**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, DC 20549**

----

 

**FORM 10-Q**
| **(Mark  one)**                                                                                                                                                                           |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **x**                                                                                                                                                                                     | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
| ** **                                                                                                                                                                                | ** ** | ** ** |
| **For the quarterly period ended June  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**                                                                                                                                                     |

 

----

**Techwell, Inc.**

(Exact name of registrant as specified in itscharter)

 
| **Delaware**                                                    | ** ** | **77-0451738**                           |
|-----------------------------------------------------------------|------------|------------------------------------------|
| (State or other jurisdiction  of Incorporation or organization) |       | (I.R.S. Employer  Identification Number) |
|                                                            |       |                                     |
| **408 E. Plumeria Drive  San Jose, California, 95134**          |
| (Address of principal executive office and zip code)            |
|                                                            |       |                                     |
| **(408) 435-3888**                                              |
| (Registrant’s telephone number, including area code)       |

 

----

Indicate by check mark whether the Registrant(1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to filing requirements forthe past 90 days.    YES  o   NO  x

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer or a non-accelerated filer  (as defined in Rule 12b-2 of theExchange Act).

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

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o Nox

As of July 31, 2006, 20,265,564 shares of theRegistrant’s common stock, $0.001 par value, were outstanding.

 

----

**TECHWELL, INC.**

**INDEX**
| ** **           | ** **                                                                                        | **Page** |
|----------------------|---------------------------------------------------------------------------------------------------|----------|
| PART I —   | FINANCIAL  INFORMATION                                                                            |     |
|                 |                                                                                              |     |
| Item 1.              | Financial  Statements (Unaudited):                                                                |     |
|                 |                                                                                              |     |
|                 | Consolidated  Balance Sheets at June 30, 2006 and December 31, 2005                               | 3        |
|                 |                                                                                              |     |
|                 | Consolidated  Statements of Operations for the three and six months ended June 30, 2006 and  2005 | 4        |
|                 |                                                                                              |     |
|                 | Consolidated  Statements of Cash Flows for the six months ended June 30, 2006 and 2005            | 5        |
|                 |                                                                                              |     |
|                 | Notes  to Consolidated Financial Statements                                                       | 6        |
|                 |                                                                                              |     |
| Item  2.             | Management’s  Discussion and Analysis of Financial Condition and Results of Operations       | 15       |
|                 |                                                                                              |     |
| Item  3.             | Quantitative  and Qualitative Disclosures About Market Risk                                       | 27       |
|                 |                                                                                              |     |
| Item  4.             | Controls  and Procedures                                                                          | 27       |
|                 |                                                                                              |     |
| PART II  — | OTHER  INFORMATION                                                                                |     |
|                 |                                                                                              |     |
| Item 1.              | Legal  Proceedings                                                                                | 28       |
|                 |                                                                                              |     |
| Item 1A.             | Risk Factors                                                                                      | 28       |
|                 |                                                                                              |     |
| Item  2.             | Unregistered  Sales of Equity Securities and Use of Proceeds                                      | 41       |
|                 |                                                                                              |     |
| Item  3.             | Defaults  Upon Senior Securities                                                                  | 41       |
|                 |                                                                                              |     |
| Item  4.             | Submission  Of Matters To A Vote Of Security Holders                                              | 41       |
|                 |                                                                                              |     |
| Item 5.              | Other  Information                                                                                | 41       |
|                 |                                                                                              |     |
| Item 6.              | Exhibits                                                                                          | 41       |
|                 |                                                                                              |     |
|                 | Signatures                                                                                        | 43       |

 

2

----

**PART I—FINANCIAL INFORMATION**

**Item 1. Financial Statements**

**TECHWELL, INC.**

**CONSOLIDATED BALANCE SHEETS**

**(Unaudited)**

**(Inthousands, except share and per share data)**
| ** **                                                                                                                                                                                                                  | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                  | ** ** | **2006**          | ** ** | **2005**              | ** ** |
| ** **                                                                                                                                                                                                                  | ** ** | ** **        | ** ** | ** **            | ** ** |
| **ASSETS**                                                                                                                                                                                                                  | ** ** | ** **        | ** ** | ** **            | ** ** |
| Current assets:                                                                                                                                                                                                             |       |              |       |                  |       |
| Cash and cash  equivalents                                                                                                                                                                                                  |       | $                 | 26,463     |                  | $          | 15,982 |   |
| Short-term  investments                                                                                                                                                                                                     |       | 17,750            |       | 804                   |       |
| Total cash, cash  equivalents and short-term investments                                                                                                                                                                    |       | 44,213            |       | 16,786                |       |
| Accounts  receivable                                                                                                                                                                                                        |       | 2,502             |       | 3,052                 |       |
| Inventory                                                                                                                                                                                                                   |       | 3,027             |       | 3,113                 |       |
| Prepaid expenses  and other current assets                                                                                                                                                                                  |       | 366               |       | 2,224                 |       |
| Total current  assets                                                                                                                                                                                                       |       | 50,108            |       | 25,175                |       |
| Property and equipment,  net                                                                                                                                                                                                |       | 515               |       | 434                   |       |
| Other assets                                                                                                                                                                                                                |       | 47                |       | 35                    |       |
| Total                                                                                                                                                                                                                       |       | $                 | 50,670     |                  | $          | 25,644 |   |
|                                                                                                                                                                                                                        |       |              |       |                  |       |
| LIABILITIES, REDEEMABLE  CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY (DEFICIT)                                                                                                                                |       |              |       |                  |       |
| Current liabilities:                                                                                                                                                                                                        |       |              |       |                  |       |
| Accounts payable                                                                                                                                                                                                            |       | $                 | 2,583      |                  | $          | 1,336 |   |
| Accrued  liabilities                                                                                                                                                                                                        |       | 3,603             |       | 2,687                 |       |
| Total current  liabilities                                                                                                                                                                                                  |       | 6,186             |       | 4,023                 |       |
| Deferred rent                                                                                                                                                                                                               |       | 27                |       | 54                    |       |
| Total  liabilities                                                                                                                                                                                                          |       | 6,213             |       | 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                                                                                                                                                                                                                 |       |              |       |                  |       |
|                                                                                                                                                                                                                        |       |              |       |                  |       |
| Stockholders’ equity  (deficit):                                                                                                                                                                                       |       |              |       |                  |       |
| Preferred stock,  $0.001 par value; 10,000,000 shares authorized and no shares outstanding at  June 30, 2006                                                                                                                |       | —            |       | —                |       |
| Common stock,  $0.001 par value; 250,000,000 and 25,000,000 shares authorized at June 30,  2006 and December 31, 2005; 20,045,147 shares and 4,369,058 shares  outstanding at June 30, 2006 and December 31, 2005 |       | 20                |       | 4                     |       |
| Additional  paid-in capital                                                                                                                                                                                                 |       | 64,825            |       | 5,355                 |       |
| Deferred  stock-based compensation                                                                                                                                                                                          |       | (992              | )          | (1,323                | )          |
| Accumulated  other comprehensive income (loss)                                                                                                                                                                              |       | (13               | )          | —                |       |
| Accumulated  deficit                                                                                                                                                                                                        |       | (19,383           | )          | (23,246               | )          |
| Total  stockholders’ equity (deficit)                                                                                                                                                                                  |       | 44,457            |       | (19,210               | )          |
| Total                                                                                                                                                                                                                       |       | $                 | 50,670     |                  | $          | 25,644 |   |

 

The accompanying notes are an integral part of theseconsolidated financial statements.

3

----

**TECHWELL, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

**(In thousands,except per share data)**
| ** **                                                      | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                      | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                                      | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                            |       |                             |       |                           |       |   |   |   |   |
| Revenues                                                        |       | $                                | 12,800     |                           | $          | 9,682 |   | $ | 22,601 |   | $ | 15,382 |   |
|                                                            |       |                             |       |                           |       |   |   |   |   |
| Cost of revenues                                                |       | 5,241                            |       | 4,226                          |       | 9,738 |   | 7,450 |   |
|                                                            |       |                             |       |                           |       |   |   |   |   |
| Gross profit                                                    |       | 7,559                            |       | 5,456                          |       | 12,863 |   | 7,932 |   |
|                                                            |       |                             |       |                           |       |   |   |   |   |
| Operating expenses:                                             |       |                             |       |                           |       |   |   |   |   |
| Research and  development                                       |       | 2,461                            |       | 1,960                          |       | 4,951 |   | 3,901 |   |
| Selling, general  and administrative                            |       | 1,884                            |       | 1,315                          |       | 3,702 |   | 2,651 |   |
| Total operating  expenses                                       |       | 4,345                            |       | 3,275                          |       | 8,653 |   | 6,552 |   |
|                                                            |       |                             |       |                           |       |   |   |   |   |
| Income from operations                                          |       | 3,214                            |       | 2,181                          |       | 4,210 |   | 1,380 |   |
| Interest income                                                 |       | 252                              |       | 80                             |       | 407 |   | 143 |   |
|                                                            |       |                             |       |                           |       |   |   |   |   |
| Income before income  taxes                                     |       | 3,466                            |       | 2,261                          |       | 4,617 |   | 1,523 |   |
| Provision for income  taxes                                     |       | 588                              |       | 63                             |       | 754 |   | 68 |   |
|                                                            |       |                             |       |                           |       |   |   |   |   |
| Net income                                                      |       | $                                | 2,878      |                           | $          | 2,198 |   | $ | 3,863 |   | $ | 1,455 |   |
|                                                            |       |                             |       |                           |       |   |   |   |   |
| Basic net income per  share                                     |       | $                                | 0.52       |                           | $          | 0.56 |   | $ | 0.77 |   | $ | 0.38 |   |
| Diluted net income per  share                                   |       | $                                | 0.15       |                           | $          | 0.12 |   | $ | 0.20 |   | $ | 0.08 |   |
|                                                            |       |                             |       |                           |       |   |   |   |   |
| Weighed average shares  used in computing net income per share: |       |                             |       |                           |       |   |   |   |   |
| Basic                                                           |       | 5,521                            |       | 3,901                          |       | 4,995 |   | 3,822 |   |
| Diluted                                                         |       | 19,163                           |       | 18,398                         |       | 19,022 |   | 18,062 |   |

 

The accompanying notes are an integral part of theseconsolidated financial statements.

4

----

**TECHWELL, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

**(In thousands)**
| ** **                                                                         | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                         | ** ** | **June 30,**              | ** ** |
| ** **                                                                         | ** ** | **2006**                       | ** ** | **2005** | ** ** |
| **Cash flows from operating  activities:**                                         | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Net income                                                                         |       | $                              | 3,863      |   | $ | 1,455 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                           |       |   |   |
|                                                                               |       |                           |       |   |   |
| Depreciation and  amortization                                                     |       | 143                            |       | 102 |   |
| Stock-based  compensation                                                          |       | 1,237                          |       | 510 |   |
| Changes in  assets and liabilities:                                                |       |                           |       |   |   |
| Accounts  receivable                                                               |       | 550                            |       | (1,200 | ) |
| Inventory                                                                          |       | 86                             |       | (3,228 | ) |
| Prepaid expenses  and other current assets                                         |       | 56                             |       | 579 |   |
| Other assets                                                                       |       | (12                            | )          | 12 |   |
| Accounts payable                                                                   |       | 1,053                          |       | 2,612 |   |
| Accrued  liabilities                                                               |       | 1,172                          |       | 479 |   |
| Restructuring  accrual                                                             |       | —                         |       | (103 | ) |
| Deferred rent                                                                      |       | (27                            | )          | 10 |   |
| Net cash  provided by operating activities                                         |       | 8,121                          |       | 1,228 |   |
| **Cash flows from investing  activities:**                                         | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Purchase of  property and equipment                                                |       | (205                           | )          | (107 | ) |
| Change in  restricted cash                                                         |       | —                         |       | 100 |   |
| Purchase of  short-term investments                                                |       | (19,265                        | )          | — |   |
| Proceeds from  maturities of short-term investments                                |       | 2,306                          |       | 5,011 |   |
| Net cash  provided by (used in) investing activities                               |       | (17,164                        | )          | 5,004 |   |
| **Cash flows from financing  activities:**                                         | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Proceeds from  initial public offering of common stock, net of offering costs      |       | 19,274                         |       | — |   |
| Proceeds from  the issuance of Series F redeemable preferred stock                 |       | —                         |       | 2,939 |   |
| Proceeds from  exercise of stock options                                           |       | 250                            |       | 152 |   |
| Collection of  notes receivable from stockholders                                  |       | —                         |       | 157 |   |
| Net cash  provided by financing activities                                         |       | 19,524                         |       | 3,248 |   |
| Net increase in cash  and cash equivalents                                         |       | 10,481                         |       | 9,480 |   |
| Cash and cash  equivalents at beginning of period                                  |       | 15,982                         |       | 2,069 |   |
| Cash and cash  equivalents at end of period                                        |       | $                              | 26,463     |   | $ | 11,549 |   |
| ** **                                                                         | ** ** | ** **                     | ** ** | ** ** | ** ** |
| **Supplemental cash flow  information—income taxes paid**                     |       | $                              | 245        |   | $ | 1 |   |
| ** **                                                                         | ** ** | ** **                     | ** ** | ** ** | ** ** |
| **Supplemental disclosure of  noncash investing and financing activities:**        | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Deferred  stock-based compensation related to stock option grants                  |       | $                              | —     |   | $ | 684 |   |
| Reversal of  deferred stock-based compensation for cancellation of stock options   |       | $                              | 132        |   | $ | 53 |   |
| Accrued offering  costs                                                            |       | $                              | 943        |   | $ | — |   |
| Accrued equipment costs                                                            |       | $                              | 19         |   | $ | — |   |

 

The accompanying notes are an integral part of theseconsolidated financial statements.

