprietary information to executeconfidentiality agreements. The steps taken by us to protect our proprietaryinformation may not be adequate to prevent misappropriation of our technology.In addition, our proprietary 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;

·                  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.

Reverseengineering, unauthorized copying or other misappropriation of our proprietarytechnologies could enable third parties to benefit from our technologieswithout compensating us for doing so. For example, if the foundry thatmanufactures our semiconductors loses control of our intellectual property, it wouldbe more difficult for us to take remedial measures since it is located inTaiwan, which does not have the same protection for intellectual property as isprovided in the United States. Any inability to adequately protect ourproprietary rights could harm our ability to compete, generate revenue and growour business.

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***We may not obtain sufficient patent protection on thetechnology embodied in the semiconductors we currently manufacture and market,which could harm our competitive position and increase our expenses.***

Although we relyprimarily on trade secret laws and contractual restrictions to protect thetechnology in the semiconductors we currently manufacture and market, oursuccess and ability to compete in the future may also depend to a significantdegree upon obtaining patent protection for our proprietary technology. As ofDecember 31, 2005, we had three issued patents in the United States and twopatent applications pending in the United States and two applications pendingin foreign jurisdictions. These patents and patent applications cover aspectsof the technology in the semiconductors we currently manufacture and market,including a patent for our video decoding architecture. Patents that wecurrently own do not cover all of the semiconductors that we presentlymanufacture and market. Our patent applications may not result in issuedpatents, and even if they result in issued patents, the patents may not haveclaims of the scope we seek. In addition, any issued patents may be challenged,invalidated or declared unenforceable. The term of any issued patents would be20 years from its filing date and if our applications are pending for a longtime period, we may have a correspondingly shorter term for any patent that mayissue. Our issued patents have expiration dates ranging from September 2, 2019to March 27, 2020. Our present and future patents may provide only limitedprotection for our technology and may not be sufficient to provide us withcompetitive advantages. For example, competitors could be successful inchallenging any issued patents or, alternatively, could develop similar or moreadvantageous technologies on their own or design around our patents. Also,patent protection in certain foreign countries may not be available or may be limitedin scope and any patents obtained may not be as readily enforceable as in theUnited States, making it difficult for us to effectively protect ourintellectual property from misuse or infringement by anyone in these countries.Our inability 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.

***Intellectual property litigation, which is common in ourindustry, could be costly, harm our reputation, limit our ability to sell ourproducts and divert the attention of management and technical personnel.***

Our industry ischaracterized by frequent litigation regarding patent and other intellectualproperty rights. In September 2000, we received a letter from another entityclaiming to have patents in certain technology and inviting us to take alicense under these patents that apply to comb filters, phase demodulation,oversampling and interpolation or scaling and deinterlacing. This third party,however, has failed to specify which of our products or technologies allegedlyinfringe on its patents. We cannot assess the potential impact on our businessbecause we cannot currently identify which of our products and technologies, ifany, might be impacted by the potential claim. Our discussions with this thirdparty are ongoing. We also were recently 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 an offer to license technology or claims ofinfringement, our business would be harmed.

Questions ofinfringement in the digital video applications market involve highly technicaland subjective analyses. Litigation may be necessary in the future to enforceany patents we may receive and other intellectual property rights, to protectour trade secrets, to determine the validity and scope of the proprietaryrights of others or to defend against claims of infringement or invalidity, andwe may not prevail in any future litigation. Litigation, whether or notdetermined in our favor or settled, could be costly, could harm our reputation,could cause our customers to use our competitors’ products and could divert theefforts and attention of our management and technical personnel from normalbusiness operations. In addition, adverse determinations in litigation couldresult in the loss of our proprietary rights, subject us to significantliabilities, require us to seek licenses from third parties or prevent us fromlicensing our technology or selling our products, any of which could seriouslyharm our business.

***Our headquarters are located in the State of California andour third-party manufacturing, assembly and testing vendors have facilities inthe State of Washington and in Asia, areas subject to significant earthquakerisks. Any disruption to our or their operations resulting from earthquakes orother natural disasters could cause significant delays in the production orshipment of our products.***

TSMC, which manufactures our semiconductors, hasfacilities in the State of Washington and in Taiwan. Our assembly and testingvendors’ 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 

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Washington state issignificant due to the proximity of major earthquake fault lines. In September1999, a major earthquake in Taiwan affected the facilities of TSMC and ASE, ourprimary assembly vendor, as well as other providers of foundry, packaging andtest services. In 2005, several typhoons also disrupted the operations of TSMCand ASE. As a result of these natural disasters, these contractors sufferedpower outages and disruptions that impaired their production capacity. In March2002 and June 2003, additional earthquakes occurred in Taiwan. The occurrenceof earthquakes or other natural disasters could result in the disruption of ourfoundry or assembly and test capacity. We may not be able to obtain alternatecapacity on favorable terms, if at all, which could harm our operating results.

