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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q



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(Mark One)

|x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ---------------------------------------------------------------------------------------



For the quarterly period ended December 31, 2005.



OR



| ̈ | 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 000-23084.



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Integrated Silicon Solution, Inc.

(Exact name of registrant as specified in its charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 77-0199971                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)
|                                                               | 
|2231 Lawson Lane, Santa Clara, California                      |  | 95054                               
|(Address of principal executive offices)                       |  | (Zip Code)                          



(408) 969-6600.

(Registrants telephone number, including area code)



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Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes   x     No ̈



Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated
filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):



Large accelerated filer ̈Accelerated filer  x    Non-accelerated filer ̈



Indicate by check mark
whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes ̈No   x



The number of outstanding shares of the registrants Common Stock as of February 3, 2006 was 37,411,348.



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##### Table of Contents

TABLE OF CONTENTS



|                             |  |                                                                                                           |  |   
|---------------------------- |  | --------------------------------------------------------------------------------------------------------- |  | --
|PART I Financial Information |  |                                                                                                          
|                             |  |                                                                                                          
|Item 1.                      |  | Financial Statements                                                                                      |  |   
|                             |  |                                                                                                          
|                             |  | Condensed Consolidated Statements of Operations Three months ended December 31, 2005 and 2004 (Unaudited) |  | 1 
|                             |  |                                                                                                          
|                             |  | Condensed Consolidated Balance Sheets December 31, 2005 (Unaudited) and September 30, 2005                |  | 2 
|                             |  |                                                                                                          
|                             |  | Condensed Consolidated Statements of Cash Flows Three months ended December 31, 2005 and 2004 (Unaudited) |  | 3 
|                             |  |                                                                                                          
|                             |  | Notes to Condensed Consolidated Financial Statements (Unaudited)                                          |  | 4 
|                             |  |                                                                                                          
|Item 2.                      |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                     |  | 15
|                             |  |                                                                                                          
|Item 3.                      |  | Quantitative and Qualitative Disclosures About Market Risk                                                |  | 23
|                             |  |                                                                                                          
|Item 4.                      |  | Controls and Procedures                                                                                   |  | 24
|                             | 
|PART II Other Information    |  |                                                                                                          
|                             |  |                                                                                                          
|Item 1.                      |  | Legal Proceedings                                                                                         |  | 24
|                             |  |                                                                                                          
|Item 1A.                     |  | Risk Factors                                                                                              |  | 24
|                             |  |                                                                                                          
|Item 6.                      |  | Exhibits                                                                                                  |  | 34
|                             | 
|Signatures                   |  | 35                                                                                                       



References in this
Report on Form 10-Q to we, us, our and ISSI mean Integrated Silicon Solution, Inc. and all entities owned or controlled by Integrated Silicon Solution, Inc.



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##### Table of Contents

Item 1. Financial Statements



Integrated Silicon Solution, Inc.

Condensed Consolidated Statements of Operations

(Unaudited)

(In thousands, except per share
data)



|                                                                                           |  |                                |        |   |      |   |         |  
|------------------------------------------------------------------------------------------ |  | ------------------------------ | ------ | - | ---- | - | ------- | -
|                                                                                           |  | Three Months EndedDecember 31, |       
|                                                                                           |  | 2005                           |        |   | 2004 |  
|Net sales (See Note 16)                                                                    |  | $                              | 51,093 |   |      | $ | 30,575  |  
|Cost of sales (See Note 16)                                                                |  |                                | 43,710 |   |      |   | 36,351  |  
|                                                                                           |  |                                |        |   |      |   |         |  
|Gross profit (loss)                                                                        |  |                                | 7,383  |   |      |   | (5,776  | )
|                                                                                           |  |                                |        |   |      |   |         |  
|Operating expenses:                                                                        |  |                                |        |   |      |   |         |  
|Research and development                                                                   |  |                                | 5,626  |   |      |   | 5,090   |  
|Selling, general and administrative                                                        |  |                                | 6,478  |   |      |   | 4,221   |  
|Acquired in-process technology charge                                                      |  |                                | 175    |   |      |   |        |  
|                                                                                           |  |                                |        |   |      |   |         |  
|Total operating expenses                                                                   |  |                                | 12,279 |   |      |   | 9,311   |  
|                                                                                           |  |                                |        |   |      |   |         |  
|Operating loss                                                                             |  |                                | (4,896 | ) |      |   | (15,087 | )
|Interest and other income (expense), net                                                   |  |                                | 1,049  |   |      |   | 606     |  
|Gain on sale of investments                                                                |  |                                |       |   |      |   | 2,370   |  
|                                                                                           |  |                                |        |   |      |   |         |  
|Loss before income taxes, minority interest and equity in net loss of affiliated companies |  |                                | (3,847 | ) |      |   | (12,111 | )
|Provision for income taxes                                                                 |  |                                | 62     |   |      |   | 1       |  
|                                                                                           |  |                                |        |   |      |   |         |  
|Loss before minority interest and equity in net loss of affiliated companies               |  |                                | (3,909 | ) |      |   | (12,112 | )
|                                                                                           |  |                               
|Minority interest in net loss of consolidated subsidiary                                   |  |                                | 424    |   |      |   | 95      |  
|                                                                                           |  |                               
|Equity in net loss of affiliated companies                                                 |  |                                | (223   | ) |      |   | (1,314  | )
|                                                                                           |  |                                |        |   |      |   |         |  
|Net loss                                                                                   |  | $                              | (3,708 | ) |      | $ | (13,331 | )
|                                                                                           |  |                                |        |   |      |   |         |  
|Basic and diluted net loss per share                                                       |  | $                              | (0.10  | ) |      | $ | (0.37   | )
|                                                                                           |  |                                |        |   |      |   |         |  
|Shares used in per share calculation                                                       |  |                                | 37,240 |   |      |   | 36,231  |  
|                                                                                           |  |                                |        |   |      |   |         |  



See accompanying notes
to condensed consolidated financial statements.



1



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##### Table of Contents

Integrated Silicon Solution, Inc.

Condensed Consolidated Balance Sheets

(In thousands)



|                                                            |  |                   |          |   |                    |   |          |  
|----------------------------------------------------------- |  | ----------------- | -------- | - | ------------------ | - | -------- | -
|                                                            |  | December 31, 2005 |          |   | September 30, 2005 |  
|                                                            |  | (unaudited)       |          |   | (1)                |  
|ASSETS                                                      |  |                   |          |   |                    |   |          |  
|                                                            |  |                  
|Current assets:                                             |  |                   |          |   |                    |   |          |  
|Cash and cash equivalents                                   |  | $                 | 32,627   |   |                    | $ | 27,484   |  
|Restricted cash                                             |  |                   | 152      |   |                    |   | 301      |  
|Short-term investments                                      |  |                   | 77,346   |   |                    |   | 96,427   |  
|Accounts receivable, net                                    |  |                   | 28,582   |   |                    |   | 28,255   |  
|Accounts receivable from related parties (See Note 16)      |  |                   | 104      |   |                    |   | 253      |  
|Inventories                                                 |  |                   | 69,120   |   |                    |   | 60,468   |  
|Other current assets                                        |  |                   | 4,701    |   |                    |   | 3,594    |  
|                                                            |  |                   |          |   |                    |   |          |  
|Total current assets                                        |  |                   | 212,632  |   |                    |   | 216,782  |  
|Investments                                                 |  |                   | 7,093    |   |                    |   | 9,182    |  
|Property, plant, equipment, and leasehold improvements, net |  |                   | 22,031   |   |                    |   | 21,725   |  
|Goodwill                                                    |  |                   | 21,561   |   |                    |   | 20,232   |  
|Purchased intangible assets, net                            |  |                   | 6,194    |   |                    |   | 6,142    |  
|Other assets                                                |  |                   | 9,382    |   |                    |   | 10,053   |  
|                                                            |  |                   |          |   |                    |   |          |  
|Total assets                                                |  | $                 | 278,893  |   |                    | $ | 284,116  |  
|                                                            |  |                   |          |   |                    |   |          |  
|LIABILITIES AND STOCKHOLDERS EQUITY                        |  |                   |          |   |                    |   |          |  
|                                                            |  |                  
|Current liabilities:                                        |  |                   |          |   |                    |   |          |  
|Short-term debt and notes                                   |  | $                 | 12,328   |   |                    | $ | 6,628    |  
|Accounts payable                                            |  |                   | 35,539   |   |                    |   | 29,612   |  
|Accounts payable to related parties (See Note 16)           |  |                   | 2,163    |   |                    |   | 6,093    |  
|Accrued compensation and benefits                           |  |                   | 3,302    |   |                    |   | 2,467    |  
|Accrued expenses                                            |  |                   | 8,429    |   |                    |   | 8,029    |  
|                                                            |  |                   |          |   |                    |   |          |  
|Total current liabilities                                   |  |                   | 61,761   |   |                    |   | 52,829   |  
|Other long-term liabilities                                 |  |                   | 1,777    |   |                    |   | 1,793    |  
|                                                            |  |                   |          |   |                    |   |          |  
|Total liabilities                                           |  |                   | 63,538   |   |                    |   | 54,622   |  
|Commitments and contingencies                               |  |                   |          |   |                    |   |          |  
|Minority interest                                           |  |                   | 4,811    |   |                    |   | 6,566    |  
|Stockholders equity:                                       |  |                   |          |   |                    |   |          |  
|Common stock                                                |  |                   | 4        |   |                    |   | 4        |  
|Additional paid-in capital                                  |  |                   | 341,933  |   |                    |   | 340,567  |  
|Accumulated deficit                                         |  |                   | (135,443 | ) |                    |   | (131,735 | )
|Unearned compensation                                       |  |                   | (14      | ) |                    |   | (17      | )
|Accumulated comprehensive income                            |  |                   | 4,064    |   |                    |   | 14,109   |  
|                                                            |  |                   |          |   |                    |   |          |  
|Total stockholders equity                                  |  |                   | 210,544  |   |                    |   | 222,928  |  
|                                                            |  |                   |          |   |                    |   |          |  
|Total liabilities and stockholders equity                  |  | $                 | 278,893  |   |                    | $ | 284,116  |  
|                                                            |  |                   |          |   |                    |   |          |  

---

|(1) | Derived from audited financial statements.
|--- | ------------------------------------------



See accompanying notes to condensed consolidated financial statements.



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Integrated Silicon Solution, Inc.

Condensed Consolidated Statements of Cash Flows

(Unaudited)

(In thousands)



|                                                                                     |  |                                 |         |   |      |   |         |  
|------------------------------------------------------------------------------------ |  | ------------------------------- | ------- | - | ---- | - | ------- | -
|                                                                                     |  | Three Months Ended December 31, |        
|                                                                                     |  | 2005                            |         |   | 2004 |  
|Cash flows from operating activities                                                 |  |                                 |         |   |      |   |         |  
|Net loss                                                                             |  | $                               | (3,708  | ) |      | $ | (13,331 | )
|Depreciation and amortization                                                        |  |                                 | 955     |   |      |   | 672     |  
|Stock based compensation                                                             |  |                                 | 1,025   |   |      |   |        |  
|Amortization of intangibles and unearned compensation                                |  |                                 | 343     |   |      |   | 102     |  
|Acquired in-process technology charge                                                |  |                                 | 175     |   |      |   |        |  
|Gain on sale of shares of Semiconductor Manufacturing International Corp. (SMIC)   |  |                                 |        |   |      |   | (2,370  | )
|Loss on embedded derivative                                                          |  |                                 |        |   |      |   | 22      |  
|Loss on disposal of fixed assets                                                     |  |                                 |        |   |      |   | 154     |  
|Net foreign currency transaction gains                                               |  |                                 | (139    | ) |      |   | (10     | )
|Equity in net loss of affiliated companies                                           |  |                                 | 223     |   |      |   | 1,314   |  
|Minority interest in net loss of consolidated subsidiary                             |  |                                 | (424    | ) |      |   | (95     | )
|Net effect of changes in current and other assets and current liabilities            |  |                                 | (5,863  | ) |      |   | 3,010   |  
|                                                                                     |  |                                 |         |   |      |   |         |  
|Net cash used in operating activities                                                |  |                                 | (7,413  | ) |      |   | (10,532 | )
|                                                                                     |  |                                
|Cash flows from investing activities                                                 |  |                                 |         |   |      |   |         |  
|Acquisition of property, equipment and leasehold improvements                        |  |                                 | (686    | ) |      |   | (612    | )
|Proceeds from sale of SMIC equity securities                                         |  |                                 |        |   |      |   | 4,519   |  
|Investment in Integrated Circuit Solution, Inc. (ICSI)                             |  |                                 | (3,511  | ) |      |   |        |  
|Investment in Signia Technologies, Inc. (Signia), net of cash and cash equivalents |  |                                 |        |   |      |   | (6,675  | )
|Purchases of available-for-sale securities                                           |  |                                 | (39,250 | ) |      |   | (64,800 | )
|Sales of available-for-sale securities                                               |  |                                 | 49,865  |   |      |   | 83,100  |  
|                                                                                     |  |                                 |         |   |      |   |         |  
|Net cash provided by investing activities                                            |  |                                 | 6,418   |   |      |   | 15,532  |  
|                                                                                     |  |                                
|Cash flows from financing activities                                                 |  |                                 |         |   |      |   |         |  
|Proceeds from issuance of common stock                                               |  |                                 | 341     |   |      |   | 551     |  
|Proceeds from borrowings under short-term lines of credit                            |  |                                 | 20,676  |   |      |   |        |  
|Principal payments of under short-term lines of credit                               |  |                                 | (15,153 | ) |      |   |        |  
|Decrease in restricted cash                                                          |  |                                 | 149     |   |      |   | 1,500   |  
|                                                                                     |  |                                 |         |   |      |   |         |  
|Net cash provided by financing activities                                            |  |                                 | 6,013   |   |      |   | 2,051   |  
|                                                                                     |  |                                 |         |   |      |   |         |  
|Effect of exchange rate changes on cash and cash equivalents                         |  |                                 | 125     |   |      |   | 224     |  
|                                                                                     |  |                                 |         |   |      |   |         |  
|Net increase in cash and cash equivalents                                            |  |                                 | 5,143   |   |      |   | 7,275   |  
|Cash and cash equivalents at beginning of period                                     |  |                                 | 27,484  |   |      |   | 17,015  |  
|                                                                                     |  |                                 |         |   |      |   |         |  
|Cash and cash equivalents at end of period                                           |  | $                               | 32,627  |   |      | $ | 24,290  |  
|                                                                                     |  |                                 |         |   |      |   |         |  



See accompanying notes
to condensed consolidated financial statements.



