**UNITED STATES**

**SECURITIES ANDEXCHANGE COMMISSION**

**Washington, D.C.20549**

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**FORM 10-K**

| **(Mark One)**                                    | ** **                                                                                              |
|---------------------------------------------------|---------------------------------------------------------------------------------------------------------|
| **x**                                             | **ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934**     |
| **For the fiscal year ended March 31, 2006** |
| **OR**                                            |
| o                                                 | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**For the transitionperiod                 to**

**Commission FileNumber: 001-13748**

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**ZiLOG, INC.**

**(Exact name ofRegistrant as specified in its charter)**

| **Delaware**                                                    | **13-3092996**                          |
|-----------------------------------------------------------------|-----------------------------------------|
| (State or other jurisdiction of incorporation or  organization) | (I.R.S. Employer Identification Number) |
| **532 Race Street, San Jose, CA**                               | **95126**                               |
| (Address of principal executive offices)                        | (Zip Code)                              |

 

**Registrant’s telephone number, including area code:** (408) 558-8500

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Securities registered pursuant to Section 12(b) ofthe Act:

NONE

Securities registered pursuant to Section 12(g) ofthe Act:

Common Stock, $0.01 pershare par value

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Indicate by check mark if the registrant is a well-knownseasoned issuer, as defined in Rule 405 of the Securities Act.   Yes o   No x

Indicate by check mark if the registrant is notrequired to file reports pursuant to Section 13 or Section 15(d) ofthe Exchange Act.   Yes o   No x

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

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, and willnot be contained, to the best of Registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K.   o

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2of the Exchange Act.

Large accelerated filer  o      Accelerated filer o      Non-accelerated filer x

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

As of September 30, 2005, the aggregate marketvalue of the Registrant’s Common Stock held by non-affiliates of the Registrantwas approximately $19,224,134 based on the closing sale price for shares of theRegistrant’s Common Stock as reported on the NASDAQ National Market. Shares ofCommon Stock held by each officer and director and by each person who owns 5%or more of the outstanding Common Stock have been excluded in that such personsmay deemed to be affiliates. This determination of affiliate status is notnecessarily a conclusive determination for other purposes.

Indicate by check mark whether the Registrant has filedall documents and reports required to be filed by section 12, 13 or 15(d) ofthe Securities Exchange Act of 1934 subsequent to the distribution ofsecurities under a plan confirmed by a court. Yes x   No o

At May 31,2006, 16,584,407 shares of the Registrant’s Common Stock were outstanding.

**DOCUMENTSINCORPORATED BY REFERENCE**

The Registrant’s definitiveProxy Statement for the Annual Meeting of Stockholders to be held on July 26,2006 is incorporated by reference in Part III of this Form 10-Kto the extent stated herein.

 

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**TABLEOF CONTENTS**

|                   | ** ** | ** **                                                                                                          | ** ** | **Page**   |
|-------------------|------------|---------------------------------------------------------------------------------------------------------------------|------------|------------|
| **PART I**   | ** ** | ** **                                                                                                          | ** ** | ** ** |
| Item 1.      |       | Business                                                                                                            |       | 5          |
| Item 1A.     |       | Risk Factors                                                                                                        |       | 14         |
| Item 2.      |       | Properties                                                                                                          |       | 29         |
| Item 3.      |       | Legal Proceedings                                                                                                   |       | 30         |
| Item 4.      |       | Submission of Matters to a Vote of Security Holders                                                                 |       | 31         |
| **PART II**  | ** ** | ** **                                                                                                          | ** ** | ** ** |
| Item 5.      |       | Market for  Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases  of Equity Securities |       | 32         |
| Item 6.           |       | Selected Consolidated Financial Data                                                                                |       | 35         |
| Item 7.           |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                    |       | 38         |
| Item 7A.     |       | Quantitative and Qualitative Disclosures About Market  Risk                                                         |       | 67         |
| Item 8.           |       | Financial Statements and Supplementary Data                                                                         |       | 68         |
| Item 9.           |       | Changes in and Disagreements with Accountant on  Accounting and Financial Disclosures                          |       | 102        |
| Item 9A.     |       | Controls and Procedures                                                                                             |       | 102        |
| Item 9B.     |       | Other  Information                                                                                                  |       | 102        |
| **PART III** | ** ** | ** **                                                                                                          | ** ** | ** ** |
| Item 10.          |       | Directors and Executive Officers of the Registrant                                                                  |       | 104        |
| Item 11.     |       | Executive Compensation                                                                                              |       | 104        |
| Item 12.          |       | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters                     |       | 104        |
| Item 13.          |       | Certain Relationships and Related Transactions                                                                      |       | 104        |
| Item 14.     |       | Principal Accounting Fees and Services                                                                              |       | 104        |
| **PART IV**  | ** ** | ** **                                                                                                          | ** ** | ** ** |
| Item 15.     |       | Exhibits and Financial Statement Schedules                                                                          |       | 105        |

 

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**FORWARD-LOOKINGSTATEMENTS**

Some of thestatements under sections entitled “Risk Factors” and “Management’s Discussionand Analysis of Financial Condition and Results of Operations” and elsewhere inthis Form 10-K constitute forward-looking statements within themeaning of the Private Securities Litigation Reform Act of 1995, Section 27Aof the Securities Act of 1933 and Section 21E of the Securities ExchangeAct of 1934. In some cases, you can identify forward-looking statements byterminology such as “may,” “will,” “should,” “expects,” “anticipates,” “believes,”“estimates,” “potential,” “continue,” or the negative terms or other comparableterminology. These statements include:

·       estimatesof our stock-based compensation expense; 

·       thesuccess of our lower geometry fab processes; 

·       estimatesof market growth; 

·       capitalexpenditures; 

·       theadequacy of available cash; the cost or outcome of any litigation pending orthreatened;

·       anygross margin improvement resulting from our research and development efforts;

·       thecost of compliance with environmental laws; and 

·       theshipment dates for our 32-bit ARM products;

These statements relate to future events or our futurefinancial performance and involve known and may involve unknown risks,uncertainties and other factors that may cause our actual results, levels ofactivity, performance or achievements to be materially different from anyfuture results, levels of activity, performance or achievements expressed orimplied by forward-looking statements including, but not limited to prospectsfor future market growth. Other factors that may cause or contribute todifferences include, but are not limited to: continued availability of third-party foundry and assembly services atcommercially-reasonable quality and prices; under-absorption of manufacturingcosts in our test and manufacturing support facilities from under-utilizationof capacity; our distributors and customers significantly reducing theirexisting inventories before ordering new products; the merger or acquisition ofany key customers or distributors; our ability to sell and/or recover thecarrying value of our assets held for sale; and anticipated costs in connectionwith the decommissioning of our MOD II wafer fabrication facility in Nampa,Idaho; and the costs associated with the Microchip lawsuit. In evaluating thesestatements, you should specifically consider various factors, including therisks outlined under “Risk Factors.”

Although we believe that the expectations in theforward-looking statements contained in this Form 10-K arereasonable, we cannot guarantee future results, levels of activity, andperformance achievements. These forward-looking statements are based on ourcurrent expectations, and we disclaim any obligation to update these forward-lookingstatements for subsequent events or to explain why actual results differ unlessotherwise required by law. You should not place undue reliance on theseforward-looking statements.

Unless otherwise specifiedas a forward-looking statement, the information contained in this report ishistorical in nature and speaks as of the date of this report unless otherwiseclearly indicated. We disclaim any obligation to update this information forsubsequent events.