5

----

**TECHWELL, INC.**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**(Unaudited)**

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

***The Company***

Techwell, Inc. (“Techwell” or the “Company”) wasincorporated in California on March 7, 1997 and reincorporated in Delaware onMarch 30, 2006.  As a result of thereincorporation, the consolidated financial statements have been adjusted togive retroactive effect to the establishment of par value for Techwell’s commonstock.  The Company is a fablesssemiconductor company that designs, markets and sells mixed signal integratedcircuits for multiple video applications in the consumer, security surveillanceand automotive markets.

The Company has branch offices in South Korea andTaiwan and recently established a subsidiary in China.  The South Korea office is primarily involvedin product development and is also involved in technical sales support.  The China office and the Taiwan officeprimarily provide sales support to customers.

***Basis ofPresentation***

The accompanying consolidated financial statements ofthe Company have been prepared without audit in accordance with therules and regulations of the Securities and Exchange Commission.  The balance sheet at December 31, 2005 has been derived from theaudited financial 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 effective by theSecurities and Exchange Commission on June 21, 2006.

In the opinion of management, the accompanyingunaudited consolidated financial statements reflect all adjustments (consistingonly of normal recurring adjustments) necessary to summarize fairly the Company’sfinancial position, results of operations and cash flows for the interimperiods presented. The operating results for the three months ended June 30,2006 are not necessarily indicative of the results that may be expected for theyear ending December 31, 2006 or for any other future period.

***Principlesof Consolidation and Year End***

The consolidated financial statements include theaccounts 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***

The preparation of financial statements in accordancewith accounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities, the disclosure of contingent assets andliabilities at the date of the consolidated financial statements and thereported amounts of revenues and expenses during the reporting period.  Actual results could differ from theseestimates.

***Certain Significant Risks and Uncertainties***

The Company operates in a dynamichigh technology industry and changes in any of the following areas could have amaterial adverse effect on the Company’s financial position and results ofoperations: unpredictable volume and timing of customer orders, which are notfixed by contract; loss of one or more of its customers; decrease in theoverall average selling prices of its products; changes in the relative salesmix of its products; changes in its cost of finished goods; the availability,pricing and timeliness of delivery of other components used in the Company’s

6

----

customers’ products; the Company’s customers’ salesoutlook, purchasing patterns and inventory adjustments based on consumerdemands and general economic conditions; product obsolescence and the Company’sability to manage product transitions; the Company’s ability to successfullydevelop, introduce and sell new or enhanced products in a timely manner; andthe timing of new product announcements or introductions by the Company or byits competitors.

***Accumulated Other ComprehensiveIncome (Loss)***

Accumulated other comprehensive income (loss) consistsof net unrealized losses on available-for-sale investments.  The change in unrealized losses oninvestments, net of tax, in the three and six months ended June 30, 2006 is$13,000.  There were no unrealized gainsor losses on investments in the three and six months ended June 30, 2005.

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

In June 2006, the Company completed its initial publicoffering and issued 2,540,225 shares of its common stock at a price of $9.00per share. The Company received approximately $17.6 million in cash, net of underwritingdiscounts, commissions and other offering costs. Simultaneously with theclosing of the initial public offering, each outstanding share of redeemableconvertible preferred stock was automatically converted into one share ofcommon stock.

****RecentAccounting Pronouncements****

In June 2006, theFinancial Accounting Standards Board (“FASB”) issued Interpretation No. 48 (“FINNo. 48”), **Accountingfor Uncertainty in Income Taxes**. This interpretation clarifiesthe accounting for uncertainty in income taxes recognized in an enterprise’sfinancial statements in accordance with FASB Statement No. 109, **Accounting forIncome Taxes. **FIN No. 48prescribes a recognition threshold and measurement attribute for the financial statement recognition andmeasurement of a tax position taken or expected to be taken in a tax return.FIN No. 48 also provides guidance on derecognition, classification, interestand penalties, accounting in interim periods, disclosure, and transition. FINNo. 48 is effective for fiscal years beginning after December 15, 2006. TheCompany is evaluating the potential impact of FIN No. 48 on its results ofoperations and financial position.

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

The Company has equity incentiveplans (“Plans”) under which it may grant stock options, restricted stock, stockunits and stock appreciation rights to employees, consultants anddirectors.  At June 30, 2006, the totalnumber of shares available for issuance under the Plans is 2,005,834.  Options granted under the Plans may 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 SFAS123(R), the Company accounted for stock-basedcompensation awards issued to its employees using the intrinsic valuemeasurement provisions of Accounting Principles Board Opinion No. 25 (“APBOpinion No. 25”), *Accounting for StockIssued 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 107 in its adoption of SFAS123(R).

The Company adopted SFAS 123(R)using the prospective transition method. Under this method, SFAS 123(R) isapplied to new awards and to awards modified, repurchased or cancelled afterthe adoption date of January 1, 2006. Compensation cost previously recorded under APB Opinion No. 25 for awardsoutstanding at the adoption date, such as unvested options, will continue to berecognized as the options vest. Accordingly, for the three and six

7

----

months ended June 30, 2006, stockbased compensation expense includes compensation cost related to estimated fairvalues of awards granted after the date of adoption of SFAS 123(R) andcompensation costs related to unvested awards at the date of adoption based onthe intrinsic values as previously recorded under APB Opinion No. 25.

Thefollowing table summarizes the distribution of stock-based compensation expense(in thousands):
| ** **                           | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                           | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                           | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| Cost of revenues                     |       | $                                | 24         |                           | $          | 9 |   | $ | 37 |   | $ | 18 |   |
| Research and  development            |       | 138                              |       | 122                            |       | 735 |   | 206 |   |
| Selling, general and  administrative |       | 252                              |       | 129                            |       | 465 |   | 286 |   |
| Related tax effect                   |       | (20                              | )          | —                         |       | (26 | ) | — |   |
| Total stock-based compensation       |       | $                                | 394        |                           | $          | 260 |   | $ | 1,211 |   | $ | 510 |   |

 

The fair value ofoptions granted after January 1, 2006 is estimated on the grant date using theBlack-Scholes option valuation model.  Thisvaluation model for stock compensation expense requires the Company to makeassumptions and judgments about the variables used in the calculation includingthe expected term (weighted average period of time that the options granted areexpected to be outstanding), the volatility of Techwell’s common stock, anassumed risk free interest rate and the estimated forfeitures of unvested stockoptions. To the extent actual results differ from the estimates, the differencewill be recorded as a cumulative adjustment in the period estimates arerevised. No compensation cost is recorded for options that do not vest.  Since the Company’s stock has not beenactively traded in the past, the Company uses the simplified calculation ofexpected life described in SAB 107 and volatility is based on an average of thehistorical volatilities of the common stock of several entities withcharacteristics similar to those of the Company.  The risk-free rate is based on the U.S.Treasury yield curve in effect at the time of grant for periods correspondingwith the expected life of the option. Expected forfeitures are based on the Company’s historical experienceand are estimated at 10%.   The Company uses the straight-line method forexpense attribution for options granted after January 1, 2006, and valued inaccordance with SFAS 123(R).

The followingassumptions are used to value stock options granted after adoption of SFAS123(R):
|                         | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **              | ** ** | **June 30, 2006**      | ** ** | **June 30, 2006**    | ** ** |
| ** **              | ** ** | ** **                       | ** ** | ** **                     | ** ** |
| Expected term in years  |       | 6.08                             |       | 6.08                           |       |
| Risk-free interest rate |       | 5.0                              | %          | 4.55% - 5.                     | 0%         |
| Expected volatility     |       | 73.8                             | %          | 73.8% - 74.                    | 1%         |
| Dividend yield          |       | 0                                | %          | 0                              | %          |

 

The totalcompensation cost attributable to activities capitalized in inventory was notsignificant in the three and six months ended June 30, 2006.

Underthe 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 the

8

----

board of directors at thedate of each grant. The Company did not obtain valuations by a valuationspecialist. Subsequent to the grant date, when the Company prepared itsfinancial statements, it performed retrospective valuations of its common stockusing the probability-weighted expected return method. The Company used thevalues determined to record retroactively stock compensation based on thedifference between the subsequently determined fair value and the exerciseprice. For options granted prior to January 1, 2006, the Company uses themultiple grant approach for expense attribution, which results in substantiallyhigher amounts of amortization in earlier years as opposed to the straight-linemethod, which results in equal amortization over the vesting period of theoptions. Under the multiple grant approach, forfeitures of unvested optionsresulting from employee terminations result in the reversal during the periodof previously expensed stock compensation associated with the unvested options.Stock compensation from vested options, whether forfeited or not, is not reversed.

Thefollowing table summarizes stock option activity during the six months endedJune 30, 2006 under all stock option plans:

|                                           | ** ** | **Number  of  Shares** | ** ** | **Weighted-  Average  Exercise  Price per  Share** | ** ** | **Weighted-  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic  Value**(in 000’s) | ** ** |
|-------------------------------------------|------------|------------------------|------------|---------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| Options outstanding at  December 31, 2005 |       | 2,417,728              |       | $                                                       | 1.22       |                                                 |       |                                                |       |   |
| Options granted                           |       | 503,000                |       | $                                                       | 9.64       |                                                 |       |                                                |       |   |
| Options  exercised                        |       | (258,893               | )          | $                                                       | 0.64       |                                                 |       |                                                |       |   |
| Options  cancelled                        |       | (111,667               | )          | $                                                       | 1.16       |                                                 |       |                                                |       |   |
| Options outstanding at  March 31, 2006    |       | 2,550,168              |       | $                                                       | 2.94       |                                                 |       |                                                |       |   |
| Options granted                           |       | —                 |       | $                                                       | —     |                                                 |       |                                                |       |   |
| Options  exercised                        |       | (99,853                | )          | $                                                       | 0.85       |                                                 |       |                                                |       |   |
| Options  cancelled                        |       | (47,429                | )          | $                                                       | 1.91       |                                                 |       |                                                |       |   |
| Options outstanding at  June 30, 2006     |       | 2,402,886              |       | $                                                       | 3.05       |                                                 | 7.56       |                                                | $          | 18,261 |   |
|                                      |       |                   |       |                                                    |       |                                                 |       |                                                |       |
| Options Exercisable at June 30, 2006      |       | 1,069,211              |       | $                                                       | 0.74       |                                                 | 5.70       |                                                | $          | 10,592 |   |

 

The fair value of options accounted for in accordancewith SFAS 123(R) and vested in thesix months ended June 30, 2006 is $598,000. The weighted-average fair value ofoptions granted in the six months ended June 30, 2006 is $7.33.   Total compensation cost of optionsgranted but not yet vested as of June 30, 2006 was $3.5 million, which isexpected to be recognized over the weighted-average period of 1.71 years.