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INTEGRATED SILICON SOLUTION, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)



1. Basis of Presentation



The accompanying unaudited condensed financial statements include the accounts of Integrated Silicon Solution, Inc. (the Company) and its consolidated majority owned subsidiaries, after elimination of all significant
intercompany accounts and transactions and have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with Rule 10-01 of Regulation S-X. Accordingly, they do not include
all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments (which are of a normal, recurring nature) considered
necessary for fair presentation have been included.



Operating
results for the three months ended December 31, 2005 are not necessarily indicative of the results that may be expected for the year ending September 30, 2006 or for any other period. The financial statements included herein should be read
in conjunction with the Companys Annual Report on Form 10-K for the fiscal year ended September 30, 2005.



2. Reclassifications



Certain reclassifications have been made to prior period balances in order to conform to the current periods presentation. In particular, accounts
receivable, net has been decreased by $1.0 million and accrued liabilities has been increased by $1.0 million as of September 30, 2005.



3. Use of Estimates



The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make
estimates and assumptions that affect the reported amounts of assets and liabilities, and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during
the reporting period. Actual results could differ from those estimates, and such difference, may be material to the financial statements.



4. Stock-based Compensation



The Company has stock option plans under which options to purchase shares of the Companys common stock may be granted to employees and directors. At
December 31, 2005, the total number of shares subject to options outstanding under all plans was 6,468,000. At December 31, 2005, 2,347,000 shares were available for grant under all plans. Options generally vest ratably over a four-year
period with a 6-month or 1-year cliff vest and then vesting ratably over the remaining period. Options granted prior to September 30, 2005 expire ten years after the date of grant; options granted after October 1, 2005 expire seven years
after the date of the grant.



The Companys employee stock
purchase plan (ESPP) permits eligible employees to purchase common stock through payroll deductions at a price equal to 85% of the lesser of the fair value of the Companys common stock as of the first day of the 24-month offering period or the
last day of each six-month purchase period. The offering periods under the ESPP commence on approximately February 1 and August 1 of each year. At December 31, 2005, 1,286,000 shares were available for issuance under the ESPP. As
approved by the Board of Directors, effective February 1, 2006, future offering periods under the ESPP will have a duration of six months and the purchase price will be equal to 85% of the fair value of the Companys Stock on the purchase
date.



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INTEGRATED SILICON SOLUTION, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(unaudited)



Beginning in fiscal 2006, the Company accounts for stock-based
compensation arrangements in accordance with the provisions of FASB No. 123(R) Share-Based Payment (SFAS 123R). Under SFAS 123R, compensation cost is calculated on the date of grant using the fair value of the option as
determined using the Black-Scholes method. The compensation cost is then amortized ratably over the vesting period of the individual option grants. The Black-Scholes valuation calculation requires the Company to estimate key assumptions such as
expected term, volatility and interest rates to determine the stock options fair value. The estimate of these key assumptions is based on the Companys historical stock price volatility, employees historical exercise patterns and judgment
regarding market factors and trends.



Prior to October 1,
2005, the Company accounted for stock options under the recognition and measurement provisions of APB Opinion No. 25 (APB 25), Accounting for Stock Issued to Employees, and related Interpretations, as permitted by FASB Statement
No. 123 (SFAS 123), Accounting for Stock-Based Compensation.



Prior to Adoption of SFAS 123R



Prior
to the adoption of SFAS 123(R), the Company provided the disclosures required under SFAS No. 123, Accounting for Stock-Based Compensation, as amended by SFAS No. 148, Accounting for Stock-Based Compensation 
Transition and Disclosures. The Company generally did not recognize stock-based compensation expense in its statement of operations for periods prior to the adoption of SFAS 123(R) except when options were granted at an exercise price lower
than the market value of the underlying common stock on the date of grant.



The following table illustrates the effect on net loss and net loss per share as if the Company had applied the fair value recognition provisions of SFAS 123(R) to options granted under the Companys stock-based
compensation plans prior to its adoption of SFAS 123(R). For purposes of this pro forma disclosure, the value of the options was estimated using a Black-Scholes option-pricing formula and amortized on a straight-line basis over the respective
vesting periods. Disclosures for the three months ended December 31, 2005 are not presented because stock-based payments were accounted for under SFAS 123(R)s fair-value method during this period. The assumptions used in the Black-Scholes
model for the three months ended December 31, 2004 were an expected term of 3.0 years, volatility of 91%, an average interest rate of 3.26% and a dividend yield of 0%.



|                                                                       |  |                                     |         |  
|---------------------------------------------------------------------- |  | ----------------------------------- | ------- | -
|                                                                       |  | Three Months EndedDecember 31, 2004 |        
|                                                                       |  | (In thousands)                      |        
|Net loss  as reported                                                 |  | $                                   | (13,331 | )
|Add back expense recorded under the intrinsic value method, net of tax |  |                                     | 22      |  
|                                                                      
|Deduct expense under the fair value method, net of tax                 |  |                                     | (1,236  | )
|                                                                       |  |                                     |         |  
|Net loss  pro forma                                                   |  | $                                   | (14,545 | )
|                                                                       |  |                                     |         |  
|Basic and diluted net loss per share  as reported                     |  | $                                   | (0.37   | )
|Basic and diluted net loss per share  pro forma                       |  | $                                   | (0.40   | )



Adoption of SFAS 123R



The Company adopted the fair value recognition
provisions of SFAS 123R using the modified prospective transition method. Under the modified prospective transition method, prior periods are not restated for the effect of adopting SFAS 123R. Commencing with the first quarter of fiscal year 2006
compensation cost includes all share-based payments granted prior to, but not yet vested as of October 1, 2005, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123, and compensation for all
share-based payments granted subsequent to October 1, 2005, based on the grant date fair value estimated in accordance with the provisions of SFAS 123R.



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##### Table of Contents

INTEGRATED SILICON SOLUTION, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(unaudited)



As a result of adopting SFAS 123R on October 1, 2005, the
Company recorded stock-based compensation expense of $1.0 million resulting in a decrease to income before income taxes for the quarter ended December 31, 2005 of $1.0 million and a decrease to net income of $1.0 million after tax. As of
December 31, 2005, there was approximately $7.6 million of total unrecognized stock-based compensation expense related to share-based payments granted under the Companys stock option plans that will be recognized over a period of four
years. Future stock option grants will add to this total whereas quarterly amortization and the vesting of the existing stock option grants will reduce this total. The Company will also record compensation expense for its ESPP for the difference
between the purchase price and the fair market value on the day of purchase.



Prior to the adoption of SFAS 123R, the Company presented all tax benefits resulting from the exercise of stock options as operating cash flows in the Statement of Cash Flows. SFAS 123R requires that these cash flows
be classified as financing cash flows. As the Company has a valuation allowance for all of its deferred tax assets, a tax benefit has not been recognized.



During the first quarter of fiscal year 2006, options to purchase 68,000 shares were exercised for a gain (aggregate intrinsic value) of $341,000
determined as of the date of option exercise.



Valuation Assumptions



Upon adoption of SFAS 123(R), the fair value of each
option grant is estimated on the date of grant using the Black-Scholes option valuation model with the following weighted-average assumptions:



|                        |  |                                     |  
|----------------------- |  | ----------------------------------- | -
|                        |  | Three Months EndedDecember 31, 2005 |  
|Expected term in years  |  | 2.50                                |  
|Volatility              |  | 55                                  | %
|Risk-free interest rate |  | 4.35                                | %
|Dividend yield          |  | 0.00                                | %



The estimate for
expected term is based on employee historical exercise patterns. Estimated volatilities are based on historic stock price volatilities of the period immediately preceding the option grant that is equal in length to the options expect term. The
Company believes that historical volatility is the best estimate of future volatility. The Company bases the risk-free interest rate on the implied yield currently available on U.S. Treasury zero-coupon issues with an equivalent remaining term. The
Company has not issued any dividends and therefore used 0% for dividend yield. The weighted-average grant date fair value of options granted during the first quarter of fiscal 2006 was $2.23. The estimated fair value of the employee stock options
are amortized to expense ratably over the vesting period of the individual option grants.



5. Concentrations



In
the three months ended December 31, 2005, no single customer accounted for over 10% of net sales. In the three months ended December 31, 2004, revenue recognized for one distributor accounted for 13% of total net sales.



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##### Table of Contents

INTEGRATED SILICON SOLUTION, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(unaudited)



6. Cash, Cash Equivalents and Restricted Cash



Cash, cash equivalents, restricted cash, and short-term investments
consisted of the following:



|                                          |  |                  |        |                   |   |       
|----------------------------------------- |  | ---------------- | ------ | ----------------- | - | ------
|                                          |  | December 31,2005 |        | September 30,2005
|                                          |  | (In thousands)  
|Cash                                      |  | $                | 30,409 |                   | $ | 16,043
|Money market instruments                  |  |                  | 2,218  |                   |   | 11,441
|Restricted cash  Certificates of deposit |  |                  | 152    |                   |   | 301   
|                                          |  |                  |        |                   |   |       
|                                          |  | $                | 32,779 |                   | $ | 27,785
|                                          |  |                  |        |                   |   |       



At December 31,
2005 and September 30, 2005, the restricted cash represents certificates of deposit the Company had used to collateralize certain lines of credit with a supplier.



7. Inventories



The following is a summary of inventories by major category:



|                     |  |                  |        |                   |   |       
|-------------------- |  | ---------------- | ------ | ----------------- | - | ------
|                     |  | December 31,2005 |        | September 30,2005
|                     |  | (In thousands)  
|Purchased components |  | $                | 11,673 |                   | $ | 10,760
|Work-in-process      |  |                  | 24,155 |                   |   | 16,005
|Finished goods       |  |                  | 33,292 |                   |   | 33,703
|                     |  |                  |        |                   |   |       
|                     |  | $                | 69,120 |                   | $ | 60,468
|                     |  |                  |        |                   |   |       



During the three
months ended December 31, 2005 and 2004, the Company recorded inventory write-downs of $3.6 million and $9.6 million, respectively. The inventory write-downs were predominately for lower of cost or market and excess and obsolescence issues on
certain of its products.



7



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##### Table of Contents

INTEGRATED SILICON SOLUTION, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(unaudited)



8. Investments



Investments consisted of the following:



|                                     |  |                |        |                       |   |           |  |   |       
|------------------------------------ |  | -------------- | ------ | --------------------- | - | --------- |  | - | ------
|December 31, 2005                    |  | AmortizedCost  |        | Gross UnrealizedGains |   | FairValue
|                                     |  | (In thousands)
|Certificates of deposit              |  | $              | 3,562  |                       | $ |          |  | $ | 3,562 
|Municipal notes and bonds            |  |                | 45,000 |                       |   |          |  |   | 45,000
|Publicly traded equity securities    |  |                | 31     |                       |   |          |  |   | 31    
|SMIC common stock                    |  |                | 24,341 |                       |   | 4,412     |  |   | 28,753
|SMIC common stocksubject to lock-up |  |                | 6,005  |                       |   | 1,088     |  |   | 7,093 
|                                     |  |                |        |                       |   |           |  |   |       
|Total                                |  | $              | 78,939 |                       | $ | 5,500     |  | $ | 84,439
|                                     |  |                |        |                       |   |           |  |   |       
|Reported as:                         |  |                |        |                       |   |           |  |   |       
|Short-term investments               |  |                |        |                       |   |           |  | $ | 77,346
|Investments                          |  |                |        |                       |   |           |  |   | 7,093 
|                                     |  |                |        |                       |   |           |  |   |       
|Total                                |  |                |        |                       |   |           |  | $ | 84,439
|                                     |  |                |        |                       |   |           |  |   |       



|                                     |  |                |        |                      |   |            |  |   |        
|------------------------------------ |  | -------------- | ------ | -------------------- | - | ---------- |  | - | -------
|September 30, 2005                   |  | AmortizedCost  |        | GrossUnrealizedGains |   | Fair Value
|                                     |  | (In thousands)
|Certificates of deposit              |  | $              | 3,525  |                      | $ |           |  | $ | 3,525  
|Municipal notes and bonds            |  |                | 55,200 |                      |   |           |  |   | 55,200 
|Publicly traded equity securities    |  |                | 483    |                      |   |           |  |   | 483    
|SMIC common stock                    |  |                | 24,341 |                      |   | 12,878     |  |   | 37,219 
|SMIC common stocksubject to lock-up |  |                | 6,005  |                      |   | 3,177      |  |   | 9,182  
|                                     |  |                |        |                      |   |            |  |   |        
|Total                                |  | $              | 89,554 |                      | $ | 16,055     |  | $ | 105,609
|                                     |  |                |        |                      |   |            |  |   |        
|Reported as:                         |  |                |        |                      |   |            |  |   |        
|Short-term investments               |  |                |        |                      |   |            |  | $ | 96,427 
|Investments                          |  |                |        |                      |   |            |  |   | 9,182  
|                                     |  |                |        |                      |   |            |  |   |        
|Total                                |  |                |        |                      |   |            |  | $ | 105,609
|                                     |  |                |        |                      |   |            |  |   |        



All debt securities
held at December 31, 2005 are due in less than one year. Certificates of deposit are in foreign institutions.