**Period Comparisons**

Our results of operations from May 1, 2002 arenot comparable to our results of operations prior to May 1, 2002, due toour adoption of “fresh-start” reporting upon our emergence from bankruptcy as 

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prescribed by the AmericanInstitute of Certified Public Accountant’s Statement of Position 90-7,“Financial Reporting by Entities in Reorganization Under the Bankruptcy Code.”Differences in our results of operations relate to depreciation of property,plant and equipment, amortization of intangible assets, interest expense andrestructuring and reorganization expenses. Additionally, these differences inour balance sheets relate to inventory, in-process research and development,property, plant and equipment, intangible assets, conversion of senior notes tocommon stock, and minority interest. Certain figures, such as net sales andcertain expenses were not affected by our adoption of fresh-start accountingand, accordingly, we believe them to be comparable. To provide a moremeaningful analysis, we have, in certain circumstances, combined results of ourPredecessor and Successor Company’s operations for fiscal year 2002. Ourcombined results for 2002 are presented for convenience of annual comparisonand are not meant to be a presentation in accordance with generally acceptedaccounting principles.

Effective December 29, 2005, we changed ourfiscal year end from December 31 to March 31. Our interim results arebased on fiscal quarters of thirteen weeks in duration ending on the lastSaturday of each calendar quarter with the exception of the last quarter, whichends on March 31 beginning in fiscal 2006. In accordance with the fiscalcalendar in place at that time, the three month transition period ended on March 27,2005 and the comparative period ended on March 28, 2004. For financial reportingpurposes and convenience of reference, we have labeled our interim fiscalperiods as ending on calendar month-end. The operating results for any interimperiod are not necessarily indicative of results for any subsequent period orthe full fiscal year

Based in San Jose,California, we were incorporated in California in October 1981 andreincorporated in Delaware in April 1997. In this report, “ZiLOG,” “theCompany,” “our,” “us,” “we,” and similar expressions refer to ZiLOG, Inc.and its subsidiaries. However, when these expressions are used throughout thisreport in connection with ZiLOG, Inc.’s reorganization under Chapter 11 ofthe U.S. bankruptcy code, they are referring only to the parent company, ZiLOG, Inc.,and not to any of its subsidiaries. ZiLOG, eZ80, Z8Encore!, Z8Encore!XP, and eZ80TMare registered trademarks of ZiLOG, Inc. and eZ80Acclaim! is a trademarkof ZiLOG, Inc.

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**PART I**

**ITEM 1.**                BUSINESS

**BUSINESS**

**Our Business**

We are a fabless semiconductor supplier of 8-bitmicrocontroller semiconductor devices. A microcontroller is a computer-on-a-chipthat is optimized to control electronic devices such as motors, remotecontrollers and user interfaces on appliances. A microcontroller is essentiallya pc on a chip and typically includes a central processing unit, non-volatileprogram memory, random access memory for data storage and various peripheralcapabilities. The microcontroller is offered as a complete solution because itincorporates application-specific software provided by the customer and mayinclude specialized peripheral device controllers and internal or externalnon-volatile memory components to enable the storage and access of additionalprogram software.

ZiLOG was founded in 1974 by Federico Faggin whoco-invented the microprocessor. We design, develop, test and market a portfolioof these devices for a variety of applications used in; consumer electronics,home appliances, security systems, point of sale terminals, personal computerperipherals, personal health and medical products.

We introduced our first products in the mid-1970’sand have since established a globally recognized brand. We sell our devicesdirectly to a diverse customer base of Original Equipment Manufacturers (“OEMs”)for general purpose use or for use in application specific end markets.  Additionally, we sell our devices todistributors who generally provide logistical and post sales support to thesecustomers.

Since 2002, we haveinvested heavily in refurbishing our portfolio and have introduced our Z8 Encore!,Z8Encore!XP, Motor control and eZ80 Acclaim! these devices are designed toincorporate reprogrammable flash memory and enhanced peripherals with featuresthat may allow such functionality as power management, secure transactions and/orconnectivity.

**Our Industry**

Microcontroller devices have been incorporated into awide variety of products in markets including consumer electronics, homeappliances, security systems, point of sale terminals, personal computerperipherals as well as industrial and automotive applications. Microcontrollersare generally segmented by word length, which is measured in bits ranging from 4-bitthrough 32-bit architectures. Although 4-bit microcontrollers arerelatively inexpensive, they generally lack the minimum performance andfeatures required for product differentiation and are typically used only toproduce basic functionality in products. While traditional 16 and 32-bitarchitectures are typically higher performance, they can be too expensive formany high-volume embedded control applications, typically costing two to fourtimes the cost of an 8-bit microcontroller. Manufacturers will choose theappropriate microcontroller based on cost, performance and functionality.Microcontrollers are used broadly in over 100 different market categories forspecific and general purpose applications.

Analysts estimate the 8bit market to be approximately $4 billion per year. We believe that 8-bitmicrocontrollers are generally perceived as the most cost-effective embeddedcontrol solution for high volume requirements. High-volume microcontrollersavailable today are typically Read Only Memory (“ROM”) or One-Time Programmable(“OTP”), which typically require longer delays and greater costs in order toimplement customer application code changes as compared to reprogrammableflash, generally resulting in longer lead times, for delivery of suchmicrocontrollers. In addition to delayed product introduction, these longerlead times can result in potential inventory obsolescence and disruptions tocustomers’ factory production when changes in the application code are requiredby the customer. To 

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addresssome of these issues, some suppliers offer OTP-based microcontrollers that canbe configured by the customer in the customer’s manufacturing line, thusminimizing lead-time and inventory risks if the customer’s application coderequires changes. Furthermore, flash memory offers the flexibility ofin-product re-programmability. While these flash-based microcontrollers wereinitially expensive relative to ROM and OTP-based microcontrollers, manufacturingtechnology has evolved over the past several years to the point where thepremium for flash microcontrollers over ROM and OTP-based microcontrollers isminimal.

**Our Strategy**

The key elements of ourstrategy are:

***Deliver Complete Solutions to Our Customers***

We are focused onproviding advanced semiconductor solutions that assist our customers in addingfunctionality and enhancing the performance of their products.

***Partner with third party manufacturers to leveragescale***

Our manufacturing strategyis to utilize third party wafer foundries to manufacture our devices. Webelieve outsourcing manufacturing enables us to access advanced processtechnologies and to reduce our manufacturing costs. This strategy allows us tofocus greater resources on product design, systems and software development andcustomer support. In line with this strategy, during 2002 and 2004 we closedour wafer manufacturing facilities in Nampa, Idaho, and migrated production ofthese products to our wafer foundry suppliers. Our new products are sourcedfrom TSMC and UMC in Taiwan and our legacy products are primarily sourced fromX-FAB in Lubbock, Texas.

**Products andApplications**

We design, develop, and market a broad portfolio ofmicrologic semiconductor devices for embedded control and communicationapplications used in consumer electronics, home appliances, security systems,point of sale terminals and personal computer peripherals, as well asindustrial and automotive applications.

Our products offer our customers the ability to integrateperipheral functions (such as network connectivity, timers, serialcommunication, analog/digital conversion, infrared data transmission anddisplay drivers) on our micrologic devices. These additional functions enhancethe capabilities of the customer’s end product, which can lower their overallsystems costs. These peripherals incorporate functionality that might otherwisebe found in a separate chip on the printed circuit board to which themicrologic device is attached.

We combine different microprocessors,memories and peripheral functions to create devices specifically tailored tomeet the requirements of targeted vertical markets.

**Customers, Salesand Marketing**

***Introduction***

To market our products, weutilize a well-trained, direct and distribution sales force, a customer-centricwebsite, technical documentation that includes product specifications andapplication notes, development tools and reference designs, sales promotionalmaterials, targeted advertising and public relations activities, andinvolvement in key trade shows and technical conferences in North America,Europe and Asia. Our direct sales force and our sales representatives covervarious geographic locations in the Americas, Europe and Asia.

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***Sales Process***

Through direct sales and distributors, we havedeveloped relationships with customers, including large OEMs and end users. Bycollaborating with customers in an interactive product design and developmentprocess, we have been able to establish long-standing relationships, which helpus solidify our customer base and define our next generation products

We work closely with our customers in identifyingopportunities for the customer to pursue end product designs using our devices.The customer’s decision to design an end product using our devices is basedupon technical and financial factors, including microprocessor performance,memory, peripheral options, pre-existing customer relationships, financialstability and pricing. Typically, a customer’s product architects and designengineers will then use our proprietary development tools over a period of manymonths or longer to design an end product and test the design using our devicesbefore making a decision.