***Adjustments During the Quarter Ended March 31, 2006***

Subsequent to theissuance of the 2005 financial statements, management determined that it hadunderestimated 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.Accordingly, the financial statements for the quarter ended March 31, 2006include the cumulative adjustment to correct these errors. Management does notbelieve the correction of these errors is material to the financial statementsfor the three months ended March 31, 2006 and for the six months ended June 30,2006 and does not believe that it will be material to the 2006 annual financialstatements.

9

----

**Note 3.  Net Income Per Share**

The Company calculatesnet 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 shares consistof convertible preferred stock, common stock options and common stock subjectto repurchase.

A reconciliation of shares used in the calculation ofbasic and diluted net income per share is as follows (in thousands):
| ** **                                             | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                             | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                             | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Weighted average common  shares outstanding            |       | 5,597                            |       | 3,937                          |       | 5,076 |   | 3,847 |   |
| Weighted average shares  subject to repurchase         |       | (76                              | )          | (36                            | )          | (81 | ) | (25 | ) |
| Shares used to  calculate basic net income per share   |       | 5,521                            |       | 3,901                          |       | 4,995 |   | 3,822 |   |
| Effect of dilutive  securities:                        |       |                             |       |                           |       |   |   |   |   |
| Convertible  preferred stock                           |       | 12,067                           |       | 12,777                         |       | 12,422 |   | 12,569 |   |
| Common stock  options                                  |       | 1,575                            |       | 1,720                          |       | 1,605 |   | 1,671 |   |
| Dilutive potential  common stock                       |       | 13,642                           |       | 14,497                         |       | 14,027 |   | 14,240 |   |
| Shares used to calculate dilutive net income per share |       | 19,163                           |       | 18,398                         |       | 19,022 |   | 18,062 |   |

 

The completion of the Company’s initial publicoffering (“IPO”) in June 2006 resulted in the conversion to common stock of alloutstanding shares of convertible preferred stock.  As a consequence, the shares used tocalculate basic net income per share have increased by the weighted averageimpact of the 12,777,118 common shares issued on conversion of the convertiblepreferred stock and the 2,540,225 shares issued in the IPO. For periods priorto the IPO, the weighted shares used to calculate diluted net income per shareinclude the effect of the convertible preferred stock.

# **Note 4.  Short-term Investments**

Short-terminvestments at June 30, 2006 are considered available-for-sale and consist ofauction rate securities. These securities are carried at fair market valuebased on market quotes. Unrealized gains and losses, net of tax, are reportedas a separate component of stockholders’ equity and included in “Accumulatedother comprehensive income (loss)”. Realized gains and losses are recorded based on the specificidentification method and are not significant in any period presented.

10

----

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

**Inventory**(inthousands):
|                 | ** ** | **June 30, 2006** | ** ** | **December 31, 2005** | ** ** |
|-----------------|------------|-----------------------------|------------|---------------------------------|------------|
| Finished goods  |       | $                           | 1,412      |                            | $          | 1,306 |   |
| Work in process |       | 1,615                       |       | 1,807                           |       |
|            |       |                        |       |                            |       |
|            |       | $                           | 3,027      |                            | $          | 3,113 |   |

**Property and equipment, net**(inthousands):
|                                                 | ** ** | **June 30, 2006** | ** ** | **December 31, 2005** | ** ** |
|-------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| Equipment and  software                         |       | $                 | 983        |                  | $          | 891 |   |
| Furniture and  fixtures                         |       | 307               |       | 273                   |       |
| Leasehold  improvements                         |       | 129               |       | 91                    |       |
|                                            |       |              |       |                  |       |
|                                            |       | 1,419             |       | 1,255                 |       |
| Less accumulated  depreciation and amortization |       | (904              | )          | (821                  | )          |
|                                            |       |              |       |                  |       |
|                                            |       | $                 | 515        |                  | $          | 434 |   |

**Accrued liabilities**(inthousands):
|                                             | ** ** | **June 30, 2006** | ** ** | **December 31, 2005** | ** ** |
|---------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| Accrued  compensation                       |       | $                 | 977        |                  | $          | 551 |   |
| Accrued  inventory purchases                |       | 72                |       | 239                   |       |
| Accrued  engineering tape-out costs         |       | 321               |       | 51                    |       |
| Customer  advances                          |       | 272               |       | 29                    |       |
| Accounting and  legal professional services |       | 704               |       | 1,274                 |       |
| Other professional  services                |       | 288               |       | 32                    |       |
| Exercise of  unvested stock options         |       | 134               |       | 159                   |       |
| Income taxes  payable                       |       | 640               |       | 135                   |       |
| Other                                       |       | 195               |       | 217                   |       |
|                                        |       |              |       |                  |       |
|                                        |       | $                 | 3,603      |                  | $          | 2,687 |   |

 

11

----

**Note 6.  SegmentInformation**

As defined by the requirements of SFAS No. 131, *Disclosure About Segments of an Enterprise andRelated Information,* the Company currently operates in onereportable segment, the designing, marketing and selling of mixed signalintegrated circuits for multiple video applications in the consumer, securitysurveillance and automotive markets. The Company’s chief operating decisionmaker is its chief executive officer. The percentage of total revenues by geographic area are as follows:
| ** **      | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **      | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **      | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| South Korea     |       | 28                               | %          | 39                             | %          | 33 | % | 43 | % |
| Taiwan          |       | 51                               | %          | 50                             | %          | 44 | % | 43 | % |
| China/Hong Kong |       | 17                               | %          | 8                              | %          | 19 | % | 10 | % |
| Japan           |       | 3                                | %          | 2                              | %          | 3 | % | 3 | % |
| United States   |       | —                           |       | 1                              | %          | — |   | 1 | % |
| Other           |       | 1                                | %          | —                         |       | 1 | % | — |   |
| Total           |       | 100                              | %          | 100                            | %          | 100 | % | 100 | % |

 

Revenuesby product line are as follows (in thousands):
| ** **                | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| Security  Surveillance(1) |       | $                                | 5,711      |                           | $          | 3,020 |   | $ | 10,663 |   | $ | 4,789 |   |
| Video Decoders(2)         |       | 5,445                            |       | 5,537                          |       | 9,097 |   | 7,637 |   |
| LCD Display(3)            |       | 1,288                            |       | 928                            |       | 2,280 |   | 2,491 |   |
| Other(4)                  |       | 356                              |       | 197                            |       | 561 |   | 465 |   |
| Total                     |       | $                                | 12,800     |                           | $          | 9,682 |   | $ | 22,601 |   | $ | 15,382 |   |

 

----

(1)           Consists of application specificproducts designed for use in security surveillance systems.

(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)           Consists of application specificproducts designed for use in LCD displays.

(4)                                  Consistsof contract development projects early generation mixed signal semiconductorsfor digital video applications unrelated to the three principal product linesand a PCI video decoder product.

12

----

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

| Country       | ** ** | **June 30, 2006** | ** ** | **December 31, 2005** | ** ** |
|---------------|------------|-----------------------------|------------|---------------------------------|------------|
| United States |       | $                           | 404        |                            | $          | 306 |   |
| Taiwan        |       | 82                          |       | 91                              |       |
| South Korea   |       | 29                          |       | 37                              |       |
|          |       |                        |       |                            |       |
| Total         |       | $                           | 515        |                            | $          | 434 |   |

 

The revenues and accounts receivable from customersrepresenting 10% or more of total revenues and accounts receivable are asfollows:
|              | ** ** | **Accounts Receivable at** | ** ** | **Revenues**          | ** ** |
|--------------|------------|---------------------------------|------------|-----------------------|------------|
| ** **   | ** ** | **June 30,**               | ** ** | **December 31,** | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
| **Customer** | ** ** | **2006**                        | ** ** | **2005**              | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
| A            |       | 18                              | %          | 15                    | %          | 10 | % | 10 | % | 11 | % | 11 | % |
| B            |       | 13                              |       | *                     |       | 11 |   | * |   | 12 |   | * |   |
| C            |       | *                               |       | *                     |       | * |   | * |   | 10 |   | * |   |
| D            |       | *                               |       | *                     |       | 15 |   | * |   | 12 |   | * |   |
| E            |       | 14                              |       | *                     |       | * |   | 17 |   | * |   | 14 |   |
| F            |       | 11                              |       | 18                    |       | * |   | * |   | * |   | * |   |
| G            |       | *                               |       | 12                    |       | * |   | * |   | * |   | * |   |
| H            |       | *                               |       | 11                    |       | * |   | * |   | * |   | * |   |

 

----

*   less than 10%

# **Note 7. Related Party Transactions**

One of the Company’sBoard members is a partner in a law firm that provides services to the Company.The Company incurred fees of $45,000 to this law firm for legal services inboth the three months ended June 30, 2006 and 2005. The Company incurred feesof $80,000 and $125,000 to this law firm for legal services in the six monthsended June 30, 2006 and 2005, respectively. The amount payable to this law firm was $25,000 at June 30, 2006 and$53,000 at December 31, 2005.

13

----

# **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 $588,000 and$63,000 was recorded in the three months ended June 30, 2006 and 2005,respectively.  A provision for incometaxes of $754,000 and $68,000 was recorded in the six months ended June 30,2006 and 2005, respectively.   Theeffective tax rate differed from the statutory federal income tax rate becausethe Company utilized prior net operating losses to offset profits made in thecurrent period.

InNovember 2005, the FASB issued FASB Staff Position (“FSP”) No. FAS123(R)-3, *Transition Election Related toAccounting for the Tax Effects of Share-Based Payment Awards.*  Effective upon issuance, this FSP describesan alternative 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). Companies have one year from the later of the adoption of SFAS123(R) or the effective date of the FSP to evaluate their transitionalternatives and make a one-time election. The Company is evaluating thepotential impact of this new guidance on its results of operations andfinancial position.

# **Note 9.  Subsequent Event**

On July 26, 2006,the Company received aggregate proceeds of $1.1 million, net of underwritingdiscounts and commissions from the sale of an additional 130,000 new sharesfollowing the underwriters’ partial exercise of their over-allotment optionreceived in connection with the Company’s initial public offering in June 2006.

14

----

# **ITEM 2. Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

*The following discussion of our financial condition andresults of operations should be read in conjunction with the financialstatements and notes to those statements included elsewhere in this QuarterlyReport on Form 10-Q as of June 30, 2006 and our audited financialstatements for the year-ended December 31, 2005 included in our Form S-1previously filed with the SEC.*

*This report contains forward-looking statements that involverisks and uncertainties.  These statements relate to future periods,future events or our future operating or financial plans or performance. These statements can often be identified by the use of forward-lookingterminology such as “expects,” “believes,” “intends,” “anticipates,” “estimates,”“plans,” “may,” or “will,” or the negative of these terms, and other similarexpressions.  These forward-looking statements include statements as tothe source of our revenues, our ability to generate revenues, our ability tosustain our growth rate and profitability, our expectation regarding theincrease in certain expenses, our cash needs, our capital requirements, and ourmarket risk sensitivity.*

*These forward-looking statements reflect our current viewswith respect to future events, are based on assumptions and are subject torisks and uncertainties.  These risks and uncertainties could cause actualresults to differ materially from those projected and include, but are notlimited to, fluctuations in our revenue and operating results, the demand fordigital video applications for the consumer, security surveillance andautomotive markets, our ability to compete, our dependence on key and highlyskilled personnel, the ability to develop new products and to enhance ourexisting products, our ability to integrate businesses that we may acquire, ourability 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. “Risk Factors.” Given these risks and uncertainties, you should not place undue reliance onthese forward-looking statements.  Except as required by federalsecurities laws, we undertake no obligation to update any forward-looking statementsfor any reason, even if new information becomes available or other events occurin 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 are a fablesssemiconductor company that designs, markets and sells mixed signal integratedcircuits for multiple video applications in the consumer, security surveillanceand automotive markets. We target video applications based on digitaltechnologies 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.

We commencedoperations in 1997. From 1997 to 1999, we were primarily involved in developingour technology. We shipped our first generation video decoder in 1999. Since1999, our business has experienced significant growth primarily as a result ofour ability to develop new products, obtain design wins and convert these

15

----

design wins intorevenues. We generated revenues from the sale of over 20 different products inthe three months ending June 30, 2006.