8



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##### Table of Contents

INTEGRATED SILICON SOLUTION, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(unaudited)



9. Other Assets



Other assets consisted of the following:



|                                 |  |                  |       |                   |   |       
|-------------------------------- |  | ---------------- | ----- | ----------------- | - | ------
|                                 |  | December 31,2005 |       | September 30,2005
|                                 |  | (In thousands)  
|Private equity method investment |  | $                | 1,394 |                   | $ | 1,561 
|Cost method equity investments   |  |                  | 3,168 |                   |   | 3,149 
|Restricted assets                |  |                  | 922   |                   |   | 914   
|Other                            |  |                  | 3,898 |                   |   | 4,429 
|                                 |  |                  |       |                   |   |       
|                                 |  | $                | 9,382 |                   | $ | 10,053
|                                 |  |                  |       |                   |   |       



The Company has
various deposits including deposits with suppliers for purchase guarantees and for customs clearance. These deposits are included in restricted assets.



10. Comprehensive Loss



Comprehensive loss includes net loss as well as other comprehensive loss. The Companys other comprehensive loss consists of changes in cumulative
translation adjustment and unrealized gains and losses on investments.



Comprehensive loss, net of taxes, was as follows:



|                                                   |  |                                |         |   |      |   |         |  
|-------------------------------------------------- |  | ------------------------------ | ------- | - | ---- | - | ------- | -
|                                                   |  | Three Months EndedDecember 31, |        
|                                                   |  | 2005                           |         |   | 2004 |  
|                                                   |  | (In thousands)                 |        
|Net loss                                           |  | $                              | (3,708  | ) |      | $ | (13,331 | )
|Other comprehensive income (loss), net of tax:     |  |                                |         |   |      |   |         |  
|Change in cumulative translation adjustment        |  |                                | 510     |   |      |   | 3,894   |  
|Change in unrealized gains/(losses) on investments |  |                                | (10,555 | ) |      |   | 536     |  
|                                                   |  |                                |         |   |      |   |         |  
|Comprehensive loss                                 |  | $                              | (13,753 | ) |      | $ | (8,901  | )
|                                                   |  |                                |         |   |      |   |         |  



The components of
accumulated other comprehensive income, net of tax, were as follows:



|                                                     |  |                  |        |   |                   |   |        |  
|---------------------------------------------------- |  | ---------------- | ------ | - | ----------------- | - | ------ | -
|                                                     |  | December 31,2005 |        |   | September 30,2005 |  
|                                                     |  | (In thousands)   |       
|Accumulated foreign currency translation adjustments |  | $                | (1,436 | ) |                   | $ | (1,946 | )
|Accumulated net unrealized gain on SMIC              |  |                  | 5,500  |   |                   |   | 16,055 |  
|                                                     |  |                  |        |   |                   |   |        |  
|Total accumulated other comprehensive income         |  | $                | 4,064  |   |                   | $ | 14,109 |  
|                                                     |  |                  |        |   |                   |   |        |  



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##### Table of Contents

INTEGRATED SILICON SOLUTION, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(unaudited)



11. Borrowings



Short term debt and notes were as follows:



|                                |  |                   |        |                              |                    |   |                   |   |                              |  |      |  
|------------------------------- |  | ----------------- | ------ | ---------------------------- | ------------------ | - | ----------------- | - | ---------------------------- |  | ---- | -
|                                |  | December 31, 2005 |        |                              | September 30, 2005 |  
|                                |  | AmountOutstanding |        | WeightedAverageInterest Rate |                    |   | AmountOutstanding |   | WeightedAverageInterest Rate | 
|                                |  | (In thousands)    |        |                              | (In thousands)     |  
|Working capital loans           |  | $                 | 10,502 |                              | 2.20               | % |                   | $ | 4,821                        |  | 2.08 | %
|Commercial paper                |  |                   | 1,826  |                              | 2.56               | % |                   |   | 1,807                        |  | 2.17 | %
|                                |  |                   |        |                              |                    |   |                   |   |                              |  |      |  
|Total short-term debt and notes |  | $                 | 12,328 |                              |                    |   |                   | $ | 6,628                        |  |      |  
|                                |  |                   |        |                              |                    |   |                   |   |                              |  |      |  



There
were no assets pledged as collateral for short-term debt or notes.



12.
Income Taxes



The income tax provision for the three month
periods ended December 31, 2005 and 2004 consists of foreign withholding taxes of $62 thousand and $1thousand, respectively.



13. Impact of Recently Issued Accounting Standards



In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections (SFAS 154) which replaces Accounting Principles
Board Opinion No. 20 Accounting Changes and SFAS No. 3, Reporting Accounting Changes in Interim Financial StatementsAn Amendment of APB Opinion No. 28. SFAS 154 provides guidance on the accounting
for and reporting of accounting changes and error corrections. It establishes retrospective application, or the latest practicable date, as the required method for reporting a change in accounting principle and the reporting of a correction of an
error. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005 and is required to be adopted by the Company in the first quarter of fiscal 2007. The Company is currently
evaluating the effect that the adoption of SFAS 154 will have on its consolidated results of operations and financial condition but does not expect it to have a material impact.



In November 2005, the FASB issued FSP FAS 115-1 and FAS 124-1, The Meaning of Other-Than-Temporary
Impairment and Its Application to Certain Investments (FSP 115-1), which provides guidance on determining when investments in certain debt and equity securities are considered impaired, whether that impairment is other-than-temporary, and
on measuring such impairment loss. FSP 115-1 also includes accounting considerations subsequent to the recognition of an other-than temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as
other-than-temporary impairments. FSP 115-1 is required to be applied to reporting periods beginning after December 15, 2005 and is required to be adopted by the Company in the second quarter of fiscal 2006. The Company is currently
evaluating the effect that the adoption of FSP 115-1 will have on its consolidated results of operations and financial condition but does not expect it to have a material impact.



10



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##### Table of Contents

INTEGRATED SILICON SOLUTION, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(unaudited)



14. Commitments and Contingencies



Commitments to Wafer Fabrication Facilities and Contract Manufacturers



The Company issues purchase orders for wafers to various
wafer foundries. These purchase orders are generally considered to be cancelable. However, to the degree that the wafers have entered into work-in-process, as a matter of practice, it becomes increasingly difficult to cancel the purchase order. As
of December 31, 2005, the Company had approximately $14.6 million of purchase orders for which the related wafers had been entered into wafer work-in-process (i.e., manufacturing had begun).



|15. | Geographic and Segment Information
|--- | ----------------------------------



The Company has one operating segment, which is to design, develop, and market high-performance SRAM, DRAM, and other memory and non-memory semiconductor
products. The following table summarizes the Companys operations in different geographic areas:



|                             |  |                                |        |      |   |       
|---------------------------- |  | ------------------------------ | ------ | ---- | - | ------
|                             |  | Three Months EndedDecember 31,
|                             |  | 2005                           |        | 2004
|                             |  | (In thousands)                
|Net sales                    |  |                                |        |      |   |       
|United States                |  | $                              | 8,080  |      | $ | 5,681 
|China                        |  |                                | 4,440  |      |   | 4,875 
|Hong Kong                    |  |                                | 8,735  |      |   | 5,538 
|Taiwan                       |  |                                | 13,263 |      |   | 4,488 
|Japan                        |  |                                | 6,756  |      |   |      
|Other Asia Pacific countries |  |                                | 5,441  |      |   | 3,681 
|Europe                       |  |                                | 4,266  |      |   | 4,946 
|Other America                |  |                                | 112    |      |   | 1,366 
|                             |  |                                |        |      |   |       
|Total net sales              |  | $                              | 51,093 |      | $ | 30,575
|                             |  |                                |        |      |   |       



|                  |  |                  |        |                    |   |       
|----------------- |  | ---------------- | ------ | ------------------ | - | ------
|                  |  | December 31,2005 |        | September 30, 2005
|                  |  | (In thousands)  
|Long-lived assets |  |                  |        |                    |   |       
|United States     |  | $                | 1,868  |                    | $ | 2,057 
|Hong Kong         |  |                  | 34     |                    |   | 34    
|China             |  |                  | 1,298  |                    |   | 1,360 
|Taiwan            |  |                  | 18,831 |                    |   | 18,274
|                  |  |                  |        |                    |   |       
|                  |  | $                | 22,031 |                    | $ | 21,725
|                  |  |                  |        |                    |   |       



16. Related Party Transactions



The Company sold and licensed memory products to ICSI and
purchased goods and contract manufacturing services from ICSI. In May 2005, the Company gained control of ICSI at which time the Company began consolidating ICSIs results of operations. At December 31, 2005, the Company had approximately
an 87% ownership interest in ICSI. The Companys Chairman and Chief Executive Officer (CEO), Jimmy S.M. Lee, is Chairman of ICSI. For the three months ended December 31, 2004, purchases of goods and services by the Company from
ICSI were approximately $300,000. The Company also paid ICSI for certain product development costs, license fees and royalties. For the three months ended December 31, 2004, these charges totaled approximately $107,000.



11



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##### Table of Contents

INTEGRATED SILICON SOLUTION, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(unaudited)



The Company purchases goods from SMIC in which the Company has
less than a 2% ownership interest. Lip-Bu Tan, a director of the Company, has been a director of SMIC since January 2002. For the three months ended December 31, 2005 and December 31, 2004, purchases of goods from SMIC were approximately
$4,381,000 and $17,267,000, respectively.



The Company sells
memory products to Flextronics. Lip-Bu Tan, a director of the Company, has been a director of Flextronics since April 3, 2003. The Company had been doing business with Flextronics prior to Mr. Tan joining the board of directors of
Flextronics.



The Company provided manufacturing support
services to Signia. The Company had less a than 50% ownership interest in Signia through November 2004. In December 2004, the Company acquired a majority ownership interest in Signia at which time the Company began consolidating Signias
results of operations. At September 30, 2005, the Company had approximately a 68% ownership interest in Signia. The Companys Chairman and CEO, Jimmy S.M. Lee, is a director of Signia. For the two months ended November 30, 2004, the
Company provided services of approximately $382,000 to Signia.



Accounts receivable from related parties consisted of the following:



|            |  |                  |     |                   |   |    
|----------- |  | ---------------- | --- | ----------------- | - | ---
|            |  | December 31,2005 |     | September 30,2005
|            |  | (In thousands)  
|Flextronics |  | $                | 104 |                   | $ | 253
|            |  |                  |     |                   |   |    



The following table
shows net sales to related parties:



|                             |  |                                |     |      |   |      
|---------------------------- |  | ------------------------------ | --- | ---- | - | -----
|                             |  | Three months endedDecember 31,
|                             |  | 2005                           |     | 2004
|                             |  | (In thousands)                
|Net sales to related parties |  |                                |     |      |   |      
|Flextronics                  |  | $                              | 111 |      | $ | 1,769
|ICSI(1)                      |  |                                |    |      |   | 1,085
|Others                       |  |                                |    |      |   | 115  
|                             |  |                                |     |      |   |      
|Total                        |  | $                              | 111 |      | $ | 2,969
|                             |  |                                |     |      |   |      

---

|(1) | Sales to ICSI were eliminated in consolidation effective May 1, 2005.
|--- | ---------------------------------------------------------------------



Accounts payable to related parties consisted of the following:



|     |  |                  |       |                   |   |      
|---- |  | ---------------- | ----- | ----------------- | - | -----
|     |  | December 31,2005 |       | September 30,2005
|     |  | (In thousands)  
|SMIC |  | $                | 2,163 |                   | $ | 6,093
|     |  |                  |       |                   |   |      



12



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##### Table of Contents

INTEGRATED SILICON SOLUTION, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(unaudited)



17. Acquisition of ICSI



On January 25, 2005, the Company announced its intent to acquire the
remaining 71% of ICSI that the Company did not then own. On May 1, 2005, ISSI assumed control of ICSI and in accordance with generally accepted accounting principles began consolidating the financial results of ICSI with its own results. In the
nine months ended September 30, 2005, the Company purchased additional shares of ICSI for approximately $52.5 million, increasing its ownership percentage to approximately 83%. In the three months ended December 31, 2005, the Company
purchased additional shares of ICSI for approximately $3.5 million, increasing its percentage ownership to approximately 87%. The Company intends to acquire substantially all of the remaining outstanding shares of ICSI for cash of approximately $13
million.



The Companys decision to acquire ICSI was
driven by several considerations including the opportunity to enhance revenue, the ability to reduce the combined companys operating expenses, stronger purchasing power, expanded sales channels, and enhanced opportunities to develop non-memory
product lines.



The Company is accounting for the acquisition
of ICSI as a step acquisition. The allocation of the purchase price of ICSI includes both tangible assets and acquired intangible assets including both developed technology and in-process research and development (IPR&D). The excess of the
purchase price over the fair value allocated to the net assets is goodwill. The Company currently does not expect to receive a tax benefit for goodwill. The amounts allocated to IPR&D have been expensed as it was deemed to have no future
alternative value. The allocation of the purchase price for the additional shares purchased in the three months ended December 31, 2005 is preliminary and could be adjusted in the March quarter.



The purchase price allocation is as follows:



|                                          |  |                   |        |   |           |   |                  |  |   |        |  
|----------------------------------------- |  | ----------------- | ------ | - | --------- | - | ---------------- |  | - | ------ | -
|                                          |  | September 30,2005 |        |   | Additions |   | December 31,2005 | 
|                                          |  | (In thousands)    |       
|Net tangible assets                       |  | $                 | 40,124 |   |           | $ | 284              |  | $ | 40,408 |  
|Intangible assets:                        |  |                   |        |   |           |   |                  |  |   |        |  
|In-process technology                     |  |                   | 2,470  |   |           |   | 175              |  |   | 2,645  |  
|Purchased intangible assets               |  |                   | 5,583  |   |           |   | 392              |  |   | 5,975  |  
|Goodwill                                  |  |                   | 19,112 |   |           |   | 1,329            |  |   | 20,441 |  
|Minority interest                         |  |                   | (6,245 | ) |           |   | 1,331            |  |   | (4,914 | )
|                                          |  |                   |        |   |           |   |                  |  |   |        |  
|Total estimated purchase price allocation |  | $                 | 61,044 |   |           | $ | 3,511            |  | $ | 64,555 |  
|                                          |  |                   |        |   |           |   |                  |  |   |        |  



The developed
technology is being amortized over lives ranging from four to six years and the other amortizable intangible assets are being amortized over lives ranging from six months to five years.