We classify a design winas the point at which the customer has purchased at least $1,000 of product.Once we have achieved a design win we deliver a limited production of thedevice to our customer. Product prototypes are then created and tested. If thedecision is made to produce the product for sale, we will receive a full productionorder. The entire cycle from design win to full production typically takesbetween 12 and 18 months, although it may take up to 36 months. After a designwin, our sales are generally made pursuant to short-term cancelable purchaseorders that can be cancelled upon 30 to 60 days notice. As a result, designwins are not necessarily an accurate or reliable indication of future netsales.

***Direct Sales Force***

Our direct sales force focuses on the Americas, Europeand Asia. We have offices located in the metropolitan areas of  San Jose, Seattle, Hong Kong, London, Munich,Seoul, Shanghai, Shenzhen (China), Singapore, Taipei and Toronto. Thepercentage of net sales derived directly from sales to OEM’s is included inTable 1 below, including one OEM customer, SMK, which represented 10%, 12%, 12%and less than 10% of the net sales for the twelve months ended March 31,2006, the three months ended March 31, 2005 and the years endedDecember 31, 2004 and December 31, 2003, respectively. Additionally,from time to time we engage sales representative firms to further augment ourown direct sales force.

Weprovide direct customer support through our field application engineers, whoare located in our sales offices around the world and work directly with localcustomers in close consultation with our factory-based technical specialists.Field application engineers typically develop technology expertise in a marketsegment that is most prominent in their geographic areas. These engineersprovide significant aid to the customer throughout the design process. Customersupport in the Americas is being provided by our North American-basedpersonnel. Our local area sales offices handle customer service functions forAsia and Europe.

| **Table 1—Percentage of Sales by Channel** | ** ** | ** ** | ** ** | **Direct to OEM’s** | ** ** | **Through Distributors** | ** ** |
|--------------------------------------------------------------------------|------------|------------|------------|------------------------------------|------------|-------------------------------|------------|
| Twelve months  ended Mar. 31, 2006                                  |       |       | 44         | %                                  |       |                          | 56         | % |   |
| Three months  ended Mar. 31, 2005                                   |       |       | 50         | %                                  |       |                          | 50         | % |   |
| Twelve months  ended Dec. 31, 2004                                  |       |       | 51         | %                                  |       |                          | 49         | % |   |
| Twelve months ended  Dec. 31, 2003                                  |       |       | 53         | %                                  |       |                          | 47         | % |   |

 

***Distribution Partners***

We entered into adistributor agreement with Future Electronics, effective October 23, 2002.This agreement provides that Future Electronics will be our exclusivefull-service distributor within North America and will also serve as anon-exclusive distributor for the rest of the world. Either party may terminatethe agreement upon 30 days’ prior written notice to the other party. FutureElectronics is a 

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privateCanadian-based company with an extensive and well-integrated internationaldistribution infrastructure. Their ability to cover a broad spectrum of marketopportunities, especially in embedded flash-based products, continues toprovide significant value and opportunities for our new flash productportfolio. Future Electronics’ value-added services to us have not increasedour costs, and include a significant number of sales representatives focused onour business, seminars and workshops to train design engineers about ourproducts, direct mail advertising, collateral materials and web site pages dedicatedto our products. Net sales through our distribution channel are included inTable 1 above. In the twelve months ended March 31, 2006, three monthtransition period ended March 31, 2005, and the years ended December 31,2004 and 2003, Future Electronics accounted for approximately 24%, 20%, 20% and18% of net sales, respectively.  Additionally, we use various distributors tosupport both our Asia and European markets. Distributors in these regions tendto specialize based on the country serviced. We have no exclusive arrangementsin these regions and have distributor agreements for the supply and support ofproduct sales to their customers.

**Manufacturing andSourcing**

Our manufacturing strategy is to utilize third-partywafer foundries to manufacture our devices. We believe outsourcingmanufacturing enables us to access advanced process technology, reduce ourresearch and development costs and reduce our manufacturing costs. We sourceour wafer requirements from third-party foundries located in Taiwan and theUnited States. Wafers for our new products are supplied by TSMC and UMC and ourlegacy products are provide by X-FAB in Lubbock, Texas. Our assembly operationsare performed by subcontractors located throughout Asia including Indonesia,Thailand and the Philippines, while a significant amount of our wafer probe andfinal product testing is conducted at our facility located in Manila,Philippines.

The SGS InternationalCertification Services AG of Zurich, Switzerland granted an ISO 9001certification to our Philippines test facility. ISO certifications reflect thestringent quality standards to which all of our products are manufactured. Webelieve that these certifications enhance the reputation and quality of ourproducts.

**Research andDevelopment**

Our research and development expenditures have beenfocused on development of flash-based microcontrollers, including our Z8Encore! and eZ80 Acclaim! families of products. Additionally, we have focusedour development resources on expanding our Crimzon family of devices for theremote control market and development of our new 32 bit ARM based family ofproducts.

Research and developmentexpenditures were $21.0 million, $5.2 million, $20.9 million and $18.0 millionin the twelve months ended March 31, 2006, the three month transitionperiod ended March 31, 2005, and the years ended December 31, 2004and 2003, representing 27%, 26%, 22% and 17% of net sales, respectively. In thetwelve months ended March 31, 2006, the three month transition periodended March 31, 2005, and the years ended December 31, 2004, and2003, our research and development expenditures were focused largely on our newembedded flash products, including our latest family of flash-basedmicrocontrollers as well as new devices and software features for our Crimzonline of consumer solution products concentrated in the infrared remote controlmarket segment   Additionally, in February 2006,we announced the release of our 32 bit ARM based family of microcontrollerproducts initially focused on the point of sale and security based targetmarkets.

**Competition**

The semiconductor industry is highly competitive andis characterized by price erosion and rapid technological change in manymarkets. The industry consists of major domestic and international 

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semiconductor companies,many of which have substantially greater resources than we do with which topursue engineering, manufacturing, marketing and distribution of theirproducts. Emerging companies are also expected to increase their participationin the semiconductor market.

We compete on a global basis with other micrologicdevice manufacturers who target the same specific market segment. We believethe primary bases for competition in this market include: price, technologicalsophistication, customer relationships, support tools, familiarity withmicrologic architecture, and existing customer investment in system softwarebased on a particular architecture. In many instances our competitors havesimilar competitive strengths to us, and they have significantly more resourcesthan we do. Many of our competitors are much larger than we are, with broadproduct offerings in many sectors.

Our current and futureproducts compete with, or may compete with, products offered by Atmel, CypressSemiconductor, Intel, Microchip, Freescale, Renasas, STMicroelectronics andTexas Instruments, among others.

**Backlog**

Our total backlog ofcancelable customer orders was $17.3 million at March 31, 2006, $13.0million at March 31, 2005, $13.6 million at December 31, 2004 and$10.0 million at December 31, 2003. Our sales are generally made pursuantto short-term cancelable purchase orders that are cancelable upon 30 to 60 daysnotice rather than long-term contracts. As a result, our backlog may not be anaccurate measure of net sales or operating results for any period.Additionally, during times of economic downturn there tends to be excesscapacity in the marketplace, driving shorter lead time expectations, whichoften results in a higher percentage of book-ship (or turns) business in theperiod.

**Patents andLicenses**

We currently have 170 U.S. and non-U.S. patents as of March 31,2006, which expire between fiscal years 2007 and 2026.