We have threeprincipal semiconductor product lines: video decoder products, securitysurveillance products and liquid crystal display, or LCD, products. Our videodecoder 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, phasealternation line, or PAL, and sequential color with memory, or SECAM, andpopular analog video signals, including composite, S-Video, component andSyndicate of Radio and Television Manufacturers, or SCART, into a standarddigital format. In 2006, we intend to expand the video decoder product line toinclude a line of mixed signal audio products that decode the audio portion ofan analog TV broadcast signal. Our security surveillance products integrateimportant functions required to display, store and transport analog videosignals from security surveillance cameras. In March 2006, we introduced twonew security surveillance products, each of which includes four video decodersand a system controller on a single semiconductor. We also introduced in March2006 a semiconductor in the CODEC segment for digital video decoderapplications designed specifically for the security surveillance market. OurLCD display products integrate important functions required to display analogTV broadcast, popular analog video, high definition video and PC graphicssignals on an LCD display. In January 2006, we announced the introduction ofthree new LCD display processors designed for the automotive end market. Thesenew products are designed to provide advanced image processing, an integratedprogrammable timing controller and multiple analog and digital video inputs.Our other products include contract development projects, early generationmixed signal semiconductors for digital video applications unrelated to ourthree principal product lines and a PCI video decoder product, which is a videodecoder that utilizes peripheral component interconnect, or PCI, technology forpersonal computer applications.

Although ourrevenues 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 increasedresearch and development and sales and marketing efforts. These expendituresmay not result in increased revenue or profitability in the future. In addition,our ability to increase our revenues will depend on increased demand fordigital video applications in the consumer, security surveillance andautomotive markets. The growth of our target markets is uncertain. In addition,the timing of orders by and shipments to our customers, as well as generaltrends in our target markets, can cause our revenue growth to be inconsistent.

We undertakesignificant product development efforts well in advance of a product’s release,and in advance of receiving purchase orders from our customers. Our productdevelopment efforts, which are focused on developing new designs with broaddemand and potential for future derivative products, typically take from sixmonths to two years until production begins, depending on the product’scomplexity. If we secure a design win, the system designer is likely tocontinue to use the same or enhanced versions of our product across a number oftheir models, which tends to extend the life cycles of our product. Conversely,if a competitor secures the design win, it may be difficult for us to sell intothe customer’s application for an extended period. Our sales cycle typicallyranges from six to 12 months. Due to the length of our product development andsales cycle, the majority of our revenues for any period is generally weightedtoward products introduced for sale, meaning products for which we commencedplacing orders with our manufacturing subcontractors, in the prior one or twoyears. As a result, our present revenues are not necessarily representative offuture sales because our future sales are likely to be comprised of a differentmix of products, some of which are now in the development stage.

As a fablesssemiconductor company, we outsource all of our manufacturing, assembly and testfunctions to third-party vendors primarily located in Taiwan. This businessmodel enables us to reduce our capital expenditures and fixed costs, whilefocusing our engineering and design resources on our core strength, the designof mixed signal semiconductors for digital video applications. We believe thismodel also reduces the impact on our business of potential end marketseasonality, cyclicality and fluctuations in demand.

We sell ourproducts to distributors that fulfill third-party orders for our products. Wealso sell directly, using independent sales representatives, to OEMs such asSamsung and LG Electronics, which are some of our largest customers, and tooriginal design manufacturers, or ODMs. In the three months ended June 30,2006, we derived approximately 76% of our revenues from products sold todistributors and 24% from products sold to OEMs or ODMs.  In the six months ended June 30, 2006, wederived approximately 77% of our revenues from

16

----

products sold todistributors and 23% 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.

We received anaggregate of 75% and 71% of our revenues from our ten largest customers in thethree months ended June 30, 2006 and 2005, respectively. For the three monthsended June 30, 2006, three of our customers accounted for 15%, 11% and 10%,respectively, of our revenues. For the three months ended June 30, 2005, two ofour customers accounted for 17% and 10%, respectively, of our revenues.  For the six months ended June 30, 2006, fourof our customers accounted for 12%, 12%, 11% and 10%, respectively, of ourrevenues. For the six months ended June 30, 2005, two of our customersaccounted for 14% and 11%, respectively, of our revenues.

We derivesubstantially all of our revenues from sales to foreign customers, particularlyin Asia. In the three months ended June 30, 2006, approximately 99% of ourrevenues were from sales in Asia, including 51% in Taiwan, 28% in South Korea,17% in China and 3% in Japan. In the three months ended June 30, 2005,approximately 99% of our revenues were from sales in Asia, includingapproximately 50% in Taiwan, 39% in South Korea, 8% in China and 2% inJapan.  In the six months ended June 30,2006, approximately 99% of our revenues were from sales in Asia, includingapproximately 44% in Taiwan, 33% in South Korea, 19% in China and 3% in Japan.In the six months ended June 30, 2005, approximately 99% of our revenues werefrom sales in Asia, including approximately 43% in Taiwan, 43% in South Korea,10% in China and 3% in Japan. We believe that a substantial majority of ourrevenues will continue to come from customers located in Asia, where most ofthe consumer electronic devices that use our integrated circuits, or ICs, aremanufactured. As a result of this regional customer concentration, we may besubject to economic and political events and other developments that impact ourcustomers in Asia. However, all of our sales, substantially all of our cost ofrevenues and a majority of our operating expenses are denominated in U.S. dollars.As a consequence, we believe that our overall exposure to foreign exchange riskis low.

We have two international branches, one in South Koreaand one in Taiwan and we recently established a subsidiary in China. As of June30, 2006, 27 of our 85 employees were located in our international subsidiaryand two international branches. Our South Korea branch is primarily involved inproduct development and is also involved in technical sales support. Our Chinasubsidiary and our Taiwan branch provide sales and marketing support.

It is difficultfor us to forecast the demand for our products, in part because of the highlycomplex supply chain between us and the end markets that incorporate ourproducts. Demand for new features changes rapidly. Distributors and ODMs add anadditional layer of complexity. We must, therefore, forecast demand not onlyfrom our direct customers, but also from other participants in this multi-leveldistribution channel. Because of our lengthy product development cycle, it iscritical for us to anticipate changes in demand for our various productfeatures and the applications they serve, to allow sufficient time for productdesign. Our failure to accurately forecast demand can lead to product shortagesthat can impede production by our customers and harm our relationship withthese customers. Conversely, our failure to forecast declining demand or shiftsin product mix can result in excess or obsolete inventory.

Generally, theaverage 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.

Our revenuesincreased by 32% for the three months ended June 30, 2006 compared to the threemonths ended June 30, 2005 and net income increased to $2.9 million for thethree months ended June 30, 2006 from $2.2 million for the three months endedJune 30, 2005. Our revenues increased by 47% for the six months ended June 30,2006 compared to the six months ended June 30, 2005 and net income increased to$3.9 million for the six

17

----

months ended June 30,2006 from $1.5 million for the three months ended June 30, 2005. However, wehad an accumulated deficit of $19.4 million as of June 30, 2006 and we may notbe able to maintain our recent growth and profitability. Our limited operatinghistory makes the prediction of future operating results very difficult. Webelieve that period-to-period comparisons of operating results should not berelied upon as predictive of future performance.

**CriticalAccounting Policies**

Our discussion andanalysis of our financial condition and results of operations are based uponour consolidated financial statements, which have been prepared in accordancewith accounting principles generally accepted in the United States. Thepreparation of these financial statements requires us to make estimates andjudgments that affect the reported amount of assets, liabilities, revenues andexpenses and related disclosure of contingent assets and liabilities. Weevaluate our estimates on an on-going basis, including those related toinventory valuations, income taxes, warranty obligations and stock-basedcompensation. We base our estimates on historical experience and on variousother assumptions that we believe to be reasonable under the circumstances, theresults of which form the basis for making the judgments we make about thecarrying values of assets and liabilities that are not readily apparent fromother sources. Because these estimates can vary depending on the situation,actual results may differ from the estimates.

We believe thefollowing critical accounting policies affect our more significant judgmentsused in the preparation of our consolidated financial statements.

*RevenueRecognition.  *Revenuesfrom product sales are recognized upon shipment, provided title and risk ofloss has passed to the customer, when persuasive evidence of an arrangementexists, the price is fixed or determinable and collectibility is probable. Wedo not allow for price protection or stock rotation rights with any of ourdistributors.

*Warranty.  *We offer a one-yearproduct replacement warranty against any defective product. We accrue forestimated returns of defective products at the time revenue is recognized,based on the rate of return for the prior 12 months. As a consequence ofstandardized manufacturing processes and product testing procedures, returns ofdefective product are infrequent and the quantities have not been significant.Accordingly, historical warranty costs have not been significant in the fiscalperiods presented.

*InventoryValuation.  *Inventoryis valued at the lower of cost or market, computed on a first-in, first-outbasis. We evaluate inventory for excess and obsolescence and write-off unitsthat are unlikely to be sold based upon a six months’ demand forecast. Thisevaluation may take into account matters including expected demand, anticipatedsales price, product obsolescence and other factors. If actual future demandfor our products is less than currently forecasted, additional inventoryadjustments may be required. Once a reserve is established, it is maintaineduntil the product to which it relates is sold or scrapped. If a unit that hasbeen written down or off is subsequently sold, the cost associated with therevenue from this unit is reduced to the extent of the write off, resulting inan increase in gross profit.

*Accountingfor Income Taxes.  *Weaccount for income taxes under the provisions of SFAS, No. 109, *Accounting for Income Taxes*. In applyingSFAS No. 109, we are required to estimate our current tax expense together withassessing temporary differences resulting from differing treatments of itemsfor tax and accounting purposes. These differences result in deferred taxassets and liabilities. Significant management judgment is required to assessthe likelihood that our deferred tax assets will be recovered from futuretaxable income. As of December 31, 2005, our total deferred tax assets wereprincipally comprised of net operating loss carryforwards, research and othercredit carryforwards and expense accruals. As of December 31, 2005, based onthe available objective evidence, we believed it is more likely than not thatour deferred tax assets will not be realizable. We based this belief primarilyon the fact that, despite our pre-tax income for the year ended December 31,2005, we have incurred cumulative pre-tax losses in all prior years.Accordingly, we provided a full valuation allowance against our net deferredtax assets as of December 31, 2005. Should sufficient positive, objectivelyverifiable evidence of the realization of our net deferred tax assets exist ata future date, we would reverse any remaining valuation allowance to the extentsupported by estimates of future taxable income at that time.

18

----

As of December 31,2005, we had approximately $14 million of federal and $9 million of state net operatingloss carryforwards available to offset future taxable income. If not utilized,these carryforwards will expire beginning in 2012 for federal and state taxpurposes. We also have research and other tax credit carryforwards ofapproximately $0.6 million and $0.5 million for federal and state income taxpurposes, respectively. If not utilized, the federal carryforwards will expirein various amounts beginning in 2012. The state tax credits can be carriedforward indefinitely.

In the future weexpect, as we have historically experienced, that substantially all of ourrevenues will come from foreign locations. As such, we are transferring certainfunctions to our foreign operations that are geographically closer to oursuppliers and customers. We are in the process of establishing a foreignsubsidiary to which we will be transferring operating activities. Some of theseactivities may include order entry, purchasing and billing functions. We havenot yet decided where to relocate these functions as we are continuing toevaluate the locations in which it will be most efficient to conduct theseoperating activities. However, we do not currently anticipate any materialchanges in personnel or facilities. Our foreign locations are in taxjurisdictions with income tax rates lower than the United States statutoryincome tax rates. Consequently, we believe that our future effective income taxrate will eventually be less than the United States statutory income tax ratesbecause we do not intend to remit these earnings from our foreign subsidiaryback to the United States. Our future effective income tax rate will be subjectto many variables, including the absolute amount and future geographicdistribution of our pre-tax income, our ability to successfully transfer ouroperating activities to our foreign operations and the amount and timing ofintercompany payments from our foreign operations subject to United Statesincome taxes related to the transfer of certain rights and functions. As aresult of any of these factors, our future effective income tax rate is likelyto fluctuate significantly over the next few years.