13



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##### Table of Contents

INTEGRATED SILICON SOLUTION, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(unaudited)



Pro forma Financial Information



The pro forma financial information presented below is presented as if the
acquisition of ICSI had occurred at the beginning of fiscal 2004. The pro forma statements of operations for the three months ended December 31, 2005 and December 31, 2004, include the historical results of the Company and ICSI plus the
effect of recurring amortization of the related intangible assets. Such pro forma results do not purport to be indicative of what would have occurred had the acquisition been made as of those dates or the results which may occur in the future. The
pro forma financial results are as follows:



|                                                         |  |                                |        |   |      |   |         |  
|-------------------------------------------------------- |  | ------------------------------ | ------ | - | ---- | - | ------- | -
|                                                         |  | Three Months EndedDecember 31, |       
|                                                         |  | 2005                           |        |   | 2004 |  
|                                                         |  | (In thousands)                 |       
|Net sales                                                |  | $                              | 51,093 |   |      | $ | 55,382  |  
|                                                         |  |                                |        |   |      |   |         |  
|Minority interest in net loss of consolidated subsidiary |  | $                              | 425    |   |      | $ | 678     |  
|                                                         |  |                                |        |   |      |   |         |  
|Net loss                                                 |  | $                              | (3,517 | ) |      | $ | (16,048 | )
|                                                         |  |                                |        |   |      |   |         |  
|Basic and diluted net loss per share                     |  | $                              | (0.09  | ) |      | $ | (0.44   | )
|                                                         |  |                                |        |   |      |   |         |  
|Shares used in basic per share calculation               |  |                                | 37,240 |   |      |   | 36,231  |  
|                                                         |  |                                |        |   |      |   |         |  



18. Subsequent Event



In January 2006, the Company completed a second tender
offer to acquire the remaining shares of ICSI that the Company did not already own. The Company acquired an additional 10% of ICSI for $9.8 million. Upon completion of the tender offer, the Company owns approximately 97% of ICSI.



14



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##### Table of Contents

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS



We have made forward-looking statements in this report that are subject to
risks and uncertainties. Forward-looking statements include information concerning possible or assumed future results of our operations. Also, when we use words such as believes, expects, anticipates or similar
expressions, we are making forward-looking statements. You should note that an investment in our securities involves certain risks and uncertainties that could affect our future financial results. Our actual results could differ materially from
those anticipated in these forward-looking statements as a result of certain factors, including those set forth in Risk Factors and elsewhere in this report.



We believe it is important to communicate our expectations to our investors. However, there may be events in the future that
we are not able to predict accurately or over which we have no control. The risks described in Risk Factors included in this report, as well as any cautionary language in this report, provide examples of risks, uncertainties and events
that may cause our actual results to differ materially from the expectations we describe in our forward-looking statements.



All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the cautionary statements
set forth in this report. Except as required by federal securities laws, we are under no obligation to update any forward-looking statement, whether as a result of new information, future events, or otherwise.



Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations



On January 25, 2005, we announced our intention to acquire ICSI. ICSI was a public company in Taiwan and traded on the Gre Tai Securities Market
(OTC). ICSI is a fabless semiconductor company whose principal products are DRAM and controller chips. Prior to this transaction, we owned approximately 29% of ICSI. In the nine months ended September 30, 2005, we purchased additional shares of
ICSI in the open market for approximately $52.5 million increasing our ownership percentage to approximately 83% at September 30, 2005. In the three months ended December 31, 2005, we purchased additional shares of ICSI in the open market
for approximately $3.5 million increasing our ownership percentage to approximately 87% at December 31, 2005. We plan to acquire substantially all of the remaining outstanding shares of ICSI for cash of approximately $13 million.



Our financial results for fiscal 2006 and for fiscal 2005 beginning
May 1, 2005 reflect accounting for ICSI on a consolidated basis. On May 1, 2005, we assumed effective control of ICSI and in accordance with generally accepted accounting principles we began consolidating the financial results of ICSI with
our results as of May 1, 2005. Our financial results for fiscal 2005 through the period ended April 30, 2005 reflect accounting for ICSI on the equity basis and include our percentage share of the results of ICSIs operations. Our
financial results for fiscal 2006 and for fiscal 2005 beginning December 1, 2004 reflect accounting for Signia Technologies Inc. (Signia), a developer of wireless semiconductors, on a consolidated basis. Effective December 2004, our ownership
of Signia became greater than 50% and we began consolidating the results of Signia. Our financial results for fiscal 2005 through the period ended November 30, 2004 reflect accounting for Signia on the cost basis. Our financial results for
fiscal 2006 and for fiscal 2005 beginning May 1, 2005 reflect accounting for Key Stream Corp. (KSC), a semiconductor company, on the equity basis. At December 31, 2005, we owned approximately 87% of ICSI, approximately 68% of Signia and
approximately 22% of KSC.



Overview



We are a fabless semiconductor company that designs and markets high
performance integrated circuits for the following key markets: (i) digital consumer electronics, (ii) networking, (iii) mobile communications and (iv) automotive electronics. Our primary products are high speed and low power SRAM
and low and medium density DRAM. We also design and market EEPROMs, SmartCards, controller chips for Flash memory sticks and card reader-writers and wireless chipsets. We were founded in October 1988 and initially focused on high performance, low
cost SRAM for PC cache memory applications. In 1997, we introduced our first low and medium density DRAM products. Prior to fiscal 2003, our SRAM product family generated a majority of our revenue. However, in 2001, the high-end networking and
telecom



15



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##### Table of Contents

markets slowed and this adversely impacted our SRAM revenue. During this period, we increased our focus on the digital
consumer electronics, mobile communications and automotive electronics markets. As a result of our success in the digital consumer electronics market, sales of our low and medium density DRAM products have increased significantly and have
represented a majority of our net sales in each year since fiscal 2003.



In order to limit and control our operating expenses, in recent years we have reduced our headcount in the U.S. and transferred various functions to Taiwan and China. Our acquisition of ICSI was a key part of this strategy. We believe this
strategy has enabled us to limit our operating expenses while simultaneously locating these functions closer to our manufacturing partners and our customers. As a result of these efforts, we currently have significantly more employees in Asia than
we do in the U.S. We intend to continue these strategies going forward.



As a fabless semiconductor company, our business model is less capital intensive because we rely on third parties to manufacture, assemble and test our products. Because of our dependence on third-party wafer foundries, our ability to
increase our unit sales volumes depends on our ability to increase our wafer capacity allocation from current foundries, add additional foundries and improve yields of die per wafer.



The average selling prices of our SRAM and DRAM products are very sensitive to supply and demand conditions in our target
markets and have generally declined over time. While the average selling prices for certain of our products increased during the first three quarters of fiscal 2004, the average selling prices for our products declined significantly in the fourth
quarter of fiscal 2004. We experienced declines in the average selling prices for certain of our products in the four quarters of fiscal 2005 and the first quarter of fiscal 2006. We expect average selling prices for our products to decline in the
future, principally due to increased market competition and an increased supply of competitive products in the market. Any future decreases in our average selling prices would have an adverse impact on our revenue growth rate, gross margins and
operating margins. Our ability to maintain or increase revenues will be highly dependent upon our ability to increase unit sales volumes of existing products and to introduce and sell new products in quantities sufficient to compensate for the
anticipated declines in average selling prices of existing products. Declining average selling prices will adversely affect gross margins unless we are able to offset such declines with commensurate reductions in per unit costs or changes in product
mix in favor of higher margin products.



Revenue from product
sales to our direct customers is recognized upon shipment provided that persuasive evidence of a sales arrangement exists, the price is fixed and determinable, title has transferred, collection of resulting receivables is reasonably assured, there
are no customer acceptance requirements and there are no remaining significant obligations. A portion of our sales is made to distributors under agreements that provide the possibility of certain sales price rebates and limited product return
privileges. Given the uncertainties associated with credits that will be issued to these distributors, we defer recognition of such sales until our products are sold by the distributors to their end customers. Revenue from sales to distributors who
do not have sales price rebates is recognized at the time our products are sold by us to the distributors.



We market and sell our products in Asia, the U.S. and Europe through our direct sales force, distributors and sales representatives. The percentage of our
revenues shipped outside the U.S. was approximately 84%, 85%, 87% and 87% in the first quarter of fiscal 2006, fiscal 2005, fiscal 2004 and fiscal 2003, respectively. We measure revenue location by the shipping destination, even if the customer is
headquartered in the U.S. We anticipate that sales to international customers will continue to represent a significant percentage of our net sales. The percentages of our revenues by region are set forth in the following table:



|       |  |                                    |   |  |      |   |  |                                      |   |  |      |  
|------ |  | ---------------------------------- | - |  | ---- | - |  | ------------------------------------ | - |  | ---- | -
|       |  | Three MonthsEnded December 31,2005 |   |  | 2005 |   |  | Fiscal Years Ended September 30,2004 |   |  | 2003 |  
|Asia   |  | 76                                 | % |  | 75   | % |  | 75                                   | % |  | 77   | %
|Europe |  | 8                                  |   |  | 9    |   |  | 11                                   |   |  | 10   |  
|U.S.   |  | 16                                 |   |  | 15   |   |  | 13                                   |   |  | 13   |  
|Other  |  |                                   |   |  | 1    |   |  | 1                                    |   |  |     |  
|       |  |                                    |   |  |      |   |  |                                      |   |  |      |  
|Total  |  | 100                                | % |  | 100  | % |  | 100                                  | % |  | 100  | %
|       |  |                                    |   |  |      |   |  |                                      |   |  |      |  



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Our sales are generally made by purchase orders. Because industry practice allows customers to reschedule
or cancel orders on relatively short notice, backlog is not a good indicator of our future sales. Cancellations of customer orders or changes in product specifications could result in the loss of anticipated sales without allowing us sufficient time
to reduce our inventory and operating expenses.



Since a
significant portion of our revenue is from the digital consumer electronics market, our business may be subject to seasonality, with increased revenues in the third and fourth calendar quarters of each year, when customers place orders to meet
year-end holiday demand. However, broad fluctuations in our overall business in the past several years makes it difficult for us to assess the impact of seasonal factors on our business.



We are subject to the risks of conducting business internationally, including economic conditions in Asia, particularly
Taiwan and China, changes in trade policy and regulatory requirements, duties, tariffs and other trade barriers and restrictions, the burdens of complying with foreign laws and, possibly, political instability. All of our foundries and assembly and
test subcontractors are located in Asia. Although we transact business predominately in U.S. dollars, we do have transactions in New Taiwan dollars, in Hong Kong dollars and in China Renminbi. Such transactions expose us to the risk of exchange rate
fluctuations. We monitor our exposure to foreign currency fluctuations, but have not to date adopted any hedging strategy. There can be no assurance that exchange rate fluctuations will not harm our business and operating results in the future.



Critical Accounting Policies



The preparation of financial statements in conformity with accounting
principles generally accepted in the U.S. requires management to make difficult and subjective estimates, judgments and assumptions. These estimates, judgments and assumptions affect the reported amounts of assets and liabilities, the disclosure of
contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenue and expenses during the reporting period. The estimates and judgments that we use in applying our accounting policies have a
significant impact on the results we report in our financial statements. We base our estimates and judgments on our historical experience combined with knowledge of current conditions and our beliefs of what could occur in the future, considering
the information available at the time. Actual results could differ from those estimates and such differences may be material to our financial statements. We reevaluate our estimates and judgments on an ongoing basis.



Our critical accounting policies which are impacted by our estimates are:
(i) the valuation of our inventory, which impacts cost of goods sold and gross profit; (ii) the valuation of our allowance for sales returns and allowances, which impacts net sales; (iii) the valuation of our allowance for doubtful
accounts, which impacts general and administrative expense; (iv) accounting for acquisitions and goodwill, which impacts other expense when we record impairments (v) the valuation of our non-marketable equity securities, which impacts
other expense when we record impairments and (vi) accounting for stock-based compensation which impacts costs of goods sold, research and development expense and selling, general and administrative expense. Each of these policies is described
in more detail below. We also have other key accounting policies that may not require us to make estimates and judgments that are as subjective or difficult, for instance, our policies with regard to revenue recognition, including the deferral of
revenues on sales to distributors with sales price rebates and product return privileges. These policies are described in the notes to our financial statements contained in our Annual Report on Form 10-K for the fiscal year ended September 30,
2005.



Valuation of inventory. Our inventories are
stated at the lower of cost or market value. Determining market value requires us to project unit prices and volumes for future periods in which we expect to sell inventory on hand as of the balance sheet date. As a result of these estimates, we may
record a charge to cost of goods sold, which decreases our gross profit, in advance of when the inventory is actually sold to reflect market values, net of sales commission costs, that are below our manufacturing costs. Conversely, if we sell
inventory that has previously been written down to the lower of cost or market at more favorable prices than we had forecasted at the time of the write-down, our gross profit may be higher. In addition to lower of cost or market write-downs, we also
analyze inventory to determine whether any of it is excess, obsolete or defective. We write down to zero dollars (which is a charge to cost of goods sold) the carrying value of inventory on hand in excess of six months historical sales volumes
to cover estimated excess and obsolete exposures, unless adjustments are made based on our judgments for newer products, end of life products or planned inventory increases. In making such judgments to write down inventory, we take into account the
product life cycles which can range from six to 30 months, the stage in the life cycle of the product, and the impact of competitors announcements and product introductions on our products.