We employ a combination of patents, copyrights,mask-work rights, trademarks and trade secrets, as well as contractualrestrictions, to protect the proprietary aspects of our business and devices.In addition to our own intellectual property, we license technologies andproducts from others as necessary to provide second sources for standardproducts or to obtain rights to cores, cells or other technology. We oftenenter into agreements to incorporate into our designs the intellectual propertyof third parties. Such agreements may impose certain obligations or limitationson our use or disclosure of such intellectual property or the enforcement ofour own intellectual property. We hold numerous U.S. and foreign patents andhave additional U.S. and foreign patent applications pending. We also holdnumerous mask works, copyrights to protect proprietary software employed in ourdevices, and trademarks. We intend to continue investing in the protection ofour intellectual property through the filing of patent applications and, ifappropriate, the registration of copyrights, mask-works and trademarks.Nevertheless, we believe that our continued success depends primarily on thetechnological skills and innovative abilities of our personnel and our abilityto rapidly commercialize product developments. Thus, we believe that the lossof any one of our patents or trade secrets would not materially affect our corebusiness.

The extent and value of our intellectual property isnecessarily uncertain. While we intend to protect our intellectual propertyrights vigorously, our efforts may not be successful. Despite our precautions,a third party may copy or otherwise obtain our devices or technology withoutauthorization, requiring patent litigation to enforce our rights. Patentlitigation is, by its nature, expensive and unpredictable. If litigated, one ormore of our patents may be found invalid or unenforceable or to have claims ofsuch narrow scope as to be of little economic value. Third parties may designaround our patents. Third parties may independently develop technology similarto our trade secrets. In addition, the laws of some foreign countries where wehave patent and trademark rights may not protect our intellectual propertyrights to 

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the same extent as thelaws of the United States. Additionally, our pending and future patentapplications should not be relied upon as they may not issue as patents, andeven if they do issue, such future patents may not be of sufficient scope orstrength to provide meaningful economic or competitive value.

The semiconductor industry is characterized by frequentlitigation regarding patent and other intellectual property rights, bothdefensive and offensive.

From time to time we have received, and may in thefuture receive communications from third parties asserting that a productoffered by us, or an aspect of our business, infringes a patent held by thethird party and/ or require a license thereto. With respect to those thirdparty communications that are currently pending but which have not yet beenfiled as a lawsuit, we believe, after having consulted with counsel, thateither (i) we have meritorious defenses, (ii) based on license termspreviously offered to us or typically available in the industry, we can obtainany necessary licenses on commercially reasonable terms, or (iii) we canmodify our products to avoid such rights, but in any case, we may be sued andassessed damages for past infringement. Indeed, licenses may not be availableon commercially reasonable terms, or at all. In addition, we have certainindemnification obligations to customers with respect to such claims ofinfringement of third party intellectual property rights by our devices. Shouldit become necessary to engage in litigation to defend against such assertions,such litigation could be expensive and time consuming. There can be no assurancethat the ultimate resolution of these matters would not have a material adverseaffect on our business.

On August 11, 2005 Microchip Technology Inc.(Microchip) filed a patent infringement claim against us in the U.S. DistrictCourt of Arizona (case number CV05-2406-PHX-MHM). Microchip allegesthat we have been infringing and currently infringes its patents numbered5,847,450, 6,696,316 and 6,483,183. Microchip claims that unspecified productsof ours, including our Z8 Encore! XP 4K Series of products, infringe thesepatents and is seeking preliminary and permanent injunctive relief, unspecifieddamages and costs including attorneys’ fees. We filed a response to the claimson September 15, 2005 generally denying the claims and challenging thevalidity of the patents. On January 10, 2006 we filed a request for patentreexamination with the U.S. PTO which was granted in February and March forall three patents. On March 13, 2006, we were informed that our motion tostay with the Federal court of Arizona was granted until such time as Microchipis informed of the outcome of the re-examinations.

We do not believe it is feasible to predict ordetermine the outcome or resolution of this litigation at this time. We believewe have meritorious defenses and will defend ourselves against these claimsvigorously. We may incur substantial expenses in our defense against theseclaims. In the event of a determination adverse to us, we may incur substantialmonetary liability, and be required to change our business practices. Either ofthese could have a material adverse effect on our financial position, resultsof operations or cash flow.

Intellectual propertylawsuits are subject to inherent uncertainties due to the complexity of thetechnical issues involved, and we may not be successful in defending ourselvesagainst intellectual property claims. The cost of defending against patentinfringement or other intellectual property litigation, in terms of managementtime and attention, legal fees and product delays, could be substantial,whatever the outcome. If any patent or other intellectual property claimsagainst us are successful, we may be prohibited from using the technologiessubject to these claims, and if we are unable to obtain a license on acceptableterms, license a substitute technology, or design new technology to avoidinfringement, we could be prohibited from using or selling the infringingproducts or technologies and be required to pay substantial damages. Such aresult could have a material adverse effect on our business. Conversely, wealso enforce our intellectual property rights where appropriate, consistentwith business considerations.

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**Employees**

As of March 31, 2006, we had 501 full timeemployees, comprised of approximately 237 in manufacturing-related activities;152 in engineering; 66 in sales and marketing; and 46 in general andadministrative functions.

Our employees are notrepresented by any collective bargaining organization.

**Environmental**

Until 2005 we operated a wafer fabrication facility. Ourmanufacturing processes required us to use various hazardous substances, and,as a result, we are subject to a variety of environmental laws and regulationsgoverning the storage, use, emission, discharge and disposal of, and humanexposure to, such substances. In particular, the process of manufacturingsilicon wafers used large amounts of corrosive and other hazardous chemicalsand huge quantities of distilled, de-ionized water. Our failure to comply withpresent or future laws and regulations or the loss of any permit required toconduct our business could result in fines being imposed on us or otherpenalties. Any failure by us to control the use of, or adequately restrict thedischarge of, hazardous substances could subject us to future liabilities thatcould materially harm our business, including under laws and regulations thatimpose liability and clean-up responsibility for releases of hazardoussubstances into the environment.

Recently, laws and regulations have been enacted inseveral European Union member countries, including several jurisdictions inwhich we operate, restricting the presence of certain substances in electronicproducts and holding producers of those products financially responsible forthe collection, treatment, recycling and disposal of certain products. Specifically,the European Union has enacted the Restriction of the Use of Certain HazardousSubstances in Electrical and Electronic Equipment, or RoHS, and the WasteElectrical and Electronic Equipment, or WEEE, directives. The RoHS directiveprohibits the use of certain substances, including lead, mercury, cadmium andchromium, in covered products placed on the market after July 1, 2006. TheWEEE directive obligates parties that place electrical and electronic equipmentonto the market in the European Union to clearly mark the equipment, registerwith and report to European Union regulators regarding distribution of theequipment, and provide a mechanism to recall and properly dispose of theequipment. Each European Union member country has enacted, or is expected tosoon enact, legislation clarifying what is and what is not covered by the WEEEdirective in that country. However, there is still some uncertainty in certainEuropean Union countries as to which party involved in the manufacture,distribution and sale of electronic equipment will be ultimately heldresponsible. If we are deemed to be a manufacturer of covered products, we maybe required to register as a producer in certain European Union countries, andincur financial responsibility with respect to products sold within theEuropean Union, including products of other manufacturers that have beenreplaced by our products. We may also incur substantial costs to change ourcontract partners manufacturing processes, redesign or reformulate, and obtainsubstitute components for, our products that are deemed covered products underthe ROHS directive. If we fail to timely provide RoHS-compliant products, wewill not be able to offer our products within European Union, and we may besubject to civil or criminal liabilities. Similar laws have been proposed andmay be enacted in other locations where we sell our products, including variousjurisdictions within the United States. We will need to ensure that we complywith such laws and regulations as they are enacted, and ensure, as appropriateor required, that our component suppliers also timely comply with such laws andregulations. If we fail to timely comply with such laws, we could facesanctions for such noncompliance and our customers further may refuse topurchase our products, which would have a material adverse effect on ourbusiness, financial condition and results of operations.