***Changes to financial accounting standards may affect ourresults of operations and cause us to change our business practices.***

We prepare ourfinancial statements to conform with accounting principles generally acceptedin the United States of America, or GAAP. These accounting principles aresubject to interpretation by the Financial Accounting Standards Board, or FASB,the Securities and Exchange Commission, or SEC, and various bodies formed tointerpret and create appropriate accounting policies. A change in thosepolicies can have a significant effect on our reported results and may affectour reporting of transactions completed before a change is announced. Changesto those rules or the questioning of current practices may adversely affect ourreported financial results or the way we conduct our business. For example,accounting policies affecting many aspects of our business, including rulesrelating to employee stock option grants, have recently been revised. The FASBand other agencies have made changes to GAAP that require us, starting in ourfirst quarter of fiscal 2006, to record a charge to earnings for the estimatedfair value of employee stock option grants and other equity incentives, whereasunder prior accounting rules charges were required only for the intrinsicvalue, if any, of such awards to employees. We may have significant and ongoingaccounting charges under the new rules resulting from option grant and otherequity incentive expensing, which could reduce our overall net income. Inaddition, since we historically have used equity-related compensation as acomponent of our total employee compensation program, the accounting change couldmake the use of equity-related compensation less attractive to us or require usto pay more cash compensation and therefore make it more difficult for us toattract and retain employees.

**RisksRelated to Our Industry**

***Due to the cyclical nature of the semiconductor industry,our operating results may fluctuate significantly, which could adversely affectthe market price of our common stock.***

The semiconductorindustry is highly cyclical and subject to rapid change and evolving industrystandards and, from time to time, has experienced significant downturns. Thesedownturns are characterized by decreases in product demand, excess customerinventories and accelerated erosion of prices. These factors have caused andcould cause substantial fluctuations in our net revenue and in our operatingresults. Any downturns in the semiconductor industry may be severe andprolonged, and any failure of this industry to fully recover from downturnscould harm our business. The semiconductor industry also periodically experiencesincreased demand and production capacity constraints, which may affect ourability to ship products. Accordingly, our operating results have varied andmay vary significantly as a result of the general conditions in thesemiconductor industry, which could cause our stock price to decline.

***The demand for semiconductors is affectedby general economic conditions, which could impact our business.***

The United Statesand international economies have recently experienced a period of slow economicgrowth. A sustained economic recovery 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 economicrecovery slows 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.

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**RisksRelated to Our Common Stock**

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

The trading priceof our common stock could be subject to wide fluctuations due to the factorsdiscussed in this risk factors section and elsewhere in this Form 10-Q. Inaddition, the stock market in general has, and The Nasdaq National Market andtechnology companies in particular have, experienced extreme price and volumefluctuations. These trading prices and valuations may not be sustainable. Thesebroad market and industry factors may decrease the market price of our commonstock, regardless of our actual operating performance. In addition, in thepast, following periods of volatility in the overall market and the market priceof a company’s securities, securities class action litigation has often beeninstituted against companies that experienced such volatility. This litigation,if instituted against us, regardless of its outcome, could result insubstantial costs and a diversion of our management’s attention and resources.

***If securities or industry analysts do not publish researchor reports about our business, or if they change their recommendationsregarding our stock adversely, our stock price and trading volume could decline.***

The trading marketfor our common stock is influenced by the research and reports that industry orsecurities analysts publish about us or our business. If one or more of theanalysts who cover us downgrade our stock, our stock price would likely decline.If one or more of these analysts cease coverage of our company or fail toregularly publish reports on us, we could lose visibility in the financialmarkets, which in turn could cause our stock price or trading volume todecline.

***Our ability to raise capital in the future may be limitedand our failure to raise capital when needed could prevent us from executingour growth strategy.***

We believe thatour existing cash and cash equivalents will be sufficient to meet ouranticipated cash needs for at least the next 12 months. The timing and amountof our working capital and capital expenditure requirements may varysignificantly depending on numerous factors, including:

·                  marketacceptance of our products;

·                  the need toadapt to changing technologies and technical requirements;

·                  the existence ofopportunities for expansion; and

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

If our capitalresources are insufficient to satisfy our liquidity requirements, we may seekto sell additional equity securities or debt securities or obtain debtfinancing. The sale of additional equity securities or convertible debtsecurities would result in additional dilution to our stockholders. Additionaldebt would result in increased expenses and could result in covenants thatwould restrict our operations. We have not made arrangements to obtainadditional financing and there is no assurance that financing, if required,will be available in amounts or on terms acceptable to us, if at all.