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Valuation of allowance for sales returns and allowances. Net sales consist principally of
total product sales less estimated sales returns. To estimate sales returns and allowances, we analyze potential customer specific product application issues, potential quality and reliability issues and historical returns. We evaluate quarterly the
adequacy of the reserve for sales returns and allowances. This reserve is reflected as a reduction to accounts receivable in our consolidated balance sheets. Increases to the reserve are recorded as a reduction to net sales. Because the reserve for
sales returns and allowances is based on our judgments and estimates, particularly as to product application, quality and reliability issues, our reserves may not be adequate to cover actual sales returns and other allowances. If our reserves are
not adequate, our net sales could be adversely affected.



Valuation of allowance for doubtful accounts. We maintain an allowance for doubtful accounts for losses that we estimate will arise from our customers inability to make required payments for goods and services purchased
from us. We make our estimates of the uncollectibility of our accounts receivable by analyzing historical bad debts, specific customer creditworthiness and current economic trends. Once an account is deemed unlikely to be fully collected, we write
down the carrying value of the receivable to the estimated recoverable value, which results in a charge to general and administrative expense, which decreases our profitability.



Accounting for Acquisitions and Goodwill. We account for acquisitions using the purchase accounting method in
accordance with Statement of Financial Accounting Standards, or SFAS, 142, Goodwill and Other Intangible Assets. Under this method, the total consideration paid, excluding, if any, the contingent consideration that has not been earned,
is allocated over the fair value of the net assets acquired, including in-process research and development, with any excess allocated to goodwill. Goodwill is defined as the excess of the purchase price over the fair value allocated to the net
assets. Our judgments as to fair value of the assets will, therefore, affect the amount of goodwill that we record. We engage a qualified third party valuation firm that specializes in the valuation of tangible and intangible assets to advise us in
the valuation analysis. The valuation firm will deliver a written analysis of the values assessed. For tangible assets acquired in any acquisition, such as plant and equipment, the useful lives are estimated by considering comparable lives of
similar assets, past history, the intended use of the assets and their condition. In estimating the useful life of the acquired intangible assets with definite lives, we and our valuation firm consider the industry environment and unique factors
relating to each product relative to our business strategy and the likelihood of technological obsolescence. Acquired intangible assets primarily include core and current technology, customer relationships and customer contracts. We are currently
amortizing our acquired intangible assets with definite lives over periods generally ranging from six months to six years.



We perform goodwill impairment tests on an annual basis and between annual tests in certain circumstances for each reporting unit. In response to changes
in industry and market conditions, we could be required to strategically realign our resources and consider restructuring, disposing of, or otherwise exiting businesses, which could result in an impairment of goodwill. In fiscal 2005, we recorded
charges for impairment of goodwill in the amount of $4.4 million.



Valuation of non-marketable securities. Our ability to recover our strategic investments in equity securities that are non-marketable and to earn a return on these investments is largely dependent on financial market conditions
and the occurrence of liquidity events, such as initial public offerings, mergers or acquisitions, and private equity transactions. The timing of when any of these events may occur is uncertain and very difficult to predict. In addition, under our
accounting policy, we are required to periodically review all of our investments for impairment. In the case of non-marketable equity securities, this requires significant judgment on our part, including an assessment of the investees
financial condition, the existence of subsequent rounds of financing and the impact of any relevant equity preferences, as well as the investees historical results of operations and projected results and cash flows. If the actual outcomes for
the investees are significantly different from their forecasts, the carrying value of our non-marketable equity securities may be above fair value, and we may incur additional charges in future periods, which will decrease our profitability.
In fiscal 2005, we recorded approximately $0.3 million impairment losses related to two of our non-marketable equity securities. At December 31, 2005, our strategic investments in non-marketable securities totaled $4.6 million.



Accounting for Stock-Based Compensation.Beginning in fiscal 2006, we
account for stock-based compensation arrangements in accordance with the provisions for SFAS 123R. Under SFAS 123R, compensation cost is calculated on the date of grant using the Black-Scholes method. The compensation cost is then amortized ratably
over the vesting



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periods of the individual option grants. The Black-Scholes method requires us to estimate key assumptions such as
expected term, volatility and interest rates that determine the stock options fair value. The estimate of these key assumptions is based on our historical stock price volatility, our employees historical exercise patterns and judgment
regarding market factors and trends. If actual results are not consistent with our assumptions and judgments used in estimating the key assumptions, we may be required to increase or decrease compensation expense, which could have a material effect
on our results of operations.



Impact of Recently Issued Accounting
Standards



In May 2005, the FASB issued SFAS No. 154,
Accounting Changes and Error Corrections (SFAS 154) which replaces Accounting Principles Board Opinion No. 20 Accounting Changes and SFAS No. 3, Reporting Accounting Changes in Interim Financial
StatementsAn Amendment of APB Opinion No. 28. SFAS 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. It establishes retrospective application, or the latest practicable date,
as the required method for reporting a change in accounting principle and the reporting of a correction of an error. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15,
2005 and is required to be adopted by us in the first quarter of fiscal 2007. We are currently evaluating the effect that the adoption of SFAS 154 will have on our consolidated results of operations and financial condition but do not expect it
to have a material impact.



In November 2005, the FASB
issued FSP FAS 115-1 and FAS 124-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments (FSP 115-1), which provides guidance on determining when investments in certain debt and equity
securities are considered impaired, whether that impairment is other-than-temporary, and on measuring such impairment loss. FSP 115-1 also includes accounting considerations subsequent to the recognition of an other-than temporary impairment
and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. FSP 115-1 is required to be applied to reporting periods beginning after December 15, 2005 and is required to be
adopted by us in the second quarter of fiscal 2006. We are currently evaluating the effect that the adoption of FSP 115-1 will have on its consolidated results of operations and financial condition but do not expect it to have a material
impact.



Three Months Ended December 31, 2005 Compared to Three
Months Ended December 31, 2004



Net Sales.
Net sales consist principally of total product sales less estimated sales returns. Net sales increased by 67% to $51.1 million in the three months ended December 31, 2005 from $30.6 million in the three months ended December 31, 2004. The
increase in net sales of $20.5 million can principally be attributed to our acquisition of a controlling interest in and the resulting consolidation of ICSI beginning in May 2005. The increase in unit shipments of our DRAM products in the three
months ended December 31, 2005 compared to the three months ended December 31, 2004 more than offset the decline in average selling prices resulting in an overall increase in DRAM revenue. In addition, the increase in unit shipments of our
SRAM products in the three months ended December 31, 2005 compared to the three months ended December 31, 2004, more than offset the decrease in the average selling prices resulting in an overall increase in SRAM revenue. We anticipate
that the average selling prices of our existing products will generally decline over time, although the rate of decline may fluctuate for certain products. There can be no assurance that any future price declines will be offset by higher volumes or
by higher prices on newer products.



In the three months ended
December 31, 2005, no single customer accounted for over 10% of net sales. In the three months ended December 31, 2004, revenue recognized for one distributor accounted for 13% of our total net sales.



Gross profit (loss). Cost of sales includes die cost from the wafers
acquired from foundries, subcontracted package, assembly and test costs, costs associated with in-house product testing, quality assurance and import duties. Gross profit increased by $13.2 million to $7.4 million in the three months ended
December 31, 2005 from a $5.8 million gross loss in the three months ended December 31, 2004. Gross margin increased to 14.5% in the three months ended December 31, 2005 from (18.9)% in the three months ended December 31, 2004.
Our gross margin for the three months ended December 31, 2005 benefited from the sale of $0.8 million of previously written down parts. Our gross margin for the three months ended December 31, 2005 included inventory write-downs of $3.6
million while our gross margin for the three months ended December 31, 2004 included inventory write-downs of $9.6 million. The inventory write-downs were predominately for lower of cost or market accounting and excess and obsolescence issues
on certain of our



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products. Excluding the inventory write-downs, the increase in gross profit was principally due to an increase in unit
shipments of our DRAM products in the three months ended December 31, 2005 compared to the three months ended December 31, 2004 which more than offset the decline in average selling prices for such products. In addition, declines in the
cost of our DRAM products more than offset declines in the average selling prices of our DRAM products in three months ended December 31, 2005. This contributed to an increase in our DRAM gross margin. Increases in the unit shipments of our
SRAM products more than offset decreases in the average selling prices of such products in the three months ended December 31, 2005 compared to the three months ended December 31, 2004, resulting in an increase in gross profit. However,
declines in the average selling prices of our SRAM products more than offset declines in the cost of our SRAM products in three months ended December 31, 2005 compared to three months ended December 31, 2004 resulting in a decline in our
SRAM gross margin. We believe that the average selling prices of our products will decline over time and, unless we are able to reduce our cost per unit to the extent necessary to offset such declines, the decline in average selling prices will
result in a material decline in our gross margin. In addition, product costs could increase if our suppliers raise prices, which could result in a material decline in our gross margin. In the past, foundries have raised wafer prices when demand for
end products increases. Although we have product cost reduction programs in place that involve efforts to reduce internal costs and supplier costs, there can be no assurance that product costs will be reduced or that such reductions will be
sufficient to offset the expected declines in average selling prices. We do not believe that such cost reduction efforts are likely to have a material adverse impact on the quality of our products or the level of service provided by us.



Research and Development. Research and development expenses
increased by 11% to $5.6 million in the three months ended December 31, 2005 compared to $5.1 million in the three months ended December 31, 2004. As a percentage of net sales, research and development expenses decreased to 11.0% in the
three months ended December 31, 2005 from 16.6% in the three months ended December 31, 2004. The three months ended December 31, 2005 includes stock based compensation expense under SFAS 123R of approximately $0.5 million. The
increase in research and development expenses attributable to our consolidation of ICSI was mostly offset by a decrease in research and development expenses in the U.S. Our research and development expenses could increase in absolute dollars in
future periods due to increased costs associated with the development of new products.



Selling, General and Administrative. Selling, general and administrative expenses increased by 53% to $6.5 million in the three months ended December 31, 2005 from $4.2 million in the three months ended
December 31, 2004. As a percentage of net sales, selling, general and administrative expenses decreased to 12.7% in the three months ended December 31, 2005 from 13.8% in the three months ended December 31, 2004. The three months
ended December 31, 2005 includes stock based compensation expense under SFAS 123R of approximately $0.5 million. Excluding the impact of SFAS 123R, the increase in selling, general and administrative expenses was attributable to our
consolidation of ICSI. Complying with the internal control requirements of the Sarbanes-Oxley Act of 2002 Section 404, which will apply to our operations at ICSI beginning in fiscal 2006, have and will continue to result in increased internal
efforts, significantly higher fees from our independent accounting firm and significantly higher fees from third party contractors. As a result, we expect our selling, general and administrative expenses will increase in absolute dollars in future
quarters, although such expenses may fluctuate as a percentage of net sales.



Acquired in-process technology charge. In the three months ended December 31, 2005, we incurred $0.2 million of acquired in-process technology charge (IPR&D) in connection with our purchase of
additional shares of ICSI. The valuation and purchase allocation is preliminary and is subject to further adjustment. The $0.2 million allocated to IPR&D was expensed in our quarter ending December 31, 2005, as it was deemed to have no
future alternative value. The purchase price allocation, including an additional charge to IPR&D, will increase in the March 2006 quarter as ISSI acquires additional shares of ICSI.



Interest and other income (expense), net. Interest and other income (expense), net was $1.0 million in the three
months ended December 31, 2005 compared to $0.6 million in the three months ended December 31, 2004. The $1.0 million of interest and other income (expense) in the three months ended December 31, 2005 is comprised primarily of
interest income of $0.7 and $0.1 million in foreign currency exchange gains. The $0.6 million other income in the three months ended December 31, 2004 was comprised primarily of interest income. The increase in interest income is primarily
attributable to higher interest rates in the three months ended December 31, 2005.



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Gain on sale of investments. In the three months ended December 31, 2004, we sold shares of
SMIC for approximately $4.5 million which resulted in a pre-tax gain of $2.4 million.



Provision for income taxes.The provision for income taxes for the three month periods ended December 31, 2005 and 2004 consists of foreign withholding taxes of $62 thousand and $1 thousand, respectively.



Minority interest in net loss of consolidated subsidiaries.The minority interest in net loss of consolidated subsidiaries was $0.4 million in the three months ended December 31, 2005 compared to $0.1 million in the three months ended December 31, 2004. The minority interest in net loss of
consolidated subsidiaries for the three months ended December 31, 2005 represents the minority shareholders proportionate share of the net loss of Signia and the minority shareholders proportionate share of the net loss of ICSI. The
minority interest in net loss of consolidated subsidiaries for the three months ended December 31, 2004 represents the minority shareholders proportionate share of the net loss of Signia for the month of December 2004.



Equity in net loss of affiliated companies.Equity in net loss of
affiliated companies was $0.2 million in the three months ended December 31, 2005 compared to a $1.3 million loss in the three months ended December 31, 2004. In the three months ended December 31, 2005, we recorded a loss of
approximately $0.2 million related to our equity interest in KSC. In the three months ended December 31, 2004, we recorded a loss of approximately $1.3 million related to our equity interest in ICSI prior to our consolidation of ICSIs
financial results.



Liquidity and Capital Resources



As of December 31, 2005, our principal sources of liquidity included
cash, cash equivalents, restricted cash and short-term investments of approximately $110.1 million. During the three months ended December 31, 2005, operating activities used cash of approximately $7.4 million compared to $10.5 million used in
the three months ended December 31, 2004. The cash used by operations was primarily due to increases in inventories of $8.1 million, increases in other assets of $0.7 million and our net loss of $3.7 million adjusted for non-cash items of
$2.2 million (stock-based compensation expense of $1.0 million, equity in net loss of affiliated companies of $0.2 million, depreciation and amortization of $1.0 million, amortization of intangibles of $0.3 million, acquired in-process
technology charge of $0.2 million and other non-cash items of $(0.5) million). This was partially offset by increases in accounts payable of $1.7 million and increases in accrued expenses of $1.2 million.