With respect toenvironmental remediation, we could incur substantial costs for the clean up ofcontaminated properties, either those we own or operate or to which we havesent wastes in the past. Under certain of these laws and regulations, currentor previous owners or operators of property may be 

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liablefor cleanup costs and other damages without regard to whether they knew of, orcaused, the contamination. The presence of, or failure to remediate,contamination could materially adversely affect the value of, and the abilityto transfer or encumber, our property. In addition, we may be required to incursignificant expense in connection with governmental investigation ofenvironmental or employee health and safety matters.

**FinancialRestructuring and Reorganization**

We filed a pre-packaged Chapter 11 reorganization planwith the United States Bankruptcy Court for the Northern District of Californiaon February 28, 2002. The court confirmed the plan on April 30, 2002,and it became effective on May 13, 2002.

Pursuant to ourreorganization plan, we extinguished $325.7 million of liabilities, whichincluded $280.0 million in principal amount of our former 91¤2%Senior Secured Notes due 2005, $27.2 million in accrued interest due on thenotes and $18.5 million of dividends payable on our former series A preferredstock. Each holder of senior notes received, in exchange for its senior notes,it’s pro rata share of:

·       14,000,000shares of our newly issued common stock. As of December 31, 2002, thisrepresented approximately 86% of our outstanding equity on a fully dilutedbasis.

·       100%of the newly issued series A preferred stock issued by our subsidiary,ZiLOG-MOD III, Inc., which we call MOD III, Inc. Holders of MOD III, Inc.series A preferred stock were entitled to receive an aggregate liquidationpreference of $30 million plus any accrued but unpaid dividends on the MOD III, Inc.series A preferred stock from the net proceeds from the sale of one of ourwafer fabrication plants located in Nampa, Idaho. We transferred this plant toMOD III, Inc. upon the effectiveness of our reorganization plan. MOD IIIInc. has subsequently sold most of its assets and redeemed a portion of suchshares. Dividends accrue on the MOD III, Inc. series A preferred stock at 91¤2%per annum, and these dividends increase the aggregate liquidation preferenceaccordingly.

·       50%of MOD III, Inc.’s newly issued series B preferred stock. We retained theremaining 50% of the new MOD III, Inc. series B preferred stock, as wellas 100% of the common stock. Holders of the new MOD III, Inc. series Bpreferred stock are entitled to receive the net sale proceeds from any sale ofMOD III, Inc.’s assets in excess of the series A preferred stockliquidation preference. Based upon the sale price received for the majority ofMOD III, Inc.’s assets, we do not expect to receive any value from ourseries B preferred stock.

Our previously outstandingcommon stock and preferred stock, and all related options and warrants, werealso cancelled pursuant to the terms of the reorganization plan, and allaccumulated dividends and any other obligations with respect to such shareswere extinguished. Each holder of common stock received a pro rata share of$50,000. Each holder of preferred stock received a pro rata share of $150,000.As a result of this reorganization, we saved more than $26.6 million in annualinterest payments on the extinguished senior notes.

**HistoricalBackground to the Plan of Reorganization**

We issued our senior secured notes in connection withour going-private transaction in 1998. From 1998 through 2002, our business andfinancial growth were negatively affected by the extremely difficult businessclimate in which we operated.

In March 2001, we retained Lazard Frères &Co., LLC as our independent financial advisor to assist us in exploring anumber of strategic alternatives. Also in March 2001, Lazard began theprocess of soliciting bids for the sale of all or parts of our business. Whilewe received a number of proposals, each of these contained significantfinancing or due diligence contingencies. After consultation with our financial

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advisor, we determinedthat these contingencies could seriously jeopardize the likelihood that astrategic transaction could be consummated.

In July 2001, holders of senior notes whocollectively held or managed approximately $165.0 million in principal amountof our senior notes formed an informal group to discuss and negotiate the termsof a possible restructuring with us. All members of this group executedconfidentiality agreements, and on July 13, 2001, members of ourmanagement met with these holders and their counsel to discuss a possiblerestructuring.

Discussions continued over the course of the summerand fall of 2001. During the course of these discussions, we concluded that thebest vehicle to achieve a restructuring of our senior notes was throughconsummation of a voluntary pre-packaged plan of reorganization under Chapter11 of the United States Bankruptcy Code. On November 27, 2001, we reacheda non-binding agreement regarding the terms of the reorganization plan withthis informal group of our note holders.

On January 28, 2002, we commenced solicitation ofacceptances of the plan of reorganization from the holders of our senior notesand preferred stock. As permitted by bankruptcy court rules, we did not solicitvotes from holders of our old common stock. In connection with thissolicitation, we entered into lock-up agreements with members of the informalgroup. Under the lock-up agreements, the members of the informal group agreed,among other things and subject to certain conditions, to vote to accept theplan of reorganization.

The voting period for the solicitation ended on February 26,2002. Holders of approximately $221.0 million of our senior notes acceptedthe plan of reorganization. None of the holders rejected the plan. All of theholders of preferred stock who voted also accepted the plan of reorganization.

On February 28, 2002,we along with MOD III, Inc. filed voluntary petitions with the UnitedStates Bankruptcy Court for the Northern District of California forreorganization under Chapter 11. The bankruptcy court confirmed thereorganization plan by its order entered on April 30, 2002, and thereorganization plan became effective on May 13, 2002.

**AvailableInformation**

The Company’s annual reports on Form 10-K,quarterly reports on Form 10-Q, current reports on form 8-K,and all amendments to those reports are available free of charge on the Company’swebsite through www.zilog.com, as soon as reasonably practicable after suchmaterial is electronically filed with or furnished to the Securities andExchange Commission. Information contained on our web site is not part of thisannual report on Form 10-K.

Alternatively, you may read and copy any materialsfiled with the SEC at the SEC’s Public Reference Room at 450 Fifth Street,NW, Washington, DC 20549 or access the information on the SEC’s website athttp://www.sec.gov. Additional information regarding operation for the PublicReference Room can be obtained by calling the SEC at 1-800-SEC-0330.

In addition, you may request a copy of these filings(including exhibits) at no cost by writing us at our principal offices at 532Race Street, San Jose, CA 95126, attention: Investor Relations, or by calling(408) 558-8500.

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**ITEM 1A.**        RISKFACTORS

**RISKFACTORS**

**Risks Related to Our Business and Industry**

*The following risk factors should be consideredcarefully in addition to the other information in the Form 10-K. Therisks described below are the ones we deem to be material to our business, butare not the only ones we face. Additional risks we are not presently aware ofor that we currently believe are immaterial may also impair our businessoperations. If any of these risks actually occurs, our business could be harmedmaterially.*

***We have experienceddeclines in net sales, and, if we fail to implement our new product strategy,we may continue to experience declines in sales and gross margins.***

In each of the past threeyears our net sales have declined significantly and our future financialresults are anticipated to be subject to substantial fluctuations. Our totalnet sales were $78.8 million for the twelve months ended March 31, 2006,$95.6 million for the calendar year ended December 31, 2004, and $103.6million for the calendar year ended December 31, 2003. We anticipate thatsales of our legacy products will continue to decline over time. Our futurefinancial performance and success are largely dependent on our ability toimplement our new product strategy, which consists partly of refocusing ourbusiness on the next generation of micrologic products built around our core 8-bitmicrologic architecture, beginning with the Z8 Encore! and eZ80 Acclaim!flash products. In November 2002 we launched our new 8-bit Z8Encore! micrologic product, in February 2003 we launched our eZ80 Acclaim!micrologic product and in March 2004 our enhanced Z8 Encore! XP flashproduct family. These products typically have a long lead time from design toproduction, which can range from twelve months to thirty-six months. These newflash products represented approximately 9% of our net sales for the year endedMarch 31, 2006, and we currently expect the contribution of these productsto continue to grow. If we are unable to develop new products in a manner thattimely meets changing market requirements, or if we are not able to achievesignificant sales of our new 8-bit micrologic products for any reason,our product strategy may fail and our net sales and operating results maycontinue to decline or not grow as currently expected. In addition, as weintroduce new products, including our flash and IR products, we experienceadditional start up costs and unfavorable manufacturing prices due to lowvolume. In addition, we do not expect margins on our flash products to be asstrong as those on our legacy products for the foreseeable future.Consequently, the introduction of new products could have a negative impact onour gross margin even if sales from such new products offset declining revenuesof our legacy products.