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

We adopted SFAS123(R) using the prospective transition method. Under this method, SFAS 123(R)is applied to new awards and to awards modified, repurchased or cancelled afterJanuary 1, 2006. Compensation cost previously recorded under Opinion 25 forunvested options will continue to be recognized as the required services arerendered. Accordingly, for the three and six months ended June 30, 2006, stockbased compensation expense includes compensation costs related to estimatedfair values of awards granted after the date of adoption of SFAS 123(R) andcompensation costs related to unvested awards at the date of adoption based onthe intrinsic values as previously recorded under Opinion 25.

For optionsgranted after January 1, 2006, and valued in accordance with SFAS 123(R), weuse the straight-line method for expense attribution. For options granted priorto January 1, 2006, we use 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.

Upon adoption ofSFAS 123(R), we were required to estimate the number of outstanding optionsthat are not expected to vest. In subsequent periods, if actual forfeituresdiffer from these estimates, we will revise our estimates. No compensation costis recognized for options that do not vest. Under the multiple grant approach,forfeitures of unvested options resulting from employee terminations result inthe reversal during the period in which the termination occurred of previouslyexpensed stock compensation associated with the unvested options. Stockcompensation from vested options, whether forfeited or not, is not reversed.

We estimated thefair value of options granted after January 1, 2006 using the Black-Scholesoption valuation model. This valuation model requires us to make assumptionsand judgments about the variables used in the calculation. These variables andassumptions include the weighted average period of time that the optionsgranted are expected to be outstanding, the volatility of our common stock, therisk free interest rate and the estimated rate of forfeitures of unvested stockoptions. If actual results differ from our estimates, we will record thedifference as a cumulative adjustment in the period we revise our estimates.Since our stock has not been actively

19

----

traded in the past, weused the simplified calculation of expected life described in the Securitiesand Exchange Commission Staff Accounting Bulletin 107 and we estimated ourstock’s volatility based on an average of the historical volatilities of thecommon stock of several entities with characteristics similar to us. Therisk-free rate is based on U.S. Treasury securities. We estimated expectedforfeitures based on our historical experience.

The followingassumptions are used to value stock options granted after adoption of SFAS123(R):

|                          | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **               | ** ** | **June 30, 2006**      | ** ** | **June 30, 2006**    | ** ** |
| ** **               | ** ** | ** **                       | ** ** | ** **                     | ** ** |
| Expected term in  years  |       | 6.08                             |       | 6.08                           |       |
| Risk-free  interest rate |       | 5.0                              | %          | 4.55% - 5.                     | 0%         |
| Expected  volatility     |       | 73.8                             | %          | 73.8% - 74.                    | 1%         |
| Dividend yield           |       | 0                                | %          | 0                              | %          |

 

We account forstock-based compensation awards issued to our employees prior to our adoptionof SFAS 123(R) on January 1, 2006 using the intrinsic value measurementprovisions of Opinion 25. Accordingly, we have recorded compensation expensefor stock options granted with exercise prices less than the fair value of theunderlying 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.

Under theprovisions of APB Opinion No. 25, wedetermine our amortization expense following the multiple grant approach, whichresults in substantially higher amounts of amortization in earlier years asopposed to the single grant approach, which results in equal amortization overthe vesting period of the options. Under the multiple grant method, theamortization in any given period is significantly impacted by the number andtiming of grants within the period and the amount by which the estimated fairvalue of our stock exceeds the exercise price of the option and, to a lesserextent, from the amortization of options granted in previous periods.Forfeitures of unvested options resulting from employee terminations result inthe reversal during the period of forfeiture of previously expensed stockcompensation associated with the unvested options. Stock compensation fromvested options, whether forfeited or not, is not reversed.

Stock-basedcompensation expense is allocated among cost of revenues, research anddevelopment expenses and selling, general and administrative expenses,respectively, based upon the employee’s job function.**We expect to continue to recognize substantial amounts ofstock-based compensation expense relating to our employee stock options infuture periods primarily as a result of our adoption of SFAS 123(R).

20

----

***Resultsof Operations***

The following tableis derived from our selected financial data and sets forth our historicaloperating results as a percentage of revenues for the periods indicated:
| ** **                                                         | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                         | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| **Consolidated Statement of Operations Data:** | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenues                                                           |       | 100.0                            | %          | 100.0                          | %          | 100.0 | % | 100.0 | % |
| Cost of  revenues*                                                 |       | 40.9                             |       | 43.6                           |       | 43.1 |   | 48.4 |   |
| Gross margin                                                       |       | 59.1                             |       | 56.4                           |       | 56.9 |   | 51.6 |   |
|                                                               |       |                             |       |                           |       |   |   |   |   |
| Operating  expenses:                                               |       |                             |       |                           |       |   |   |   |   |
| Research and development*                                          |       | 19.2                             |       | 20.2                           |       | 21.9 |   | 25.4 |   |
| Selling, general and administrative*                               |       | 14.7                             |       | 13.7                           |       | 16.4 |   | 17.2 |   |
|                                                               |       |                             |       |                           |       |   |   |   |   |
| Total operating expenses                                           |       | 33.9                             |       | 33.9                           |       | 38.3 |   | 42.6 |   |
|                                                               |       |                             |       |                           |       |   |   |   |   |
| Income from  operations                                            |       | 25.2                             |       | 22.5                           |       | 18.6 |   | 9.0 |   |
| Interest income                                                    |       | 1.9                              |       | 0.9                            |       | 1.8 |   | 0.9 |   |
|                                                               |       |                             |       |                           |       |   |   |   |   |
| Income before  income taxes                                        |       | 27.1                             |       | 23.4                           |       | 20.4 |   | 9.9 |   |
| Provision for income  taxes                                        |       | 4.6                              |       | 0.7                            |       | 3.3 |   | 0.4 |   |
| Net Income                                                         |       | 22.5                             | %          | 22.7                           | %          | 17.1 | % | 9.5 | % |

 

----

(*)  Percentages include stock-based compensation.The table below indicates the percentage of stock-based compensation attributedto each item as a percentage of revenues for the periods indicated:
| ** **                           | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                           | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                           | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| Costs and  expenses:                 |       |                             |       |                           |       |   |   |   |   |
| Cost of revenues                     |       | 0.2                              | %          | 0.1                            | %          | 0.2 | % | 0.1 | % |
| Research and  development            |       | 1.1                              |       | 1.3                            |       | 3.3 |   | 1.3 |   |
| Selling, general and  administrative |       | 2.0                              |       | 1.3                            |       | 2.1 |   | 1.9 |   |

 

21

----

***Revenues by product line are as follows (inthousands):***
| ** **                | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| Security  Surveillance(1) |       | $                                | 5,711      |                           | $          | 3,020 |   | $ | 10,663 |   | $ | 4,789 |   |
| Video  Decoders(2)        |       | 5,445                            |       | 5,537                          |       | 9,097 |   | 7,637 |   |
| LCD Display(3)            |       | 1,288                            |       | 928                            |       | 2,280 |   | 2,491 |   |
| Other(4)                  |       | 356                              |       | 197                            |       | 561 |   | 465 |   |
| Total                     |       | $                                | 12,800     |                           | $          | 9,682 |   | $ | 22,601 |   | $ | 15,382 |   |

 

----

(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 contract development projects early generation mixed signal semiconductorsfor digital video applications unrelated to the three principal product linesand a PCI video decoder product.

**Comparisons of the Three Months Ended June 30, 2006 and 2005**

*Revenues.*    Our revenues consist of salesof our mixed signal integrated circuits for digital video applications.  We have three principal product lines:  video decoder, security surveillance and LCDdisplay.  All of our sales aredenominated in U.S. dollars.

Revenueswere $12.8 million for the three months ended June 30, 2006 and $9.7 millionfor the three months ended June 30, 2005, an increase of 32%.  Revenues from our security surveillanceproducts increased approximately $2.7 million, or 89%, in the three monthsended June 30, 2006 compared to the three months ended June 30, 2005, primarilyas a result of the increase in sales of our four-in-one security surveillanceproducts.  Revenues from video decoderproducts decreased approximately $0.1 million, or 2%, in the three months endedJune 30, 2006 compared to the three months ended June 30, 2005, primarily as aresult of a shift in sales from general-purpose videodecoders to application specific products specifically for the securitysurveillance market.  Revenuesfrom our LCD display products increased by $0.4 million, or 39%, in the threemonths ended June 30, 2006 compared to the three months ended June 30, 2005,primarily as a result of increased demand in the automotive market.  Other revenues increased $0.2 million, or81%, in the three months ended June 30, 2006 as compared with the three monthsended June 30, 2005, primarily as a result of increased sales of our PCI videodecoder product introduced in the first quarter of 2005.

*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.

22

----

Gross profit was $7.6 million for the threemonths ended June 30, 2006 and $5.5 million for the three months ended June 30,2005, an increase of 39%.  Gross margin was 59% for the three monthsended June 30, 2006 increasing from 56% for the three months ended June30, 2005.  The increase in gross margin was primarily aresult of reduced materials andproduction costs in the second quarter of 2006 compared to the second quarterof 2005.  Additionally, gross margin inthe second quarter of 2006 benefited from sales of inventory that was previouslywritten-off of approximately $0.3 million.

Weincurred stock-based compensation included in cost of revenues associated withoutsourced manufacturing support and quality assurance personnel of less than$0.1 million in both the three months ended June 30, 2006 and 2005.

*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.

Researchand development expenses were $2.5 million, or 19% of revenues, for the threemonths ended June 30, 2006 and $2.0 million or 20% of revenues for the threemonths ended June 30, 2005.  Compensationrelated expenses increased by approximately $0.4 million due in part to theincrease in engineering headcount from 38 at June 30, 2005 to 40 at June 30,2006 and increased expenses associated with our Korea branch.

Weincurred stock-based compensation expense associated with research anddevelopment personnel of $0.1 million in both the three months ended June30, 2006 and 2005.

*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 $1.9 million, or 15% of revenues, forthe three months ended June 30, 2006 and $1.3 million or 14% of revenues forthe three months ended June 30, 2005. The increase in expense in absolute dollars was due primarily toincreased compensation and consulting related expenses of $0.3 million tosupport increasing customer interest in our products and the growth of ourbusiness and an increase in professional services expense of $0.1 million foraudit and legal services associated with the growth in our business. Theseincreases in expense were offset in part by a decrease of $0.1 million incommission expense for sales representatives reflecting a larger proportion ofsales to distributors in the period.  Weexpect selling, general and administrative expenses to continue to increase inthe future in support of our anticipated growth as we hire additionalpersonnel, expand our sales and marketing efforts and pay increased salescommissions based on a projected increase in sales volume.  Administrative expenses will also increase tocover additional costs associated with operating as a public company, such asimprovements to our information technology infrastructure and increased costsassociated with our efforts to comply with the Sarbanes-Oxley Act of 2002.

Weincurred stock-based compensation expense associated with selling, general andadministrative personnel of $0.3 million and $0.1 million in the threemonths ended June 30, 2006 and 2005, respectively.

*Interest Income.*    Interest income was $0.3million for the three months ended June 30, 2006 and $0.1 million for the threemonths ended June 30, 2005.  The increasewas due to higher cash, cash equivalent and short-term investment balances as aresult of our initial public offering and higher interest rates in the threemonths ended June 30, 2006.

23

----

*Income Taxes.*    Our provision for income taxeswas $0.6 million for the three months ended June 30, 2006 and $0.1 million forthe three months ended June 30, 2005. The effective tax rate for both periods differed from the statutoryfederal income tax rate primarily because we utilized prior net operatinglosses to offset profits.

**Comparisons of the Six Months Ended June 30, 2006 and 2005**

*Revenues.*   Revenues were $22.6 million for the sixmonths ended June 30, 2006 and $15.4 million for the six months ended June 30,2005, an increase of 47%.  Revenues fromour security surveillance products increased approximately $5.9 million, or123%, in the six months ended June 30, 2006 compared to the six months endedJune 30, 2005, primarily as a result of the increase in sales of our four-in-onesecurity surveillance products.  Revenuesfrom video decoder products increased approximately $1.5 million, or 19%, inthe six months ended June 30, 2006 compared to the six months ended June 30,2005, primarily as a result of a general increase in demand in the market thatour video decoders serve offset by a shift insales from general-purpose video decoders to application specific productsspecifically for the security surveillance market.  Revenues from of our LCD display productsdecreased by $0.2 million, or 8%, in the six months ended June 30, 2006compared to the six months ended June 30, 2005, caused in part by a large orderfrom a single customer that was shipped in the first quarter of 2005.  Other revenues increased $0.1 million, or 21%,in the six months ended June 30, 2006 as compared with the six months endedJune 30, 2005, primarily as a result of increased sales of our PCI videodecoder product introduced in the first quarter of 2005.