In the three months ended December 31, 2005, we generated $6.4 million
from investing activities compared to $15.5 million generated in the three months ended December 31, 2004. The cash generated from investing activities in the three months ended December 31, 2005 primarily resulted from net sales of
available-for-sale securities of $10.6 million. In addition, in the December 2005 quarter, we used approximately $3.5 million for the purchase of additional shares of ICSI. The cash generated from investing activities in the three months ended
December 31, 2004 primarily resulted from net sales of available-for-sale securities of $18.3 million. In addition, in the December 2004 quarter, we generated approximately $4.5 million from the sale of additional shares of SMIC, resulting in a
pre-tax gain of approximately $2.4 million. We used approximately $6.7 million for our additional investment in Signia.



In the three months ended December 31, 2005, we made capital expenditures of approximately $0.7 million for test equipment and engineering tools. We
expect to spend approximately $1.0 million to $3.0 million to purchase capital equipment during the next twelve months, principally for the purchase of design and engineering tools, additional test equipment, and computer software and hardware. We
expect to fund our capital expenditures from our existing cash and cash equivalent balances.



We generated $6.0 million from financing activities during the three months ended December 31, 2005 compared to $2.1 million in the three months ended December 31, 2004. In the three months ended
December 31, 2005, we used $15.2 million for the repayment of short-term borrowings. The source of financing for the three months ended December 31, 2005, was borrowings of $20.7 million under ICSI lines of credit, proceeds from the
issuance of common stock of $0.3 million from stock option exercises and a decrease in restricted cash of $0.2 million. The source of financing for the three months ended December 31, 2004 was a decrease in restricted cash of $1.5 million and
proceeds from the issuance of common stock of $0.6 million from stock option exercises.



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We have $21.8 million available through a number of short-term lines of credit with various financial
institutions in Taiwan. These lines of credit expire at various times through December 2006. As of December 31, 2005, we had outstanding borrowings of approximately $12.3 million under these short-term lines of credit. Our unused short-term
lines of credit and unused lines of credit for short-term notes amounted to approximately $8.3 million and $1.2 million, respectively, at December 31, 2005.



Our headquarters are located in a leased site in Santa Clara, California. Outside of the U.S., we have operations in leased
sites in China and Hong Kong. In addition to these sites, we lease sales offices in the U.S., Europe and Asia. These leases expire at various dates through 2007. In Taiwan, we own and occupy the ICSI building. The land upon which the ICSI building
is situated is leased under an operating lease that expires in March 2016. Our outstanding commitments under these leases are approximately $4.0 million.



We generally warrant our products against defects in materials and workmanship for a period of 12 months. Liability for a stated warranty period is
usually limited to the replacement of defective items or return of amounts paid. Warranty expense has historically been immaterial to our financial statements.



On January 25, 2005, we announced our intent to acquire the remaining 71% of ICSI that we did not then own. In the nine months ended
September 30, 2005, we purchased additional shares of ICSI for approximately $52.5 million, increasing our ownership percentage to approximately 83% at September 30, 2005. In the three months ended December 31, 2005, we purchased
additional shares of ICSI for approximately $3.5 million, increasing our percentage ownership to approximately 87% at December 31, 2005. We intend to acquire substantially all of the remaining outstanding shares of ICSI for cash of
approximately $13 million which includes $9.8 million spent in January 2006.



We believe our existing funds will satisfy our anticipated working capital and other cash requirements through at least the next 12 months. We may from time to time take actions to further increase our cash position
through equity or debt financings, sales of shares of investments, bank borrowings, or the disposition of certain assets. From time to time, we may also commit to acquisitions or equity investments, including strategic investments in wafer
fabrication foundries or assembly and test subcontractors. To the extent we enter into such transactions, we may need to seek additional equity or debt financing to fund such activities. There can be no assurance that any such additional financing
could be obtained on terms acceptable to us, if at all.



Off-Balance Sheet
Arrangements



As of December 31, 2005, we did not
have any significant off-balance sheet arrangements, as defined in Item 303 (a)(4)(ii) of SEC Regulation S-K.



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Item 3. Quantitative and Qualitative Disclosures about Market Risk



Our financial market risk includes foreign currency transactions, exposure to changes in interest rates on our fixed rate debt, our investments in
marketable equity securities and our investments in private companies.



We anticipate that international sales will continue to account for a significant portion of our consolidated revenue. Our international sales are largely denominated in U.S. dollars and therefore are not subject to material foreign
currency exchange risk. However, we have operations in China, Europe, Taiwan, Hong Kong, India, Japan and Korea where expenses are denominated in each countrys local currency and are subject to foreign currency exchange risk. In the quarter
ended December 31, 2005, we recorded exchange gains of approximately $0.1 million. However, in the quarter ended September 30, 2005, we recorded exchange losses of approximately $0.9 million. Prior to this we had not experienced any
significant negative impact on our operations as a result of fluctuations in foreign currency exchange rates. We do not currently engage in any hedging activities.



We had cash, cash equivalents, restricted cash and short-term investments of $81.4 million at December 31, 2005
excluding $28.7 million of SMIC stock included in short-term investments. The primary objective of our investment activities is to preserve principal while at the same time maximizing yields without increasing risk. We invest primarily in
high-quality, short-term debt instruments such as municipal auction rate certificates and instruments issued by high quality financial institutions and companies, including money market instruments. A hypothetical one percentage point decrease in
interest rates would result in approximately a $0.8 million decrease in our interest income.



We own shares in SMIC which has been a publicly traded company since March 2004. SMICs ordinary shares are traded on the Hong Kong Stock Exchange and SMIC American Depository Receipts (ADR) are
traded on the New York Stock Exchange. Each SMIC ADR represents fifty (50) ordinary shares. We use the weighted-average cost method to determine the cost basis of shares of SMIC. In fiscal 2005, we sold shares of SMIC and recorded gross
proceeds of approximately $8.7 million and a pre-tax gain of approximately $4.4 million. Since SMICs IPO, we account for our shares in SMIC under the provisions of FASB 115 and mark the shares to the market value with the offset recorded in
accumulated other comprehensive income. The cost basis of our shares in SMIC is approximately $30.3 million and the market value at December 31, 2005 was approximately $35.8 million. The market value of SMIC shares is subject to fluctuations
and our carrying value will be subject to adjustments to reflect changes in SMICs market value in future periods. In the event the market value of our SMIC shares declines below our cost basis, and the decline is other-than-temporary, we may
be required to recognize a loss on our investment through operating results. Our shares in SMIC are subject to certain lockup restrictions and therefore are not freely tradable. These lockup restrictions generally lapse at the rate of 15% of our
pre-offering shares every 180 days following SMICs IPO in March 2004. Thus, all of our shares in SMIC will be freely tradable in February 2007.



We have investments in equity securities of privately held companies of approximately $4.6 million at December 31, 2005. These investments are
generally in companies in the semiconductor industry. These investments are included in other assets and are accounted for using the equity or cost method. For investments in which no public market exists, our policy is to review the operating
performance, recent financing transactions and cash flow forecasts for such companies in assessing whether our investments in these companies are impaired below our cost basis. Impairment losses on equity investments are recorded when events and
circumstances indicate that such assets are impaired and the decline in value is other than temporary. In this regard, we recorded approximately $0.3 million impairment losses on two equity investments in fiscal 2005.



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Item 4. Controls and Procedures



Our Chief Executive Officer and Chief Financial Officer, based on the evaluation of our disclosure controls and procedures (as defined in Rule 13a-15(e) or 15d-15(e) under the Securities Exchange Act of 1934, as amended) required by
paragraph (b) of Rule 13a-15 or Rule 15d-15, have concluded that, as of December 31, 2005, our disclosure controls and procedures were effective to ensure that the information we are required to disclose in reports that we file or submit
under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. During the three months ended December 31, 2005, there was no
change in our internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Rule 13a-15 or Rule 15d-15 that has materially affected, or is reasonably likely to materially affect, our
internal control over financial reporting.



Part II. OTHER INFORMATION



Item 1. Legal Proceedings



None.



Item 1A. Risk Factors



We have
incurred significant losses in certain recent periods, and there can be no assurance that we will be able to achieve or sustain profitability in the future.



We incurred a loss of $3.7 million in the first quarter of fiscal 2006, which included an inventory write-down of $3.6 million. We incurred losses of
$37.9 million in fiscal 2005, which included inventory write-downs of $13.9 million, charges of $11.7 million related to our equity interest in ICSI, charges on impairment of goodwill and investments of $4.7 million and charges for
in-process R&D of $2.8 million. Though we were profitable in the first three quarters of fiscal 2004, we incurred a loss of $15.6 million in the fourth quarter of fiscal 2004, which included an inventory write-down of $12.1 million. We incurred
losses in the ten consecutive quarters ended September 30, 2003 totaling $124.0 million. We expect to incur a loss in the March 2006 quarter and may incur losses in subsequent quarters. Our ability to achieve and maintain profitability on a
quarterly or fiscal year basis in the future will depend on a variety of factors, including the need for future inventory write-downs, our ability to increase net sales, maintain or expand gross margins, introduce new products on a timely basis,
secure sufficient wafer fabrication capacity and control operating expenses, including stock-based compensation as required by SFAS 123R. Adverse developments with respect to these or other factors could result in quarterly or annual operating
losses in the future.



Fluctuations in ICSIs operating results will
also impact our results. We may encounter difficulties in integrating ICSI into ISSI.



On January 25, 2005, we announced our intent to acquire the remaining 71% of ICSI that we did not then own. In the nine months ended September 30, 2005, we purchased additional shares of ICSI for
approximately $52.5 million, increasing our ownership percentage to approximately 83% at September 30, 2005. In the three months ended December 31, 2005, we purchased additional shares of ICSI for approximately $3.5 million, increasing our
percentage ownership to approximately 87% at December 31, 2005. We intend to acquire substantially all of the remaining outstanding shares of ICSI for cash of approximately $13 million. Our financial results for fiscal 2005 through the period
ended April 30, 2005 reflect accounting for ICSI on the equity basis and include our percentage share of the results of ICSIs operations. Effective May 1, 2005, in accordance with generally accepted accounting principles, we began
consolidating the financial results of ICSI with our own results. As a result, our statement of operations is impacted by the financial results of ICSI and the minority interest is reflected in the minority interest in net loss of consolidated
subsidiary.



Our acquisition of ICSI requires combining two
employee teams in Taiwan: ICSI and ISSI-Taiwan. We may not be able to retain the individual employees that we believe are key contributors if they decide to leave us. Further, we are now in the process of streamlining our operations because
duplications exist as a result of the acquisition. We may



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encounter operational problems that could impact planning, on-time-delivery, product quality, customer relations or other
problems resulting from difficulties in combining the operations. Such problems could result in lower revenue or increased expenses. Furthermore, we could be subject to charges for impairment if ICSIs business materially declines. Furthermore,
the costs of the combined operations may be higher than anticipated and the revenues of the combined operations may be lower than expected. There is no assurance that ICSI will contribute positively to our business or operating results.



Our operating results are expected to continue to fluctuate and may not meet our
financial guidance or published analyst forecasts. This may cause the price of our common stock to decline significantly.



Our future quarterly and annual operating results are subject to fluctuations due to a wide variety of factors, including:



| |  |  | the cyclicality of the semiconductor industry;
| | - |  | ----------------------------------------------



| |  |  | declines in average selling prices of our products;
| | - |  | ---------------------------------------------------



| |  |  | inventory write-downs for lower of cost or market or excess and obsolete;
| | - |  | -------------------------------------------------------------------------



| |  |  | excess inventory levels at our customers;
| | - |  | -----------------------------------------



| |  |  | decreases in the demand for our products;
| | - |  | -----------------------------------------



| |  |  | oversupply of memory products in the market;
| | - |  | --------------------------------------------



| |  |  | our ability to successfully integrate the operations of ICSI;
| | - |  | -------------------------------------------------------------



| |  |  | our ability to control or reduce our operating expenses;
| | - |  | --------------------------------------------------------



| |  |  | shortages in foundry, assembly or test capacity;
| | - |  | ------------------------------------------------



| |  |  | disruption in the supply of wafers, assembly or test services;
| | - |  | --------------------------------------------------------------



| |  |  | changes in our product mix which could reduce our gross margins;
| | - |  | ----------------------------------------------------------------



| |  |  | cancellation of existing orders or the failure to secure new orders;
| | - |  | --------------------------------------------------------------------



| |  |  | a failure to introduce new products and to implement technologies on a timely basis;
| | - |  | ------------------------------------------------------------------------------------



| |  |  | market acceptance of ours and our customers products;
| | - |  | ------------------------------------------------------



| |  |  | economic slowness and low end-user demand;
| | - |  | ------------------------------------------



| |  |  | a failure to anticipate changing customer product requirements;
| | - |  | ---------------------------------------------------------------



| |  |  | fluctuations in manufacturing yields at our suppliers;
| | - |  | ------------------------------------------------------



| |  |  | our failure to deliver products to customers on a timely basis;
| | - |  | ---------------------------------------------------------------



| |  |  | the timing of significant orders;
| | - |  | ---------------------------------



| |  |  | increased expenses associated with new product introductions, masks or process changes;
| | - |  | ---------------------------------------------------------------------------------------



| |  |  | the ability of customers to make payments to us; and
| | - |  | ----------------------------------------------------



| |  |  | the commencement of, or developments with respect to, any future litigation or antidumping proceedings.
| | - |  | -------------------------------------------------------------------------------------------------------



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Our sales depend on DRAM and SRAM products and reduced demand for these products or a decline in average selling
prices could harm our business.



In the first quarter of
fiscal 2006 and in fiscal 2005, approximately 90% and 88%, respectively, of our net sales were derived from the sale of DRAM and SRAM products, which are subject to unit volume fluctuations and declines in average selling prices that could harm our
business. For example, we experienced a sequential decline in revenue from $61.5 million in our September 2005 quarter to $51.1 million in our December 2005 quarter. This decline in revenue was primarily the result of a decrease in unit shipments
and the average selling prices of our DRAM products. In the December 2005 quarter, we turned down some orders that had unfavorable margins as a result of the decrease in the average selling prices in the market. We may not be able to offset any
future price declines for our products by higher volumes or by higher prices on newer products. Historically, average selling prices for semiconductor memory products have declined, and we expect that average selling prices for our products will
decline in the future. Our ability to maintain or increase revenues will depend upon our ability to increase unit sales volume of existing products and introduce and sell new products that compensate for the anticipated declines in the average
selling prices of our existing products.