***If we are unable to obtain adequate productioncapacity or quality, our business will be harmed.***

We rely on independentthird-party foundry manufacturers including X-FAB, TSMC, and UMC to fabricatewafers for all of our product needs. Industry-wide shortages in foundrycapacity could harm our financial results. If we are unable to obtain therequisite foundry capacity to manufacture our products, or if we have to payhigher than anticipated prices to foundries in periods of tight capacity, wemay not be able to meet our customers’ demand for our products. Any delay ininitiating production at third-party foundries, any inability to have newproducts manufactured at such foundries or any failure to meet our customers’demands could damage our relationships with our customers and may decrease oursales.

Othersignificant risks associated with relying on these third-party foundriesinclude:

·       reducedcontrol over the cost of our products, delivery schedules, capacity constraintsand product quality;

·       limitedwarranties on wafers or products supplied to us;

·       increasedexposure to potential misappropriation of our technology;

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·       yieldor quality issues with the supplier which could result in us being unable tosupply product to customers or providing product that doe not meet theirquality or performance standards;

·       vulnerabilityto third-party foundries’ financial, operations or production difficulties; and

·       the time and costassociated with switching or sourcing alternate foundries.

***We may requireadditional capital in the future, and additional funds may not be available onterms acceptable to us.***

Based on our existingfinancial plans and forecasts we believe that our existing cash and cashequivalents will be sufficient to meet our planned capital needs for the next12 months. However, it is possible that we may need to raise additional capitalto fund our future activities. We may be able to raise these funds by sellingsecurities to the public or selected investors, or by borrowing money. We maynot be able to obtain additional funds on favorable terms, or at all. Ifadequate funds are not available, we may be required to curtail our operationssignificantly, reduce planned capital expenditures and research anddevelopment, make selective dispositions of our assets or obtain funds througharrangements with strategic partners or others that may require us torelinquish rights to certain technologies or potential markets, or otherwiseimpair our ability to remain competitive.

***We could berequired to incur significant capital expenditures for test and informationtechnology and equipment to remain competitive, the failure, inadequacy ordelayed implementation of which could harm our ability to effectively operateour business.***

Our capital expenditureswere $4.2 million for the twelve months ended March 31, 2006, $4.4 millionand $1.9 million for the twelve months ended December 31, 2004 and 2003,respectively. We may be required to increase our future capital expenditures tomeet increased demand.

Semiconductormanufacturing has historically required, and in the future is likely tocontinue to require, a constant upgrading of process technology to remaincompetitive, as new and enhanced semiconductor processes are developed whichpermit smaller, more efficient and more powerful semiconductor devices. Eventhough we outsource our manufacturing, we are required to spend funds on maskdesigns and process technology improvements to remain competitive. We maintaincertain of our own test facilities, which have required and will continue torequire significant investments test technology and equipment.

We also may incursignificant costs to implement new test equipment and information technologiesto increase our productivity and efficiency. Any such implementation, however,can be negatively impacted by failures or inadequacies of the new test orinformation technology and unforeseen delays in its implementation, any ofwhich may require us to spend additional resources to correct these problemsor, in some instances, to conclude that the new technology implementationshould be abandoned. In the case of abandonment, we may have to recognizelosses for amounts previously expended in connection with such implementationthat have been capitalized on our balance sheet.

We cannot assure you thatwe will have sufficient capital resources to make necessary investments in testequipment or information technology and equipment.

***Interruptions ininformation technology systems could affect our business.***

We rely on the efficientand uninterrupted operation of complex information technology systems andnetworks to operate our business, especially between the Philippines and ourSan Jose, California headquarters. Any significant system or networkdisruption, including but not limited to computer viruses, security breach, andenergy blackouts could have a material adverse impact on our operations, salesand operating results. We have implemented measures to manage our risks relatedto such disruptions, but 

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suchdisruptions could negatively impact our operations and financial results. Inaddition, we may incur additional costs to remedy the damages caused by thesedisruptions or security breaches.

***If we are unable toprevail in a patent litigation lawsuit we may incur substantial monetaryliability and may be required or change our business practices.***

On August 11, 2005Microchip Technology Inc. (Microchip) filed a patent infringement claim againstthe Company in the U.S. District Court of Arizona (case number CV05-2406-PHX-MHM).Microchip alleges that the Company has been infringing and currentlyinfringes its patents numbered 5,847,450, 6,696,316 and 6,483,183.Microchip claims that unspecified products of the company, including theZ8 Encore! XP 4K Series of products, infringe these patents and isseeking preliminary and permanent injunctive relief, unspecified damages andcosts including attorneys’ fees. We filed a response to the claims on September 15,2005 generally denying the claims and challenging the validity of the patents. OnJanuary 10, 2006, the Company filed a request for patent reexaminationwith the U.S. PTO which was granted in February and March for allthree patents. On March 13 2006, the Company was informed that its motionto stay with the Federal court of Arizona was granted until such time asMicrochip is informed of the outcome of the re-examinations.

We do not believe it isfeasible to predict or determine the outcome or resolution of this litigation atthis time. We believe we have meritorious defenses and will defend ourselvesagainst these claims vigorously. We may incur substantial expenses in ourdefense against these claims. In the event of a determination adverse to us, wemay incur substantial monetary liability, and be required to change ourbusiness practices. Either of these could have a material adverse effect on ourfinancial position, results of operations or cash flow.

***We depend onthird-party assemblers throughout Asia, including Indonesia, Thailand and thePhilippines, and the failure of these third parties to continue to provideservices to us on sufficiently favorable terms could harm our business.***

We use outside contractassemblers in Indonesia, Thailand and the Philippines for packaging ourproducts. These countries have been subject to political instability andterrorist activities. The packaging of semiconductors is a complex processrequiring, among other things, a high degree of technical skill and advancedequipment. If we are unable to obtain additional assembly capacity onsufficiently favorable terms, our ability to maintain or grow our net salescould be impaired. Shortages in contract assembly capacity could causeshortages in our products and could also result in the loss of customers as aresult of delays. Because we rely on these third parties, we also have lesscontrol over our costs, delivery schedules and quality of our products and ourtechnology is at greater risk of misappropriation.

***Our success dependson our ability to introduce new products on a timely basis.***

Ouroperating results depend on our ability to introduce and sell new products on atimely basis that can compete effectively based on price and performance andthat address customer requirements. Rapidly changing technologies and industrystandards, along with frequent new product introductions, characterize theindustries that are currently the primary end-users of semiconductors. As theseindustries evolve and our customers and potential customers introduce newproducts, our success will depend on our ability to adapt to such changes in atimely and cost-effective manner by designing, developing, manufacturing,marketing and providing customer support for new products and technologies. Inthe past, we have brought products to market on an untimely basis or canceledthe introduction of previously planned products, such as our Cartezian line of32-bit microprocessors. Our ability to introduce and sell new productssuccessfully depends on several factors, including: 

•     developmentof support tools and technical documentation that make complex products easyfor engineers to understand and use;

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•     propernew product selection;

•     timelycompletion and introduction of new product designs;

•     supportfrom our foundry service providers; 

•     complexityof the new products to be designed and manufactured; and

•     marketacceptance of our products and our customers’ products.

The emphasis of our newproduct development is on the next generation of products built on our 8-bitmicrologic architecture. If market demand for these products does not developas we anticipate, our product development strategy could fail. Because ourproducts are complex, we may not meet the design and introduction schedules forany new products or any additions or modifications to our existing products,and these products may not achieve market acceptance. In addition, we may notbe able to sell these products at prices that are favorable to us.