***Substantial future sales of our common stock in the publicmarket could cause our stock price to fall.***

Additional sales of our common stock in the publicmarket, or the perception that these sales could occur, could cause the marketprice of our common stock to decline. At September 30, 2006, we had 20,222,605shares of common stock outstanding. Of these outstanding shares,

·                  5,630,000 shares are eligible forresale; and

·                  14,599,272 shares will be available forsale December 19, 2006, which is the date of the expiration of lock-upagreements the holders of our common stock entered into with us or with theunderwriters in connection with our initial public offering, subject to vestingrequirements and certain volume limitations.

Any or all ofthese shares may be released prior to expiration of the 180-day lock-up periodat the discretion of Lehman Brothers Inc. without prior notice. To the extentshares are released before the expiration of the lock-up period and theseshares are sold into the market, the market price of our common stock coulddecline.

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In addition, theholders of approximately 10,247,536 shares of common stock are entitled torights to cause us to register the sale of those shares under the SecuritiesAct. Registration of these shares under the Securities Act would result inthese shares, other than shares purchased by our affiliates, becoming freelytradable without restriction under the Securities Act immediately upon theeffectiveness of the registration.

Some of our officers have entered into 10b5-1trading plans, which generally provide for pre-determined sales of stock bythese officers. The sales of stock by our officers, even if made pursuant tothese 10b5-1 trading plans may cause our stock price to fall.

***Our corporate actions are substantially controlled byofficers, directors, principal stockholders and affiliated entities.***

Our directors,executive officers and their affiliated entities beneficially own a significantpercentage of our outstanding common stock. These stockholders, if they actedtogether, could exert substantial control over matters requiring approval byour stockholders, including electing directors and approving mergers or otherbusiness combination transactions. This concentration of ownership may alsodiscourage, delay or prevent a change in control of our company, which coulddeprive our stockholders of an opportunity to receive a premium for their stockas part of a sale of our company and might reduce our stock price. Theseactions may be taken even if they are opposed by our other stockholders.

***Management may apply our cash and equivalents, short-termand long-term investments to uses that do not increase our market value orimprove our operating results.***

We intend to useour cash and equivalents, short-term and long-term investments for generalcorporate purposes, including working capital and capital expenditures. We mayalso use a portion of our cash and equivalents, short-term and long-terminvestments to acquire or invest in complementary technologies, businesses orother assets. We have not reserved or allocated our cash and equivalents,short-term and long-term investments for any specific purpose, and we cannotstate with certainty how our management will use our cash and equivalents, short-termand long-term investments. Accordingly, our management has considerablediscretion in applying our cash and equivalents, short-term and long-terminvestments, and you will not have the opportunity, as part of your investmentdecision, to assess whether we are using our cash and equivalents, short andlong-term investments appropriately. We may use our cash and equivalents,short-term and long-term investments for purposes that do not result in anyincrease in our results of operations or market value. Until the cash andequivalents, short-term and long-term investments are used, they may be placedin investments that do not produce income or that lose value.

***Delaware law and our corporate charter and bylaws containanti-takeover provisions that could delay or discourage takeover attempts thatstockholders may consider favorable.***

Provisions in ourcertificate of incorporation, as amended and restated, may have the effect ofdelaying or preventing a change of control or changes in our management. Theseprovisions include the following:

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

·                     theprohibition of cumulative voting in the election of directors, which wouldotherwise allow less than a majority of stockholders to elect directorcandidates;

·                     therequirement for advance notice for nominations for election to the board ofdirectors or for proposing matters that can be acted upon at a stockholders’meeting;

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

·                     the abilityof the board of directors to issue, without stockholder approval, up to10,000,000 shares of preferred stock with terms set by the board of directors,which rights 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;

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·                     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

·                     theelimination of the right of stockholders to call a special meeting ofstockholders and to take action by written consent.

In addition,because we are incorporated in Delaware, we are governed by the provisions ofSection 203 of the Delaware General Corporation Law. These provisions mayprohibit or restrict large stockholders, in particular those owning 15% or moreof our outstanding voting stock, from merging or combining with us. Theseprovisions in our certificate of incorporation and bylaws and under Delawarelaw could discourage potential takeover attempts and could reduce the pricethat investors might be willing to pay for shares of our common stock in thefuture and result in our market price being lower than it would without these provisions.