*GrossProfit and Gross Margin.*  Gross profit was  $12.9million for the six months ended June 30, 2006 and $7.9 million for the sixmonths ended June 30, 2005, an increase of 62%. Gross margin was 57% for thesix months ended June 30, 2006 increasing from 52% for the six months ended June30, 2005.  The increase in gross margin was primarily aresult of reduced materialscosts and production costs in the six months ended June 30, 2006 compared tothe same period in 2005.  Our grossmargin in the six months ended June 30, 2005 was adversely impacted by the decline in the average selling priceof our LCD display products arising from discounts granted on a large orderfrom a single customer.

Weincurred stock-based compensation included in cost of revenues associated withoutsourced manufacturing support and quality assurance personnel of less than$0.1 million in both the six months ended June 30, 2006 and 2005.

*Research and Development.*  Research and developmentexpenses were $5.0 million, or 22% of revenues, for the six months ended June30, 2006 and $3.9 million or 25% of revenues for the six months ended June 30,2005.  Compensation related expensesincreased by approximately $0.7 million due to the increase in engineeringheadcount and increased expenses associated with our Korea branch. These increasesin expenses are partially offset by a decrease of $0.3 million in tape outexpenses that are not incurred uniformly every quarter.

Weincurred stock-based compensation expense associated with research anddevelopment personnel of $0.7 million and $0.2 million in the six monthsended June 30, 2006 and 2005, respectively. Stock-based compensation expense increased by $0.5 million for the sixmonths ended June 30, 2006 primarily as a result of stock options granted inthe first quarter of 2006 to certain consultants as compensation for productdevelopment services of $0.5 million.

*Selling, General and Administrative*.  Selling,general and administrative expenses were $3.7 million, or 16% ofrevenues, for the six months ended June 30, 2006 and $2.7 million or 17% ofrevenues for the six months ended June 30, 2005.  The increase in expense in absolutedollars 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 and an increase in professionalservices expense of $0.3 million for audit and legal services associated withthe growth in our business. These increases in expense were offset in part by adecrease of $0.1 million in commission expense for sales representativesreflecting greater sales to distributors.

Weincurred stock-based compensation expense associated with selling, general andadministrative personnel of $0.5 million and $0.3 million the sixmonths ended June 30, 2006 and 2005, respectively.

24

----

*Interest Income.*    Interest income was $0.4million for the six months ended June 30, 2006 and $0.1 million for the sixmonths ended June 30, 2005.  The increasewas due to higher cash, cash equivalent and short-term investment balances as aresult of our initial public offering and higher interest rates in the sixmonths ended June 30, 2006.

*Income Taxes.*    Our provision for income taxeswas $0.8 million for the six months ended June 30, 2006 and $0.1 million forthe six months ended June 30, 2005.  Theeffective tax rate for both periods differed from the statutory federal incometax rate primarily because we utilized prior net operating losses to offsetprofits.

***Liquidityand Capital Resources***

Since ourinception, we have financed our growth primarily with proceeds from theissuance of preferred stock and common stock. As of June 30, 2006, we had cash, cash equivalents and short-terminvestments of $44.2 million. The Company maintains its cash, cash equivalentsand short-term investments with high credit-quality financialinstitutions.  As of the June 30, 2006,we had total working capital of $43.9 million. Our primary capital requirementsare to fund working capital needs.

Net cash providedby operating activities was $8.1 million in the six months ended June 30,2006.  The net cash provided by ouroperating activities in the six months ended June 30, 2006 was primarily due toour net income of $3.9 million and an increase in accounts payable and accruedliabilities of $2.2 million associated with increasing customer demand as aresult of new product introductions and increased sales of existing productsand a decrease in inventory of $0.1 million. The net cash provided by our operating activities was also due to adecrease in accounts receivable of $0.6 million attributable to the timing ofcustomer collections. We incurred non-cash expenses of $1.2 million for stockcompensation expenses and $0.1 million in depreciation expenses in the sixmonths ended June 30, 2006.

Net cash providedby operating activities was $1.2 million in the six months ended June 30,2005.  The net cash provided by ouroperating activities in the six months ended June 30, 2005 was primarily due toour net income of $1.5 million and an increase in accounts payable and accruedliabilities of $3.1 million and prepaid expenses and other current assets of$0.6 million which was offset by increases in inventory of $3.2 million andaccounts receivable of $1.2 million.  Theincreases in inventory and accounts receivable and accounts payable wereassociated with the increase in revenues during the period as a result of newproduct introductions and increased sales of existing products.  We incurred non-cash expenses of $0.5 millionfor stock compensation expenses and $0.1 million in depreciation expenses inthe six months ended June 30, 2005.

Net cash used in our investing activities was $17.2million in the six months ended June 30, 2006 reflecting purchases ofshort-term investments of $19.3 million and capital purchases of $0.2 millionoffset by maturities of short-term investments of $2.3 million.  Net cash provided by investing activities was$5.0 million in the six months ended June 30, 2005 reflecting maturities ofshort-term investments of $5.0 million.

Net cash provided by financing activities was $19.5million in the six months ended June 30, 2006. The net cash provided by financing activities in the six months endedJune 30, 2006 primarily consisted of proceeds from our initial stock offeringnet of underwriting discounts, commissions and offering costs of $19.3 millionand proceeds from the exercise of stock options of $0.3 million.

Net cash providedby our financing activities was $3.2 million in the six months ended June30, 2005. Net cash provided by our financing activities consisted of proceedsof $2.9 million from the issuance of Series F redeemable preferredstock, $0.2 million from the exercise of common stock options and $0.2 millionfrom collections of stockholders’ notes receivable.

We consider allhighly liquid investments purchased with a remaining maturity of three monthsor less at the date of purchase to be cash equivalents. Cash and cashequivalents consist of demand accounts, money market funds and commercialpaper. Short-term investments consist of auction rate securities.

25

----

We believe ourexisting cash, cash equivalents and short-term investments, as well as cashthat we expect to generate from operating activities, will be sufficient tomeet our anticipated cash needs for at least the next 12 months.

Ourlong-term future capital requirements will depend on many factors, includingour level of revenues, the timing and extent of spending to support our productdevelopment efforts, the expansion of sales and marketing activities, thetiming 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 funding throughpublic or private equity or debt financing and additional funds may not beavailable 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.

***Off-Balance Sheet Arrangements***

As ofJune 30, 2006, we have no off-balance sheet arrangements as defined in Item303(a)(4) of the Securities and Exchange Commission’s Regulation S-K.

** *Contractual Obligations***

As of June 30, 2006, we had $0.5 million of totalfuture net lease commitments compared to $0.8 million at December 31, 2005. Thefollowing table identifies our commitments to settle contractual obligations asof June 30, 2006:
|                            | ** ** | **Payment Due by Period** | ** ** |
|----------------------------|------------|------------------------------------------|------------|
| ** **                 | ** ** | **Total**                                | ** ** | **Less than 1  year** | ** ** | **1-3 years** | ** ** | **4-5 years** | ** ** |
|                       |       |                                     |       |   |   |   |   |   |   |
| Minimum Lease  Commitments |       | $                                        | 477        |   | $ | 338 |   | $ | 139 |   | $ | — |   |
| Purchase  Commitments      |       | 4,196                                    |       | 4,196 |   | — |   | — |   |
| Total Commitments          |       | $                                        | 4,673      |   | $ | 4,534 |   | $ | 139 |   | $ | — |   |

 

****RecentAccounting Pronouncements****

In June 2006, theFinancial Accounting Standards Board (“FASB”) issued Interpretation No. 48 (“FINNo. 48”), **Accountingfor Uncertainty in Income Taxes**. This interpretation clarifiesthe accounting for uncertainty in income taxes recognized in an enterprise’sfinancial statements in accordance with FASB Statement No. 109, **Accounting forIncome Taxes. **FIN No. 48prescribes a recognition threshold and measurement attribute for the financialstatement recognition and measurement of a tax position taken or expected to betaken in a 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.

26

----

**ITEM 3. Quantitative and QualitativeDisclosures about Market Risk**

Theprimary objectives of our investment activity are to preserve principal,provide liquidity and maximize income without significantly increasing therisk. Some of the securities we invest in are subject to market risk. Thismeans that a change in prevailing interest rates may cause the principal amountof the investment to fluctuate. To minimize this risk, we maintain ourportfolio of cash equivalents and short-term investments in money market funds,commercial paper and auction rate securities which are investment gradesecurities with a maximum dollar weighted maturity of two years or less. Therisk associated with fluctuating interest rates is limited to our investmentportfolio, and we believe that a 10% change in interest rates would not have asignificant impact on our interest income.

Todate, our international customer agreements have been denominated solely inU.S. dollars, and accordingly, we have not been exposed to foreign currencyexchange rate fluctuations from customer agreements, and do not currentlyengage in foreign currency hedging transactions. However, the functionalcurrency of our operations in Taiwan and South Korea is the U.S. dollar and ourlocal accounts are maintained in the local currency in Taiwan and South Korea,respectively, and thus we are subject to foreign currency exchange ratefluctuations associated with remeasurement to U.S. dollars. Such fluctuationshave not been significant historically.

**ITEM 4. Controls and Procedures**

(a) ***Evaluation of disclosure controls and procedures.***We maintain “disclosure controls and procedures,” as such term is defined inRule 13a-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”),that are designed to ensure that information required to be disclosed by us inreports that we file or submit under the Exchange Act is recorded, processed,summarized, and reported within the time periods specified in Securities andExchange Commission rules and forms, and that such information is accumulatedand communicated to our management, including our Chief Executive Officer andChief Financial Officer, as appropriate, to allow timely decisions regardingrequired disclosure. In designing and evaluating our disclosure controls andprocedures, management recognized that disclosure controls and procedures, nomatter how well conceived and operated, can provide only reasonable, notabsolute, assurance that the objectives of the disclosure controls andprocedures are met. Our disclosure controls and procedures have been designedto meet the reasonable assurance standards. Additionally, in designingdisclosure controls and procedures, our management necessarily was required toapply its judgment in evaluating the cost-benefit relationship of possibledisclosure controls and procedures. The design of any disclosure controls andprocedures also is based in part upon certain assumptions about the likelihoodof future events, and there can be no assurance that any design will succeed inachieving its stated goals under all potential future conditions.

Based on their evaluation as of theend of the period covered by this quarterly report on Form 10-Q, our ChiefExecutive Officer and Chief Financial Officer have concluded that, as of suchdate, our disclosure controls and procedures were effective at the reasonableassurance level.

(b) ***Changes in internal control over financial reporting.***There was no change in our internal control over financial reporting (asdefined in Rule 13a-15(f) under the Exchange Act) identified in connection withthe evaluation described in Item 4 above that occurred during the periodcovered by this quarterly report that has materially affected, or is reasonablylikely to materially affect, our internal control over financial reporting.

27

----

**PART II—OTHER INFORMATION**

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

We arecurrently not a party to any material legal proceedings. We may from time totime become involved in litigation relating to claims arising from our ordinarycourse of business. These claims, even if not meritorious, could result in theexpenditure of significant financial and managerial 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 ourrevenue and operating results on a quarterly basis could cause the market priceof our common stock to decline.***

Our revenue and operatingresults are difficult to predict, have in the past fluctuated, and may in thefuture fluctuate from quarter to quarter. It is possible that our operatingresults in some quarters will be below market expectations. This would likelycause the market price of our common stock to decline. Our quarterly operatingresults 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;

·                  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 ofnew product announcements or introductions by us or by our competitors.

We base our plannedoperating 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 wouldharm our operating results for that quarter.