***We may be unable tomake the substantial research and development investments required to remaincompetitive in our business***.

The semiconductor industryrequires substantial investment in research and development in order to developand bring to market new and enhanced technologies and products. We arecommitted to maintaining spending on new product development in order to staycompetitive in our markets. There can be no assurances that we will havesufficient resources to maintain the level of investment in research anddevelopment that is required to remain competitive.

***Our industry ishighly competitive, and we may not be able to compete effectively.***

Thesemiconductor industry is intensely competitive and is characterized by priceerosion, rapid technological change and heightened competition in many markets.The industry consists of major domestic and international semiconductorcompanies, many of which have substantially greater financial and otherresources than we do with which to pursue engineering, manufacturing, marketingand distribution of their products. Emerging companies are also increasingtheir participation in the semiconductor industry. Our current and futureproducts compete with, or may compete with, products offered by Atmel, CypressSemiconductor, Intel, Microchip, Freescale, National Semiconductor, Renasas,ST Microelectronics and Texas Instruments, among others. Some of our principalproducts such as the Z80 microprocessor are licensed by our competitors,or are in the public domain, and can be manufactured and sold to our customersby our competitors, possibly with added features or at lower prices than wecharge. Our ability to compete successfully in our markets depends on factorsboth within and outside of our control, including:

•     ourability to design and manufacture new products that implement new technologies,including our eZ80 Acclaim! and Z8 Encore! product families;

•     ourability to protect our products by effectively utilizing intellectual propertylaws;

•     ourproduct quality, reliability, ease of use and price;

•     thediversity of our product line and feature sets within our products;

•     ourefficiency of production;

•     ourability to obtain adequate supplies of raw materials and other supplies atacceptable prices;

•     thepace at which customers incorporate our devices into their products; and

•     thesuccess of our competitors’ products and general economic conditions.

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***Our quarterlyoperating results are likely to fluctuate and may fail to meet expectations,which may cause the price of our securities to decline.***

Ourquarterly operating results have fluctuated in the past and will likelycontinue to fluctuate in the future. If our quarterly operating results fail tomeet expectations, the price of our securities could fluctuate or declinesignificantly. In addition, high proportions of our costs are fixed, due inpart to our significant sales, research and development and manufacturingcosts. Therefore, small declines in revenue could disproportionately affect ouroperating results in a quarter. A variety of factors could cause our quarterlyoperating results to fluctuate, including:

•     ourability to introduce and sell new products and technologies on a timely basis,such as our Z8 Encore! and eZ80 Acclaim! device families and extensions ofthese product families;

•     anyshortage of wafer or assembly manufacturing capacity at our third-partyvendors;

•     competitivedevelopments, including pricing pressures;

•     technologicalchange and product obsolescence;

•     changesin product mix or fluctuations in manufacturing yields;

•     variabilityof our customers’ product life cycles;

•     thelevel of orders that we receive and can ship in a quarter and customer orderpatterns;

•     seasonality;

•     inventorywrite-downs or asset impairments;

•     restructuringcharges;

•     increasesin the cost or scarcity of raw materials; and

•     gainor loss of significant customers.

***We depend on ordersthat are received and shipped in the same quarter, and therefore our results ofoperations may be subject to significant variability from quarter to quarter.***

Our net sales in any givenquarter depend upon a combination of orders received in that quarter forshipment in that quarter and shipments from backlog. Our backlog at thebeginning of each quarter does not include all sales needed to achieve expectedrevenues for that quarter. Consequently, we are dependent on obtaining ordersto be shipped in the same quarter that the order is received for a significantportion of net sales in that quarter. Moreover, customers may rescheduleshipments, and production difficulties could delay shipments. Accordingly, wehave limited visibility into future product shipments, and our results ofoperations may be subject to significant variability from quarter to quarter.

***We operate in thehighly cyclical semiconductor industry, and have experienced a downturn in thebusiness cycle, which has materially adversely affected our revenues and cashgeneration.***

The semiconductor industryis highly cyclical and has experienced significant economic downturns, often inconnection with, or in anticipation of, maturing product cycles (forsemiconductors and for the end-user products in which they are used) anddeclines in general economic conditions. These downturns have beencharacterized by diminished product demand, erosion of average selling prices,production over-capacity and high inventory levels. For example, beginning inthe quarter ended December 31, 2000, we experienced a three-year downturnin our business cycle. We believe that, in light of these events, some of ourcustomers curtailed and may in the future delay or further curtail spending ontechnology, which could negatively affect our quarterly results or financialcondition in the future. Similar economic downturn in the semiconductorindustry could increase pressure on us to reduce our prices, which could impairour 

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revenues,gross margins and operating cash flow. From time to time, the semiconductorindustry also has experienced periods of increased demand and productioncapacity constraints. We have in the past experienced substantialperiod-to-period declines in operating results, and will likely in the futureexperience substantial period-to-period fluctuations in operating results thatare attributable to semiconductor industry conditions or events occurring inthe general economy.

***Average selling pricesin the semiconductor industry typically decline over time, which directlyaffects our revenue and margins.***

Historically, averageselling prices in the semiconductor industry have decreased over the life ofany particular product. To the extent that our products achieve marketacceptance, competitors typically seek to offer competitive products or embarkon discount pricing strategies. We have in the past and may in the future berequired to reduce selling prices in response to competition. From time to timetechnology and manufacturing changes have the impact of lower average sellingprices, such as the conversion of hardware to software modems and packaged todie only sales. If we are unable to offset any reductions in the selling pricesof our products by introducing new products at higher prices or by reducing ourcosts, our revenues, gross margins and operating results could be impaired. Inaddition, if the price at which we can sell products in our inventory declinesbelow the cost of such products we may be required to write down the value ofsuch inventory.

***A significantamount of our revenues comes from relatively few of our customers anddistributors, and any decrease of revenues from these customers anddistributors, or the loss of their business, could significantly harm ourfinancial results.***

Historically we have been,and we expect to continue to be, dependent on a relatively small number ofdistributors for a significant portion of our revenues. We depend onthird-party distributors to market and sell our products, and these third-partydistributors accounted for approximately 56% of our net sales for the twelvemonths ended March 31, 2006, 50% for the three months ended March 31,2005, and 49% and 47% of our net sales for the twelve months ended December 31,2004 and 2003, respectively. In addition, our five largest distributorsaccounted for approximately 44% of our net sales for the twelve months ended March 31,2006, 40% for the three months ended March 31, 2005, and 37% of net salesfor 2004. One distribution customer accounted for approximately 24% of our netsales for the twelve months ended March 31, 2006, 20% for the three monthsended March 31, 2005, and 20% and 18% for the twelve months ended December 31,2004 and 2003, respectively. Our distributors decide whether to include ourproducts among those that they sell, and they may carry and sell product linesthat are competitive with ours. Because our distributors are not required tomake a specified minimum level of purchases from us, we cannot be sure thatthey will prioritize selling our products. We also rely on our distributors toaccurately report to us on a timely basis their sales of our products andprovide certain support services to our customers. Our inability to obtain accurateand timely reports and to successfully manage these relationships couldmaterially adversely affect our business and financial reports. Ourdistributors may not continue to effectively market, sell or support ourproducts. During the quarter ended December 31, 2005, one of our Europeandistributors merged with another company. As a result of this transition,personnel assigned to the ZiLOG account may be reallocated or the level ofservice or amount of our product that is carried could change. Any such changesor future consolidation activity by our distributors could harm our results ofoperations.

***We depend onrelatively few major customers for a substantial portion of our sales.***

Our ten largest customers,excluding our distributors, accounted for approximately 33% of our net salesfor the twelve months ended March 31, 2006, 31% for the three months endedMarch 31, 2005, and 37% and 38% for the twelve months ended December 31,2004 and 2003, respectively.  For thetwelve months ended March 31, 2006, three months ended March 31,2005, and the twelve months ended 

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December 31,2004 and 2003, we had one distribution customer that accounted for 24%, 20%,20% and 18% of our net sales, respectively.  For the twelve months ended March 31,2006, three months ended March 31, 2005, and the twelve months ended December 31,2004 and 2003, we had one OEM customer that accounted for 10%, 12%, 12% and 11%of our net sales, respectively.