***We will incur increased costs as a result of being a publiccompany.***

As a publiccompany, we will 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, haverequired 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 will incur additional costs associated with our public companyreporting requirements. We also expect these new rules and regulations to makeit more difficult and more expensive for us to obtain director and officerliability insurance and we may be required to accept reduced policy limits andcoverage or incur substantially higher costs to obtain the same or similarcoverage. As a result, it may be more difficult for us to attract and retainqualified persons to serve on our board of directors or as executive officers.We are currently evaluating and monitoring developments with respect to thesenew rules, and we cannot predict or estimate the amount of additional costs wemay incur or the timing of such costs.

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

(a) During the quarter ended September 30, 2006, we sold anaggregate of 14,166 shares of our common stock to employees and consultants forcash consideration in the aggregate amount of $0.1 million upon the exercise ofstock options granted under our Stock Option Plans which were not registeredunder the Securities Act of 1933. These issuances were deemed exempt fromregistration under the Securities Act of 1933 in reliance on Rule 701promulgated under the Securities Act of 1933 as offers and sales of securities pursuantto certain compensatory benefit plans and contracts relating to compensation incompliance with Rule 701.

(b) On June 21, 2006, our registration statement on Form S-1(Registration No. 333-130965) was declared effective for our initial publicoffering.  This offering closed on June26, 2006.  The managing underwriters wereLehman Brothers Inc., Cowen and Company, LLC, Needham & Company, LLC, PiperJaffray & Co. and Pacific Growth Equities, LLC.

Under this registration statement, we registered 5,500,000shares of our common stock at a price to the public of $9.00 per share. Weregistered 2,540,225 of these shares on the Company’s behalf and 2,959,775 of theseshares on behalf of certain of our selling stockholders.

The sale of 2,540,225 shares of common stock by the Companyresulted in aggregate gross proceeds to the Company of approximately $22.9million, approximately $1.6 million of which the Company applied tounderwriting discounts and commissions and approximately $3.8 million of whichthe Company applied to pay other expenses of the offering. 

On July 26, 2006, the Company received aggregate gross proceedsof $1.2 million from the sale of an additional 130,000 shares, approximately$0.1 million of which the Company applied to underwriting discounts andcommissions, following the underwriters’ partial exercise of theirover-allotment option received in connection with the Company’s initial publicoffering.

As a result, the Company received net proceeds ofapproximately $18.6 million from the offering.

At September 30,2006 we had substantially all net proceeds from the offering invested in moneymarket funds, commercial paper, corporate bonds, U.S. government agencysecurities and auction rate securities. We intend to use these net proceeds forgeneral corporate purposes, including working capital and capital expenditures.We may also use a portion of the net proceeds to acquire or invest incomplementary technologies, businesses or other assets.

(c) Not applicable.

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**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**

On November 6,2006, we signed a new lease agreement for our current headquarter facility thatwill accommodate our principal administrative, sales, marketing, support andresearch and development functions. Under the new lease agreement beginning onJanuary 1, 2007, we will continue occupying approximately 27,900 square feet ofspace in San Jose, California with the lease expiring on December 31, 2011.

**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.                  |

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(1)    Thematerial contained in Exhibit 32.1 and Exhibit 32.2 is not deemed “filed” withthe SEC and is not to be incorporated by reference into any filing of theCompany under the Securities Act of 1933 or the Securities Exchange Act of1934, whether made before or after the date hereof and irrespective of anygeneral incorporation language contained in such filing, except to the extentthat the registrant specifically incorporates it by reference.

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**Signatures**

Pursuantto the requirements of the Securities Exchange Act of 1934, as amended, theregistrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.
| Dated: November 13, 2006 |   |                                                                       |
|--------------------------|--------|----------------------------------------------------------------------------|
|                     |   |                                                                       |
|                     |   | /s/ FUMIHIRO KOZATO                                                        |
|                     |   | Fumihiro Kozato                                                            |
|                     |   | Chief Executive Officer                                                    |
|                     |   |                                                                       |
| Dated: November 13, 2006 |   |                                                                       |
|                     |   |                                                                       |
|                     |   |                                                                       |
|                     |   | /s/ MARK VOLL                                                              |
|                     |   | Mark Voll                                                                  |
|                     |   | Vice President of Finance and Administration   and Chief Financial Officer |

 

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