28

----

***We have a historyof losses, have only recently become profitable and may not sustain or increaseprofitability in the future which may cause the market price of our commonstock to decline.***

We first becameprofitable in the second quarter of 2005. We incurred significant net lossesprior to that quarter. As of June 30, 2006, we had an accumulated deficit ofapproximately $19.4 million. To sustain or increase profitability, we will needto 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 ofdemand for digital video applications for the consumer, security surveillanceand automotive markets does not continue, our ability to increase our revenuecould suffer.***

Our ability to increaseour revenue will depend on increased demand for digital video applications inthe consumer, security surveillance and automotive markets. If our targetmarkets do not grow as rapidly or to the extent we anticipate, our businesscould suffer. The growth of our target markets is uncertain and will depend inparticular 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.

***The average sellingprices of our semiconductor products have historically decreased rapidly andwill likely do so in the future, which could harm our revenue and grossprofits.***

The semiconductorproducts we develop and sell are subject to rapid declines in average sellingprices. From time to time, we have had to reduce our prices significantly tomeet customer requirements, and we may be required to reduce our prices in thefuture. Reductions in our average selling prices to one customer could impactour average selling prices to all customers which may negatively impact ourrevenues. This would cause our gross margins to decline which in turn maynegatively impact our operating results. Our financial results will suffer ifwe are unable to offset any reductions in our average selling prices byincreasing our sales volumes, reducing our costs or developing new or enhancedproducts on a timely basis with higher selling prices or gross margins.

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

The markets in which weoperate are extremely competitive and are characterized by rapid technologicalchange, continuously evolving customer requirements and declining averageselling prices. We may not be able to compete successfully against current orpotential competitors. If we do not compete successfully, our market share andrevenue may decline. We compete with large semiconductor manufacturers anddesigners. Most of our current and potential competitors have longer operatinghistories, significantly greater resources and name recognition and a largerbase of customers than we do. This may allow them to respond more quickly thanwe can to new or emerging technologies or changes in customer requirements. Inaddition, these competitors may have greater credibility with our existing andpotential customers. Many of our current and potential customers have their owninternally developed semiconductor solutions and may choose not to purchaseproducts from third party suppliers like us.

29

----

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

We believe our futuresuccess will depend in large part upon our ability to attract and retain highlyskilled managerial, engineering and sales and marketing personnel. The loss ofany key employees or the inability to attract or retain qualified personnel,including engineers and sales and marketing personnel, could delay thedevelopment and introduction of, and harm our ability to sell, our products andharm 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 of ourboard of directors and management team recently joined us. For example, MarkVoll, our chief financial officer, joined us in November 2005. Because of theserecent 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 todevelop new products and enhance our existing products in order to react torapid technological change and market demands, our business will suffer.***

We must develop newproducts and enhance our existing products with improved technologies to meetrapidly 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 and enhancingthese products is uncertain and can be time-consuming, costly and complex.There is a risk that these developments and enhancements will be late, fail tomeet customer or market specifications or not be competitive with products fromour 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.

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

We expend considerableresources in order to achieve design wins for our products, especially our newproducts and product enhancements. Once a customer designs a semiconductor intoa product, it is likely to continue to use the same semiconductor or enhancedversions of that semiconductor from the same supplier across a number ofsimilar and successor products for a lengthy period of time due to thesignificant costs associated with qualifying a new supplier and potentially redesigningthe product to incorporate a different semiconductor. If we fail to achieve aninitial design win in a customer’s qualification process, we may lose theopportunity for significant sales to that customer for a number of its productsand for a lengthy period of time. This may cause us to be unable to recoup ourinvestments in our products, which would harm our business.

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

Our semiconductors areprincipally designed to decode analog broadcast TV signals into digital images.We believe the transmission of broadcast TV signals will over time shift fromanalog signals to digital signals. We are in the process of developing mixedsignal and digital technology to decode digital signals. However, transmissionof

30

----

digital video involves a combination of emergingtechnologies. The complexities of these technologies and the variability inimplementations between manufacturers may cause our development ofsemiconductors to be costly and time-consuming. We may never obtain thebenefits of our investment in developing this technology. The complexities ofdigital broadcast technologies may also cause some of the semiconductors we aredeveloping to ultimately work incorrectly for reasons that may be eitherrelated or unrelated to our products, or not be interoperable with other keyproducts. Delays or difficulties in integrating our semiconductors into digitalbroadcast TV products or the failure of products incorporating digitalbroadcast TV to achieve broad market acceptance could have an adverse effect onour business.

***A significantportion of our products are sold into the consumer and security surveillancemarkets, and if sales of our semiconductors into these markets decline or donot increase, or if we do not increase our sales into the automotive market,our business and financial results could suffer.***

We sell semiconductors targetedfor the consumer, security surveillance and automotive markets. We believe thatfor the year ended December 31, 2005 more than 80% of our sales were derivedfrom the sale of our products designed for the consumer and securitysurveillance markets. If sales of semiconductors into these markets decline ordo not increase, or if demand slows in these markets generally, our operatingresults would suffer. In addition, we have increased our focus on theautomotive market and devoted substantial resources to the development ofsemiconductors for digital video applications that address this market. If weare not successful in selling our semiconductors into this market, we may notrecover the costs associated with our efforts in this area and our operatingresults could suffer.

***Our customers inthe consumer market experience seasonality, which is likely to cause ourrevenues to fluctuate.***

A significant number ofour semiconductors are sold for use in the consumer market. Our customers whomanufacture products for the consumer market experience seasonality in thesales of their products, which in turn may affect the timing and volume oforders for our semiconductors. Because the consumer market for digital videoapplications is characterized by this seasonality, our operating results mayvary significantly from quarter to quarter. For example, we generallyexperience lower sales in the first calendar quarter with our video decoder andLCD display products as a result of the seasonality associated with the consumermarkets. These sales fluctuations are expected to continue.

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

Our sales are made on thebasis 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 ofcustomer demand. This process requires us to make multiple demand forecastassumptions, each of which may introduce error into our estimates. If weoverestimate customer demand, we may manufacture products that we may not beable to sell. As a result, we would have excess inventory, which would increaseour losses. Conversely, if we underestimate customer demand or if sufficientmanufacturing capacity were unavailable, we would forego revenue opportunities,lose market share and damage our customer relationships.

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

Our revenues have grownrapidly in a short period of time. We do not expect to achieve similar growthrates in future periods. You should not rely on the results of any priorquarterly 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.

31

----

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

In the future, we maypursue 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 could affect our future results.***

Our future effective taxrates could be favorably or unfavorably affected by the absolute amount andfuture 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 of approximately$14 million and $9 million, respectively. These net operating losscarryforwards may be used to offset future taxable income and thereby reduceour U.S. federal income taxes otherwise payable. Section 382 of the InternalRevenue Code of 1986, as amended, or the Code, imposes an annual limit on theability of a corporation that undergoes an ‘‘ownership change’’ to use its netoperating 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 ableto manage our future growth effectively, and we may need to incur significantexpenditures to address the additional operational and control requirements ofour growth.***

We are experiencing aperiod of significant growth and expansion, which has placed, and any futureexpansion will continue to place, a significant strain on our management,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

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

32

----

Our efforts may requiresubstantial managerial and financial resources and may increase our operatingcosts even though these efforts may not be successful. If we are unable tomanage our growth effectively, we may not be able to take advantage of market opportunities,develop new products, satisfy customer requirements, execute our business planor respond to competitive pressures.

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

We occasionally haveexperienced 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 test ourproducts, they are complex and may contain defects and errors. In the past, wehave 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 alimited number of independent subcontractors for the manufacture, assembly andtesting of our semiconductors, and the failure of any of these third-partyvendors to deliver products or otherwise perform as requested could damage ourrelationships with our customers, decrease our sales and limit our growth.***

We do not have our ownmanufacturing 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 our products. If these vendors do not provide uswith high-quality products, services and production and test capacity in atimely manner, or if one or more of these vendors terminates its relationshipwith us, we may be unable to obtain satisfactory replacements to fulfillcustomer orders on a timely basis, our relationships with our customers couldsuffer and our sales could decrease. Other significant risks associated withrelying on these third-party vendors include:

·                  reducedcontrol over product cost, delivery schedules and product quality;

·                  potentialprice increases;

·                  inabilityto achieve required production or test capacity and achieve acceptable yieldson a timely basis;

·                  longerdelivery times;

·                  increasedexposure to potential misappropriation of our intellectual property;

·                  shortagesof materials that foundries use to manufacture products;

33

----

·                  laborshortages or labor strikes; and

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

We currently do not havelong-term supply contracts with any of our third-party vendors. Therefore, theyare not obligated to perform services or supply products to us for any specificperiod, in any specific quantities or at any specific price, except as may beprovided in a particular purchase order. Neither TSMC nor ASE has providedcontractual assurances to us that adequate capacity will be available for us tomeet future demand for our products. These third party vendors may allocatecapacity to the production of other companies’ products while reducingdeliveries to us on short notice. In particular, other customers that arelarger and better financed than we are or that have long-term agreements withTSMC or ASE may cause either or both of them to reallocate capacity to thosecustomers, decreasing the capacity available to us.

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

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 could negativelyimpact our sales volumes and net revenue.

***We may experiencedifficulties in transitioning to smaller geometry process technologies or inachieving higher levels of design integration, which may result in reducedmanufacturing yields, delays in product deliveries and increased expenses.***

To reduce costs andmaintain 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 manufacturingprocesses, which resulted in reduced manufacturing yields, delays in productdeliveries and increased expenses. We may face similar difficulties, delays andexpenses in the future. If our foundry, or we, experience significant delays inthese transitions or fail to efficiently implement these transitions, ourbusiness, financial condition and results of operations could suffer.

***Our businessdepends on international customers, suppliers and operations in Asia, and as aresult we are subject to regulatory, operational, financial and politicalrisks, which could adversely affect our financial results.***

The percentage of ourrevenues attributable to sales to customers in Asia was 99% in the three monthsended June 30, 2006 and 2005 and the six months ended June 30, 2006 and 2005.We expect that revenues from customers in Asia will continue to account forsubstantially all of our revenues. Currently, we maintain international salesoffices in Asia, and we rely on a network of third-party sales representativesto sell our products internationally. We have also established offices inChina, Taiwan and South Korea, which serve various aspects of our business.Moreover, we have in the past relied on, and expect to continue to rely on,suppliers, manufacturers and subcontractors located in Asia, including Taiwan.Accordingly, we are subject to several risks and challenges, any of which couldharm our business and financial results. These risks and challenges include:

·                  difficultiesand costs of staffing and managing international operations across differentgeographic areas and cultures;

·                  compliancewith a wide variety of domestic and foreign laws and regulations, includingthose relating to the import or export of semiconductor products;

34

----

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

·                  ourability to receive timely payment and collect our accounts receivable;

·                  political,legal and economic instability, foreign conflicts and the impact of regionaland global 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;

·                  fluctuationsin freight rates and transportation disruptions.

***Our sales cycle can be lengthy, which couldresult in uncertainty and delays in generating revenue.***

Because our products arebased on constantly evolving technologies, we have experienced a lengthy salescycle for some of our semiconductors, particularly those designed for digitalvideo applications in the automotive market. Our sales cycle typically rangesfrom six to 12 months. We may experience a delay between the time we increaseexpenditures for research and development, sales and marketing efforts andinventory and the time we generate revenue, if any, from these expenditures. Inaddition, because we do not have long-term commitments from our customers, wemust repeat our sales process on a continual basis even for current customerslooking to purchase a new product. As a result, our business could be harmed ifa customer reduces or delays its orders, chooses not to release productsincorporating our semiconductors or elects not to purchase a new product orproduct enhancements from us.

***We primarily sellour semiconductors through distributors, and if our relationships with one ormore of those distributors were to terminate, our operating results may beharmed.***

Wemarket and distribute our products primarily through distributors. Thisdistribution channel has been characterized by rapid change and consolidations.Distributors have accounted for a significant portion of our revenues in thepast. Sales to our distributors represented approximately 65% of our revenuesin 2005 and approximately 77% of our revenues in the six months ended June 30,2006.

Ouroperating results and financial condition could be significantly disrupted bythe loss of one or more of our current distributors and sales representatives,volume pricing discounts, order cancellations, delays in shipment by one of ourmajor distributors or sales representatives or the failure of our distributorsor sales representatives to successfully sell our products.