Any future downturn in the markets
we serve would harm our business and financial results.



Substantially all of our products are incorporated into products for the digital consumer electronics, networking, mobile communications and automotive electronics markets. Historically, these markets have experienced cyclical depressed
business conditions, often in connection with, or in anticipation of, a decline in general economic conditions or due to adverse supply and demand conditions in such markets. For example, our sales declined significantly in the fourth quarter of
fiscal 2004 compared to the third quarter of fiscal 2004 due to an oversupply of DRAM devices in the market and a general softness in SRAM demand. Industry downturns have resulted in reduced demand and declining average selling prices for our
products which adversely affected our business. We expect that our industry will remain cyclical, but are unable to predict when any upturn or downturn will occur or how long it will last.



Shifts in industry-wide capacity may cause our results to fluctuate. These shifts may
occur quickly with little or no advance notice. Such shifts have historically resulted in significant inventory write-downs.



The semiconductor industry is highly cyclical and is subject to significant downturns resulting from excess capacity, overproduction, reduced demand or
technological obsolescence. Shifts in industry-wide capacity from shortages to oversupply or from oversupply to shortages may result in significant fluctuations in our quarterly or annual operating results. These shifts in industry conditions can
occur quickly with little or no advance notice to us. Adverse changes in industry conditions are likely to result in a decline in average selling prices and the stated value of inventory. In the first quarter of fiscal 2006, in fiscal 2005 and
fiscal 2004, we recorded inventory write-downs of $3.6 million, $13.9 million and $17.3 million, respectively. The inventory write-downs primarily related to valuing our inventory at the lower-of-cost-or-market, and to a lesser extent, adjusting our
inventory valuation for certain excess and obsolete products.



We write down to zero carrying value of inventory on hand in excess of six months historical sales volumes to cover estimated excess and obsolete exposures, unless adjustments are made based on managements judgments for newer
products, end of life products or planned inventory increases. In making such judgments to write down inventory, management takes into account the product life cycles which can range from six to 30 months, the stage in the life cycle of the product,
the impact of competitors announcements and product introductions on our products.



We believe that six months is an appropriate period because it is difficult to accurately forecast for a specific product beyond this time frame due to the potential introduction of products by competitors, technology
obsolescence or fluctuations in demand. Future additional inventory write-downs may occur due to lower of cost or market accounting, excess inventory or inventory obsolescence.



If we are unable to obtain an adequate supply of wafers, our business will be harmed.



If we are unable to obtain an adequate supply of wafers from our current
suppliers or any alternative sources in a timely manner, our business will be harmed. Our principal manufacturing relationships are with SMIC, TSMC, Chartered Semiconductor Manufacturing, Powerchip Semiconductor and ProMOS Technologies. Each of our
wafer foundries also supplies wafers to other semiconductor companies, including certain of our competitors or for their own account. Although we are allocated specific wafer capacity from our suppliers, we may not be able to obtain such capacity in



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periods of tight supply. If any of our suppliers experience manufacturing failures or yield shortfalls, choose to
prioritize capacity for other uses, or reduce or eliminate deliveries to us, we may not be able to obtain enough wafers to meet the market demand for our products which would adversely affect our revenues. Once a product is in production at a
particular foundry, it is time consuming and costly to have such product manufactured at a different foundry. In addition, we may not be able to qualify additional manufacturing sources for existing or new products in a timely manner and we cannot
be certain that other manufacturing sources would be able to deliver an adequate supply of wafers to us.



Our gross margins may decline even in periods of increasing revenue.



Our gross margin is affected by a variety of factors, including our mix of products sold, average selling prices for our products and cost of wafers. Even
when our revenues are increasing, our gross margin may be adversely affected if such increased revenue is from products with lower margins or declining average selling prices. During periods of strong demand, wafer capacity is likely to be in short
supply and we will likely have to pay higher prices for wafers, which would adversely affect our gross margin unless we are able to increase our product prices to offset such costs. To maintain our gross margins when average selling prices are
declining, we must introduce new products with higher margins or reduce our cost per unit. There can be no assurance that we will be able to increase unit sales volumes, introduce and sell new products or reduce our cost per unit.



We may encounter difficulties in effectively integrating newly acquired businesses.



From time to time, we intend to acquire other companies or
assets that we believe to be complementary to our business. Acquisitions may result in use of our cash resources, potentially dilutive issuances of equity securities, incurrence of debt and contingent liabilities, amortization expenses related to
intangible assets, and the possible impairment of goodwill, which could harm our profitability. In addition, acquisitions involve numerous risks, including:



| |  |  | higher than estimated acquisition expenses;
| | - |  | -------------------------------------------



| |  |  | difficulties in successfully assimilating the operations, technologies and personnel of the acquired company;
| | - |  | -------------------------------------------------------------------------------------------------------------



| |  |  | diversion of managements attention from other business concerns;
| | - |  | -----------------------------------------------------------------



| |  |  | risks of entering markets in which we have no, or limited, direct prior experience;
| | - |  | -----------------------------------------------------------------------------------



| |  |  | the risk that the markets for acquired products do not develop as expected; and
| | - |  | -------------------------------------------------------------------------------



| |  |  | the potential loss of key employees and customers as a result of the acquisition.
| | - |  | ---------------------------------------------------------------------------------



In this regard, in fiscal 2005, we increased our ownership in Signia to approximately 68% of the outstanding shares. The
cost of this additional investment was approximately $8.1 million in cash. We may encounter difficulties in effectively working with Signia. In addition, we could be subject to charges for impairment if Signias business materially declines.
For the period ending September 30, 2005, we incurred an impairment charge of $4.4 million related to the goodwill acquired with Signia. There is no assurance that Signia or any future acquisitions will contribute positively to our
business or operating results.



We rely on third-party contractors to
assemble and test our products and our failure to successfully manage our relationships with these contractors could damage our relationships with our customers, decrease our sales and limit our growth.



We rely on third-party contractors located in Asia to assemble and test our
products. There are significant risks associated with our reliance on these third-party contractors, including:



| |  |  | reduced control over product quality;
| | - |  | -------------------------------------



| |  |  | potential price increases;
| | - |  | --------------------------



| |  |  | reduced control over delivery schedules;
| | - |  | ----------------------------------------



| |  |  | capacity shortages;
| | - |  | -------------------



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| |  |  | their inability to increase production and achieve acceptable yields on a timely basis;
| | - |  | ---------------------------------------------------------------------------------------



| |  |  | absence of long-term agreements;
| | - |  | --------------------------------



| |  |  | limited warranties on products supplied to us; and
| | - |  | --------------------------------------------------



| |  |  | general risks related to conducting business internationally.
| | - |  | -------------------------------------------------------------



If any of these risks are realized, our business and results of operations could be adversely affected until our subcontractor is able to remedy the
problem or until we are able to secure an alternative subcontractor.



The
loss of a significant customer or a reduction in orders from such a customer could adversely affect our operating results.



As sales to our customers are executed pursuant to purchase orders and no purchasing contracts typically exist, our customers can cease doing business
with us at any time. For example, during the September 2004 quarter, we experienced cancelled or reduced orders from some of our larger customers that adversely impacted our operating results. We may not be able to retain our key customers, such
customers may cancel or reschedule orders, and in the event of canceled orders, such orders may not be replaced by other sales. In addition, sales to any particular customer may fluctuate significantly from quarter to quarter, and such fluctuating
sales could harm our business and financial results.



We have significant
international sales and operations and risks related to our international activities could harm our operating results.



In the three months ended December 31, 2005, approximately 16% of our net sales was attributable to customers located in the U.S., 8% was
attributable to customers located in Europe and 76% was attributable to customers located in Asia. In fiscal 2005, approximately 15% of our net sales was attributable to shipments in the U.S., 9% was attributable to shipments in Europe and 75% was
attributable to shipments in Asia. In fiscal 2004, approximately 13% of our net sales was attributable to shipments in the U.S., 11% was attributable to shipments in Europe and 75% was attributable to shipments in Asia. We anticipate that sales to
international sites will continue to represent a significant percentage of our net sales. In addition, all of our wafer foundries and assembly and test subcontractors are in Taiwan, China and Singapore and a substantial majority of our employees are
located outside of the U.S.



We are subject to the risks of
conducting business internationally, including:



| |  |  | global economic conditions, particularly in Taiwan and China;
| | - |  | -------------------------------------------------------------



| |  |  | duties, tariffs and other trade barriers and restrictions;
| | - |  | ----------------------------------------------------------



| |  |  | foreign currency fluctuations;
| | - |  | ------------------------------



| |  |  | changes in trade policy and regulatory requirements;
| | - |  | ----------------------------------------------------



| |  |  | transportation delays;
| | - |  | ----------------------



| |  |  | the burdens of complying with foreign laws;
| | - |  | -------------------------------------------



| |  |  | imposition of foreign currency controls;
| | - |  | ----------------------------------------



| |  |  | language barriers;
| | - |  | ------------------



| |  |  | difficulties in hiring experienced engineers in countries such as China;
| | - |  | ------------------------------------------------------------------------



| |  |  | difficulties in collecting foreign accounts receivable;
| | - |  | -------------------------------------------------------



| |  |  | travel or other restrictions related to public health issues such as severe acute respiratory syndrome (SARS);
| | - |  | --------------------------------------------------------------------------------------------------------------



| |  |  | political instability, including any changes in relations between China and Taiwan; and
| | - |  | ---------------------------------------------------------------------------------------



| |  |  | earthquakes and other natural disasters.
| | - |  | ----------------------------------------



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Our revenues and business would be harmed if we are not able to successfully develop, introduce and sell new products
and develop and implement new manufacturing technologies in a timely manner.



We operate in highly competitive, quickly changing markets which are characterized by rapid obsolescence of existing products. As a result, our future success depends on our ability to develop and introduce new
products that our customers choose to buy in significant quantities. If we fail to introduce new products in a timely manner or if our customers products do not achieve commercial success, our business and results of operations could be
seriously harmed. The design and introduction of new products is challenging as such products typically incorporate more functions and operate at faster speeds than prior products. Increasing complexity generally requires smaller features on a chip.
This makes developing new generations of products substantially more difficult than prior generations. Further, new products may not work properly in our customers applications. If we are unable to design, introduce, market and sell new
products successfully, our business and financial results would be seriously harmed.



Our products are complex and could contain defects, which could reduce sales of those products or result in claims against us.



We develop complex and evolving products. Despite testing by us and our customers, errors may be found in existing or new products. This could result in a
delay in recognition or loss of revenues, loss of market share or failure to achieve market acceptance. The occurrence of defects could also cause us to incur significant warranty, support and repair costs, could divert the attention of our
engineering personnel from our product development efforts, and could harm our relationships with our customers. The occurrence of these problems could result in the delay or loss of market acceptance of our products and would likely harm our
business. Defects, integration issues or other performance problems in our products could result in financial or other damages to our customers or could lessen market acceptance of our products. Our customers could also seek and obtain damages from
us for their losses. From time to time, we have been involved in disputes regarding product warranty issues. Although we seek to limit our liability, a product liability claim brought against us, even if unsuccessful, would likely be time consuming
and could be costly to defend.



Potential intellectual property claims and
litigation could subject us to significant liability for damages and could invalidate our proprietary rights.



In the semiconductor industry, it is not unusual for companies to receive notices alleging infringement of patents or other intellectual property rights.
We have been, and from time-to-time expect to be, notified of claims that we may be infringing patents, maskwork rights or copyrights owned by third-parties. If it appears necessary or desirable, we may seek licenses under patents that we are
alleged to be infringing. Licenses may not be offered and the terms of any offered licenses may not be acceptable to us.



The failure to obtain a license under a key patent or intellectual property right from a third party for technology used by us could cause us to incur
substantial liabilities and to suspend the manufacture of the products utilizing the invention or to attempt to develop non-infringing products, any of which could harm our business. Furthermore, we may become involved in protracted litigation
regarding the alleged infringement by us of third-party intellectual property rights or litigation to assert and protect our patents or other intellectual property rights. Any litigation relating to patent infringement or other intellectual property
matters could result in substantial cost and diversion of our resources, which could harm our business.



We may be unable to effectively protect our intellectual property, which would negatively impact our ability to compete.



We believe that the protection of our intellectual proprietary rights will continue to be important to the success of our business. We rely on a
combination of patent, copyright, trademark and trade secret laws and restrictions on disclosure to protect our intellectual property rights. We also enter into confidentiality or license agreements with our employees, consultants and business
partners, and control access to and distribution of our documentation and other proprietary information. Despite these efforts, unauthorized parties may attempt to copy or otherwise obtain and use our proprietary technology. Monitoring unauthorized
use of our technology is difficult, and we cannot be certain that the steps we have taken will prevent unauthorized use of our technology, particularly in foreign countries where the laws may



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not protect our proprietary rights as fully as do the laws of the U.S. Many U.S. companies have encountered substantial
infringement problems in foreign countries, including countries in which we design and sell our products. We cannot be certain that patents will be issued as a result of our pending applications nor can we be certain that any issued patents would
protect or benefit us or give us adequate protection from competing products. For example, issued patents may be circumvented or challenged and declared invalid or unenforceable. We also cannot be certain that others will not develop our unpatented
proprietary technology or effective competing technologies on their own.



We
have acquired equity positions for strategic reasons in other companies which may significantly decrease in value.



Over the last several years, we have acquired equity positions for strategic reasons in other technology companies and we may make similar equity
purchases in the future. At December 31, 2005, our strategic investments in non-marketable securities totaled $4.6 million. These equity investments may not increase in value and there is the possibility that they could decrease in value over
time, even to the point of becoming completely worthless. These equity securities are evaluated for impairment on a recurring basis and any reductions in the carrying value would lower our profitability. In this regard, we recorded approximately
$0.3 million in impairment losses on two of our equity positions in fiscal 2005. In addition, we recorded approximately $0.3 million and $1.3 million in impairment losses during fiscal 2004 and fiscal 2003, respectively.