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

We seek to protect ourproprietary 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:

·                  thelaws of other countries in which we market our semiconductors, such as somecountries in the Asia/Pacific region, may offer little or no protection for ourproprietary technologies;

·                  peoplemay not be deterred from misappropriating our technologies despite theexistence of laws 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.

35

----

Reverse engineering,unauthorized copying or other misappropriation of our proprietary technologiescould enable third parties to benefit from our technologies withoutcompensating us for doing so. For example, if the foundry that manufactures oursemiconductors loses control of our intellectual property, it would be moredifficult for us to take remedial measures since it is located in Taiwan, whichdoes not have the same protection for intellectual property as is provided inthe United States. Any inability to adequately protect our proprietary rightscould harm our ability to compete, generate revenue and grow our business.

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

Although we 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 belimited in scope and any patents obtained may not be as readily enforceable asin the United 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.

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

Our industry 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 administrativeproceeding in front of the intellectual property tribunal in South Korea inwhich another party unsuccessfully sought a determination that our TW2824 andTW2834 products infringed a South Korean patent allegedly held by that party.We have certain indemnification obligations to customers under our contractdevelopment projects with respect to any infringement of third-party patentsand intellectual 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 of infringementin the digital video applications market involve highly technical andsubjective analyses. Litigation may be necessary in the future to enforce anypatents we may receive and other intellectual property rights, to protect ourtrade secrets, to determine the validity and scope of the proprietary rights ofothers or to defend against claims of infringement or invalidity, and we maynot prevail in any future litigation. Litigation, whether or not determined inour favor or settled, could be costly, could harm our reputation, could causeour customers to use our competitors’ products and could divert the efforts andattention of our management and technical personnel from normal businessoperations. In addition, adverse determinations in litigation could result inthe loss of our proprietary rights, subject us to significant liabilities,require us to seek licenses from third parties or prevent us from licensing ourtechnology or selling our products, any of which could seriously harm ourbusiness.

36

----

***Our headquartersare located in California and our third-party manufacturing, assembly andtesting vendors are concentrated in Asia and elsewhere in the Pacific Rim,areas subject to significant earthquake risks. Any disruption to our or theiroperations resulting from earthquakes or other natural disasters could cause significantdelays in the production or shipment of our products.***

TSMC, which manufacturesour semiconductors, and ASE, which performs substantially all of our assemblyand testing facilities, are each 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 is significant due to the proximity of major earthquake fault lines.In September 1999, a major earthquake in Taiwan affected the facilities of TSMCand ASE, as well as other providers of foundry, packaging and test services. In2005, several typhoons also disrupted the operations of TSMC and ASE. As aresult of these natural disasters, these contractors suffered power outages anddisruptions that impaired their production capacity. In March 2002 and June2003, additional earthquakes occurred in Taiwan. The occurrence of earthquakesor other natural disasters could result in the disruption of our foundry orassembly and test capacity. We may not be able to obtain alternate capacity onfavorable terms, if at all, which could harm our operating results.

***Changes tofinancial accounting standards may affect our results of operations and causeus to change our business practices.***

We prepare our financialstatements to conform with accounting principles generally accepted in theUnited States of America, or GAAP. These accounting principles are subject tointerpretation by the Financial Accounting Standards Board, or FASB, the Securitiesand Exchange Commission, or SEC, and various bodies formed to interpret andcreate appropriate accounting policies. A change in those policies can have asignificant effect on our reported results and may affect our reporting oftransactions completed before a change is announced. Changes to those rules orthe questioning of current practices may adversely affect our reportedfinancial results or the way we conduct our business. For example, accountingpolicies affecting many aspects of our business, including rules relating toemployee stock option grants, have recently been revised. The FASB and otheragencies have made changes to GAAP that require us, starting in our firstquarter of fiscal 2006, to record a charge to earnings for the estimated fairvalue 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 changecould make the use of equity-related compensation less attractive to us orrequire us to pay more cash compensation and therefore make it more difficultfor us to attract and retain employees.

**Risks Related to Our Industry**

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

The 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 periodicallyexperiences increased demand and production capacity constraints, which mayaffect our ability to ship products. Accordingly, our operating results havevaried and may vary significantly as a result of the general conditions in the semiconductorindustry, which could cause our stock price to decline.

37

----

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

The United States andinternational 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.

**Risks Related to Our Common Stock**

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

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

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

The trading market forour 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 likelydecline. If one or more of these analysts cease coverage of our company or failto regularly 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 toraise capital in the future may be limited and our failure to raise capitalwhen needed could prevent us from executing our growth strategy.***

We believe that ourexisting cash and cash equivalents will be sufficient to meet our anticipatedcash needs for at least the next 12 months. The timing and amount of ourworking capital and capital expenditure requirements may vary significantlydepending on numerous factors, including:

·                  marketacceptance of our products;

·                  theneed to adapt to changing technologies and technical requirements;

·                  theexistence of opportunities for expansion; and

·                  accessto and availability of sufficient management, technical, marketing andfinancial personnel.

If our capital resourcesare insufficient to satisfy our liquidity requirements, we may seek to selladditional equity securities or debt securities or obtain debt financing. Thesale of additional equity securities or convertible debt

38

----

securities would result in additional dilution to ourstockholders. Additional debt would result in increased expenses and couldresult in covenants that would restrict our operations. We have not madearrangements to obtain additional financing and there is no assurance thatfinancing, if required, will be available in amounts or on terms acceptable tous, if at all.

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

Additional salesof our common stock in the public market, or the perception that these salescould occur, could cause the market price of our common stock to decline. AtJune 30, 2006, we had 20,045,147 shares of common stock outstanding. Of these outstanding shares,

·                  5,500,000 shares are eligible forresale; and

·                  14,545,147 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 of theseshares may be released prior to expiration of the 180-day lock-up period at thediscretion of Lehman Brothers Inc. without prior notice. To the extent sharesare released before the expiration of the lock-up period and these shares aresold into the market, the market price of our common stock could decline.

In addition, the holdersof approximately 10,247,536 shares of common stock are entitled to rights tocause us to register the sale of those shares under the Securities Act.Registration of these shares under the Securities Act would result in theseshares, other than shares purchased by our affiliates, becoming freely tradablewithout restriction under the Securities Act immediately upon the effectivenessof the registration.

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

Our directors, executiveofficers 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. These actionsmay be taken even if they are opposed by our other stockholders.

***Management mayapply our cash and equivalents and short-term investments to uses that do notincrease our market value or improve our operating results.***

We intend to use our cashand equivalents and short-term investments for general corporate purposes,including working capital and capital expenditures. We may also use a portionof our cash and equivalents and short-term investments to acquire or invest incomplementary technologies, businesses or other assets. We have not reserved orallocated our cash and equivalents and short-term investments for any specificpurpose, and we cannot state with certainty how our management will use ourcash and equivalents and short-term investments. Accordingly, our managementhas considerable discretion in applying our cash and equivalents and short-terminvestments, and you will not have the opportunity, as part of your investmentdecision, to assess whether we are using our cash and equivalents and short-terminvestments appropriately. We may use our cash and equivalents and short-terminvestments for purposes that do not result in any increase in our results ofoperations or market value. Until the cash and equivalents and short-terminvestments are used, they may be placed in investments that do not produceincome or that lose value.

39

----

***Delaware law andour corporate charter and bylaws contain anti-takeover provisions that coulddelay or discourage takeover attempts that stockholders 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:

·                     theright of the board of directors to elect a director to fill a vacancy createdby the expansion 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;

·                     theability of the board of directors to alter our bylaws without obtainingstockholder approval;

·                     theability of 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;

·                     therequired approval of holders of at least two-thirds of the shares entitled tovote at an election of directors to adopt, amend or repeal our bylaws or amendor repeal the provisions of our certificate of incorporation regarding theindemnification of directors and officers and the ability of stockholders totake action;

·                     therequired approval of holders of at least a majority of the shares entitled tovote at an election 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 weare incorporated in Delaware, we are governed by the provisions of Section 203of the Delaware General Corporation Law. These provisions may prohibit orrestrict large stockholders, in particular those owning 15% or more of ouroutstanding voting stock, from merging or combining with us. These provisionsin our certificate of incorporation and bylaws and under Delaware law coulddiscourage potential takeover attempts and could reduce the price thatinvestors might be willing to pay for shares of our common stock in the futureand result in our market price being lower than it would without theseprovisions.

***We will incurincreased costs as a result of being a public company.***

As a public company, wewill incur significant legal, accounting and other expenses that we did notincur as a private company. In addition, the Sarbanes-Oxley Act of 2002, aswell as new rules subsequently implemented by the SEC and Nasdaq, have requiredchanges in corporate governance practices of public companies. We expect thesenew rules and regulations to increase our legal and financial compliance costsand to make some activities more time-consuming and costly. For example, as aresult of becoming a public company, we have added an independent director,created additional board committees and adopted policies regarding internalcontrols and disclosure controls and procedures. In addition, we will incuradditional costs associated with our public company reporting requirements. Wealso expect these new rules and regulations to make it more difficult and moreexpensive for us to obtain director and officer liability insurance and we maybe required to accept reduced policy limits and coverage or incur substantiallyhigher costs to obtain the same or similar coverage. As a result, it may bemore difficult for us to attract and retain qualified persons to serve on ourboard of directors or as executive officers. We are currently evaluating andmonitoring developments with respect to these new rules, and we cannot predictor estimate the amount of additional costs we may incur or the timing of suchcosts.

40

----

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

(a)During the quarter ended June 30, 2006, we sold an aggregate of 91,728 sharesof our common stock to employees and consultants for cash consideration in theaggregate amount of $0.1 million upon the exercise of stock options grantedunder our Stock Option Plans which were not registered under the Securities Actof 1933. These issuances were deemed exempt from registration under theSecurities Act of 1933 in reliance on Rule 701 promulgated under the SecuritiesAct of 1933 as offers and sales of securities pursuant to certain compensatorybenefit plans and contracts relating to compensation in compliance with Rule701.

(b) OnJune 21, 2006, our registration statement on Form S-1 (Registration No.333-130965) was declared effective for our initial public offering.  This offering closed on June 26, 2006.  The managing underwriters were LehmanBrothers Inc., Cowen and Company, LLC, Needham & Company, LLC, PiperJaffray & Co. and Pacific Growth Equities, LLC.

Underthis registration statement, we registered 5,500,000 shares of our common stockat a price to the public of $9.00 per share. We registered 2,540,225 of theseshares on the Company’s behalf and 2,959,775 of these shares on behalf ofcertain of our selling stockholders.

The saleof 2,540,225 shares of common stock by the Company resulted in aggregate grossproceeds to the Company of approximately $22.9 million, approximately $1.6million of which the Company applied to underwriting discounts and commissionsand approximately $3.7 million of which the Company will apply to pay other expensesof the offering. As a result, the Company will receive net proceeds ofapproximately $17.6 million from the offering.

At July 31, 2006 we hadall net proceeds from the offering invested in money market funds, commercialpaper 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) Notapplicable.

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

Not applicable.

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

Not applicable.

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

Not applicable.

**ITEM 6.****          Exhibits**

(a)                                   Exhibits

 
| Exhibit  Number | ** ** | **Description**                                                                                                                                                       |
|-----------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **      | ** ** | ** **                                                                                                                                                            |
| 31.1            |       | Certification of Chief Executive Officer pursuant to  Securities Exchange Act Rules 13a-15(e), as adopted pursuant to Section 302  of the Sarbanes-Oxley Act of 2002. |

 

41

----

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

 

----

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

 

42

----

**Signatures**

Pursuantto the requirements of the Securities Exchange Act of 1934, as amended, the registranthas duly caused this report to be signed on its behalf by the undersignedthereunto duly authorized.

 
| Dated: August 11, 2006  |                                                                                 |
|-------------------------|--------------------------------------------------------------------------------------|
|                    |                                                                                 |
|                    |                                                                                 |
|                    | /s/ Fumihiro  Kozato                                                                 |   |
|                    | Fumihiro Kozato**                                                                    |
|                    | Chief Executive Officer                                                              |
|                    |                                                                                 |
| Dated:  August 11, 2006 |                                                                                 |
|                    |                                                                                 |
|                    |                                                                                 |
|                    | /s/ Mark Voll                                                                        |   |
|                    | Mark Voll  Vice President of Finance and Administration  and Chief Financial Officer |

 

43

----