In addition, we own shares in SMIC with a cost basis of approximately $30.3
million and a market value at December 31, 2005 of approximately $35.8 million. The market value of SMIC shares is subject to fluctuation and our carrying value will be subject to adjustments to reflect the current market value. Our shares in
SMIC are subject to certain lockup restrictions and therefore all of such shares are not freely tradable. These lockup restrictions generally lapse at the rate of 15% of our pre-offering shares every 180 days following SMICs IPO which occurred
in March 2004. Thus, all of our shares in SMIC will be freely tradable in February 2007. As a result of these lockup restrictions and potential fluctuations in SMICs stock price, we may be unable to realize the market value at
December 31, 2005.



Due to the potential value of our strategic
investments, we could be determined to be an investment company and, if such a determination were made, we would become subject to significant regulation that would adversely affect our business.



We are a fabless semiconductor company engaged in the design and marketing of
high performance integrated circuits. We have acquired non-controlling equity positions in SMIC and other companies for strategic, commercial reasons relating to our primary business. Most of our equity positions are in privately held entities that
do not have a readily determinable market value. However, the shares we hold in SMIC are publicly traded on the Hong Kong Stock Exchange and the New York Stock Exchange. These securities have significant value and may increase in value in the
future. In addition, our equity positions could be considered to be investment securities under the Investment Company Act of 1940 (1940 Act), raising a question of whether we are an investment company required to register
and be regulated under the 1940 Act. We believe that we are primarily engaged in the semiconductor business and that any such securities we own are ancillary and strategically related to our semiconductor business. Accordingly, we do not believe
that we are an investment company. If a court or the Securities and Exchange Commission disagrees with this interpretation, we may be required to either dispose of a portion of the securities we own in SMIC and other companies to comply with the
1940 Act or register under the 1940 Act. If we choose to dispose of an additional portion of our securities in SMIC, our ability to secure access to wafer capacity from SMIC may be adversely impacted. If we choose to register as an investment
company, we will become subject to significant regulation under the 1940 Act which would materially adversely affect our ability to operate as a semiconductor company.



Recent changes in securities laws and regulations are increasing our costs.



The Sarbanes-Oxley Act of 2002 that became law in July 2002, as well as new
rules subsequently implemented by the Securities and Exchange Commission and the Nasdaq Stock Market, have required, and will require, changes to some of our accounting and corporate governance practices, including the report on our internal
controls as required by Section 404 of the Sarbanes-Oxley Act of 2002. These rules and regulations have increased our accounting, legal and other costs, and have made some activities more difficult, time consuming and/or costly. In particular,
complying with the internal control requirements of Sarbanes-Oxley Section 404 has resulted in increased internal efforts, significantly higher fees from our independent accounting firm and significantly higher fees from third party
contractors. We also expect



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these rules and regulations to make it more difficult and more expensive for us to obtain director and officer liability
insurance, and we may be required to accept reduced coverage or incur substantially higher costs to obtain coverage. These rules and regulations could also make it more difficult for us to attract and retain qualified executive officers and
qualified members of our board of directors, particularly to serve on our audit committee.



We may experience difficulties and increased expenses in complying with Sarbanes-Oxley Section 404.



Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, beginning with our Annual Report on Form 10-K for our fiscal year ending
September 30, 2005, we are required to furnish a report by our management on our internal control over financial reporting. Such report contains among other matters, an assessment of the effectiveness of our internal control over financial
reporting as of the end of our fiscal year, including a statement as to whether or not our internal control over financial reporting is effective. This assessment includes disclosure of any material weaknesses in our internal control over financial
reporting identified by management and also contains a statement that our auditors have issued an attestation report on managements assessment of such internal controls. Public Company Oversight Board Auditing Standard No. 2 provides the
professional standards and related performance guidance for auditors to attest to, and report on, managements assessment of the effectiveness of internal control over financial reporting under Section 404.



We concluded that our internal control over financial reporting was effective
and our auditors concurred with such assessment at September 30, 2005. Our internal control analysis for fiscal 2005 was not required to cover ICSI. However, ICSI will be covered by our internal control analysis for fiscal 2006. As a result, we
expect compliance with Section 404 for fiscal 2006 to require significant effort and expense. If in the future we are unable to assert that our internal control over financial reporting is effective (or if our auditors are unable to attest that
our managements report is fairly stated or they are unable to express an opinion on the effectiveness of our internal controls), we could lose investor confidence in the accuracy and completeness of our financial reports, which would have an
adverse effect on our stock price.



Our reported financial results may be
adversely affected by changes in accounting principles generally accepted in the United States.



We prepare our financial statements in conformity with accounting principles generally accepted in the U.S. These accounting principles are subject to
interpretation by the Financial Accounting Standards Board, the American Institute of Certified Public Accountants, the Securities and Exchange Commission and various bodies formed to interpret and create appropriate accounting policies. A change in
these policies or interpretations could have a significant effect on our reported financial results, and could affect the reporting of transactions completed before the announcement of a change. For example, beginning in the first quarter of fiscal
2006, with the adoption of SFAS 123(R), we now record a charge to earnings for employee stock option grants for all stock options unvested at and granted after October 1, 2005. This accounting pronouncement has and is expected to continue to
negatively impact our financial results. Technology companies generally, and our company specifically, rely on stock options as a major component of our employee compensation packages. Because we are required to expense options, we may be less
likely to sustain profitability or we may have to decrease or eliminate option grants. Decreasing or eliminating option grants may negatively impact our ability to attract and retain qualified employees.



We depend on our ability to attract and retain our key technical and management personnel.



Our success depends upon the continued service of our key
technical and management personnel. Several of our important manufacturing and other subcontractor relationships are based on personal relationships between our senior executive officers and such parties. In particular, our Chairman and Chief
Executive Officer has long-term relationships with our key foundries. If we were to lose the services of any key executives, it may negatively impact the related business relationships since we have no long-term contractual agreements with such
parties. Our success also depends on our ability to continue to attract, retain and motivate qualified technical personnel, particularly experienced circuit designers and process engineers. The competition for such employees is intense. We have no
employment contracts or key person life insurance policies with or for any of our employees. The loss of the service of one or more of our key personnel could harm our business.



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Our stock price is expected to continue to be volatile.



The trading price of our common stock has been and is expected to be subject
to wide fluctuations in response to:



| |  |  | quarter-to-quarter variations in our operating results;
| | - |  | -------------------------------------------------------



| |  |  | general conditions or cyclicality in the semiconductor industry or the end markets that we serve;
| | - |  | -------------------------------------------------------------------------------------------------



| |  |  | new or revised earnings estimates or guidance by us or industry analysts;
| | - |  | -------------------------------------------------------------------------



| |  |  | comments or recommendations issued by analysts who follow us, our competitors or the semiconductor industry;
| | - |  | ------------------------------------------------------------------------------------------------------------



| |  |  | aggregate valuations and movement of stocks in the broader semiconductor industry;
| | - |  | ----------------------------------------------------------------------------------



| |  |  | announcements of new products, strategic relationships or acquisitions by us or our competitors;
| | - |  | ------------------------------------------------------------------------------------------------



| |  |  | increases or decreases in available wafer capacity;
| | - |  | ---------------------------------------------------



| |  |  | governmental regulations, trade laws and import duties;
| | - |  | -------------------------------------------------------



| |  |  | announcements related to future or existing litigation involving us or any of our competitors;
| | - |  | ----------------------------------------------------------------------------------------------



| |  |  | announcements of technological innovations by us or our competitors;
| | - |  | --------------------------------------------------------------------



| |  |  | additions or departures of senior management; and
| | - |  | -------------------------------------------------



| |  |  | other events or factors, many of which are beyond our control.
| | - |  | --------------------------------------------------------------



In addition, stock markets have experienced extreme price and trading volume volatility in recent years. This volatility has had a substantial effect on
the market prices of securities of many technology companies for reasons frequently unrelated to the operating performance of the specific companies. These broad market fluctuations may adversely affect the market price of our common stock.



Foundry capacity can be limited, and we may be required to enter into
costly arrangements to secure foundry capacity.



If we are
not able to obtain additional foundry capacity as required, our relationships with our customers would be harmed and our future sales would be adversely impacted. In order to secure foundry capacity, we have entered into in the past, and may enter
into in the future, various arrangements with suppliers, which could include:



| |  |  | purchases of equity or debt securities in foundries;
| | - |  | ----------------------------------------------------



| |  |  | joint ventures;
| | - |  | ---------------



| |  |  | process development relationships with foundries;
| | - |  | -------------------------------------------------



| |  |  | contracts that commit us to purchase specified quantities of wafers over extended periods;
| | - |  | ------------------------------------------------------------------------------------------



| |  |  | increased price for wafers;
| | - |  | ---------------------------



| |  |  | option payments or other prepayments to foundries; and
| | - |  | ------------------------------------------------------



| |  |  | nonrefundable deposits with, or loans to, foundries in exchange for capacity commitments.
| | - |  | -----------------------------------------------------------------------------------------



We may not be able to make any such arrangements in a timely fashion or at all, and such arrangements, if any, may not be on
terms favorable to us. Once we make commitments to secure foundry capacity, we may incur significant financial penalties if we subsequently determine that we are not able to utilize all of that capacity. Such penalties may be substantial and could
harm our financial results.



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Our foundries may experience lower than expected yields which could adversely effect our business.



The manufacture of integrated circuits is a highly complex and technically
demanding process. Production yields and device reliability can be affected by a large number of factors. As is typical in the semiconductor industry, our outside foundries have from time to time experienced lower than anticipated manufacturing
yields and device reliability problems, particularly in connection with the introduction of new products and changes in such foundrys processing steps. There can be no assurance that our foundries will not experience lower than expected
manufacturing yields or device reliability problems in the future, which could materially and adversely affect our business and operating results.



Strong competition in the semiconductor memory market may harm our business.



The semiconductor memory market is intensely competitive and has been characterized by an oversupply of product, price
erosion, rapid technological change, short product life cycles, cyclical market patterns, and heightened foreign and domestic competition. Many of our competitors offer broader product lines and have greater financial, technical, marketing,
distribution and other resources than us. In particular, a competitor with a materially smaller die size and lower cost could dramatically gain market share in a short period of time. We may not be able to compete successfully against any of these
competitors. Our ability to compete successfully in the memory market depends on factors both within and outside of our control, including:



| |  |  | the pricing of our products;
| | - |  | ----------------------------



| |  |  | the supply and cost of wafers;
| | - |  | ------------------------------



| |  |  | product design, functionality, performance and reliability;
| | - |  | -----------------------------------------------------------



| |  |  | successful and timely product development;
| | - |  | ------------------------------------------



| |  |  | the performance of our competitors and their pricing policies;
| | - |  | --------------------------------------------------------------



| |  |  | our ability to successfully integrate the operations of ICSI;
| | - |  | -------------------------------------------------------------



| |  |  | wafer manufacturing over or under capacity;
| | - |  | -------------------------------------------



| |  |  | real or perceived imbalances in supply and demand for our products;
| | - |  | -------------------------------------------------------------------



| |  |  | the rate at which OEM customers incorporate our products into their systems;
| | - |  | ----------------------------------------------------------------------------



| |  |  | the success of our customers products and end-user demand;
| | - |  | -----------------------------------------------------------



| |  |  | access to advanced process technologies at competitive prices;
| | - |  | --------------------------------------------------------------



| |  |  | achievement of acceptable yields of functional die;
| | - |  | ---------------------------------------------------



| |  |  | the capacity of our third-party contractors to assemble and test our products;
| | - |  | ------------------------------------------------------------------------------



| |  |  | the gain or loss of significant customers; and
| | - |  | ----------------------------------------------



| |  |  | the nature of our competitors and general economic conditions.
| | - |  | --------------------------------------------------------------



In addition, we are vulnerable to technology advances utilized by competitors to manufacture higher performance or lower cost products. We may not be able
to compete successfully in the future as to any of these factors. Our failure to compete successfully in these or other areas could harm our business and financial results.



Terrorist attacks, threats of further attacks, acts of war and threats of war may negatively impact all aspects of our operations,
revenues, costs and stock price.



Terrorist acts, conflicts
or wars, as well as future events occurring in response or connection to them, including future terrorist attacks against U.S. targets, rumors or threats of war, actual conflicts involving the U.S. or its allies (such as the war in Iraq), conflict
between China and Taiwan, or trade disruptions impacting our domestic or foreign suppliers



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or our customers, may impact our operations and may, among other things, cause delays or losses in the delivery of wafers
or other products to us and decreased sales of our products. More generally, these events have affected, and are expected to continue to affect, the general economy and customer demand for products sold by our customers. Any of these occurrences
could have a significant impact on our operating results, revenues and costs, which in turn may result in increased volatility in our common stock price and a decline in the price of our common stock.



Item 6. Exhibits



(a)
The following exhibits are filed as a part of this report.



| |  |              |  |                                                                                                                         
| |  | ------------ |  | ------------------------------------------------------------------------------------------------------------------------
| |  | Exhibit 10.1 |  | 1993 Employee Stock Purchase Plan, as amended.                                                                          
| |  |             
| |  | Exhibit 31.1 |  | Certification Pursuant to SEC Release No. 33-8238, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
| |  |             
| |  | Exhibit 31.2 |  | Certification Pursuant to SEC Release No. 33-8238, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
| |  |             
| |  | Exhibit 32   |  | Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 



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SIGNATURES



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



|                        |  |                                               
|----------------------- |  | ----------------------------------------------
|                        |  | Integrated Silicon Solution, Inc. (Registrant)
|                        | 
|Dated: February 9, 2006 |  | /s/ Gary L. Fischer                           
|                        |  | Gary L. Fischer                               
|                        |  | Acting Chief Financial Officer                
|                        |  | (Principal Financial and Accounting Officer)  



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