Concentration of net salesto particular customers may change from period to period, but we expect thatsales to a limited number of customers will continue to account for asignificant percentage of our revenues in any particular period for theforeseeable future. We have very few long-term contracts with our customers,and, like us, our customers typically compete in cyclical industries. Weroutinely purchase inventory based on customers’ estimates of demand for theirproducts, which is difficult to predict. Thus, our customers may decide not topurchase our products at all, to purchase fewer products than they did in thepast, or to alter their purchasing patterns on short notice, particularlybecause substantially all of our sales are made on a purchase order or salesorder acknowledgment basis, which permits our customers to cancel, change ordelay product purchase commitments.

Any of our large customersmay choose to exit the business we supply or partner with or acquire productfrom our competitors. Should this occur our results of operations would likelybe harmed. The loss of one or more major customers or any reduction, delay orcancellation of orders by any of these customers or our failure to marketsuccessfully to new customers could result in a significant reduction in netsales during one or more periods, excess inventory or write-downs of inventory.

***Our revenue maydecline if customers for whom we are sole source providers seek alternativesources of supply.***

We serve as the solesource provider for some of our OEM customers. Those customers may choose toreduce their dependence on us by seeking second sources of supply, which couldreduce our revenue. To remain a sole source provider, we must continue todemonstrate to our customers that we have adequate alternate sources forcomponents, that we maintain adequate alternatives for production, and that wecan deliver value added products on a timely basis.

***Our internationaloperations subject us to risks inherent in doing business in foreign countriesthat could impair our results of operations.***

Approximately60% of our net sales for the twelve months ended March 31, 2006,approximately 66% of our net sales for the three months ended March 31,2005, approximately 66% and 66% of our net sales for the twelve month periodsended December 31, 2004, and, 2003, respectively, calculated consistentwith revenue recognition of distribution revenue on a deferred (re-sale) basiswere made to foreign countries. These sales to foreign customers will continueto represent a significant portion of our net sales in the future. We maintainsignificant operations or rely on a number of contract manufacturers in thePhilippines, Indonesia, Taiwan, Thailand, India and other locations in Asia. Wecannot assure you that we will be successful in overcoming the risks thatrelate to or arise from operating in international markets. Risks inherent indoing business on an international level include: 

•     economicand political instability;

•     changesin regulatory requirements, tariffs, customs, duties and other trade barriers;

•     transportationdelays;

•     powersupply shortages and shutdowns;

•     difficultiesin staffing and managing foreign operations and other labor problems;

•     existenceof language barriers and cultural distinctions;

•     actsof God, including floods, typhoons and earthquakes;

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•     Taxationof our earnings and the earnings of our personnel; and

•     otheruncertainties relating to the administration of, or changes in, or newinterpretation of, the laws, regulations and policies of the jurisdictions inwhich we conduct our business.

In addition, our activitiesoutside the United States are subject to risks associated with fluctuatingcurrency values and exchanges rates, hard currency shortages and controls oncurrency exchange. While our sales are primarily denominated in U.S. dollars,worldwide semiconductor pricing is influenced by currency rate fluctuations,and such fluctuations could harm our operating results materially.

The risks inherent in ourinternational operations have been increased by the threat of terrorist attacks.These attacks, coupled with an international military response, have created anuncertain economic environment, and we cannot predict the impact of thesepolitical threats or any related military action, on our customers or ourbusiness.

***We have had ahistory of losses, and we may not be profitable in the future.***

We have had a history oflosses for each of the years in the six-year period ended March 31, 2006,excluding the one-time gain on extinguishment of debt and fresh-startadjustments in 2002. We may not be profitable in the future.

***We depend on keypersonnel, and the loss of our current personnel or our failure to hire andretain additional personnel could harm our business.***

We depend on our abilityto attract and retain highly skilled technical and managerial personnel. We believethat our future success in developing marketable products and achieving acompetitive position will depend in large part on our ability to identify,recruit, hire, train, retain and motivate highly skilled technical, executive,managerial, marketing and customer service personnel. Competition for thesepersonnel is intense, especially in Northern California, where our headquartersare located, and we may not be able to successfully recruit, assimilate orretain sufficiently qualified personnel. Our failure to recruit and retainnecessary technical, executive, managerial, marketing and customer servicepersonnel could harm our business and our ability to obtain new customers anddevelop new products. In addition, our history of losses and our bankruptcy filingcould impair our ability to recruit and retain employees. We do not haveemployment contracts with any of our executive officers.

As employee incentives, weissue common stock options that generally have exercise prices at the marketvalue at time of the grant and that are subject to vesting. At times, our stockprice has declined substantially, reducing the effectiveness of theseincentives.

***We may fail toprotect our proprietary rights, and the cost of protecting those rights,whether we are successful or not, may harm our ability to compete.***

The extent and value ofour intellectual property is necessarily uncertain, and our efforts to protectour intellectual property rights may not be successful. Despite ourprecautions, a third party may copy or otherwise obtain our devices ortechnology without authorization, requiring patent litigation to enforce ourrights. Patent litigation is, by its nature, expensive and unpredictable. Iflitigated, one or more of our patents may be found invalid or unenforceable orto have claims of such narrow scope as to be of little economic value. Thirdparties may design around our patents. Third parties may independently developtechnology similar to our trade secrets. In addition, the laws of some foreigncountries where we have patent and trademark rights may not protect ourintellectual property rights to the same extent as the laws of the UnitedStates.

Additionally, our pendingand future patent applications should not be relied upon as they may not issueas patents, and even if they do issue, such future patents may not be ofsufficient scope or strength to provide meaningful economic or competitivevalue.

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Litigation may benecessary to enforce our intellectual property rights, to protect our tradesecrets or to determine the validity and scope of our proprietary rights or theproprietary rights of others. Any such litigation may be unsuccessful and couldrequire us to incur substantial costs and divert significant valuableresources, including the efforts of our technical and management personnel,which may harm our business materially.

***The semiconductorindustry is characterized by frequent litigation regarding patent and otherintellectual property rights, both defensive and offensive.***

In addition to theMicrochip lawsuit described elsewhere, from time to time we have received, andmay in the future receive, communications from other third parties assertingthat a product offered by us, or an aspect of our business, infringes a patentheld by the other third party and/or requires a license thereto. With respectto those other third party communications that are currently pending, webelieve, after having consulted with counsel, that either (i) we havemeritorious defenses, (ii) based on license terms previously offered to usor typically available in the industry, we can obtain any necessary licenses oncommercially reasonable terms, or (iii) we can modify our products toavoid such rights, but if this is not the case, we may be sued and assesseddamages for past infringement. Indeed, licenses may not be available oncommercially reasonable terms, or at all. In addition, we have certainindemnification obligations to customers with respect to the infringement ofthird party intellectual property rights by our devices.

We have received in thepast a letter from an electronic equipment manufacturer that makes productsthat are competitive to certain of our key products, asserting that the sale ofcertain of our key products may be infringing certain patents owned by them.After having consulted with counsel, we believe that we have meritoriousdefenses to the assertions set forth in the letter. However, should it becomenecessary to engage in litigation to defend against such assertions, suchlitigation could be expensive and time consuming. There can be no assurancethat the ultimate resolution of this matter would not have a material adverseaffect on our business.

Intellectual property lawsuits are subject to inherentuncertainties due to the complexity of the technical issues involved, and wemay not be successful in defending ourselves against intellectual propertyclaims. The cost of defending against patent infringement or other intellectualproperty litigation, in terms of management time and attention, legal fees andproduct delays, could be substantial, whatever the outcome. If any patent orother intellectual property claims against us are successful, we may beprohibited from using the technologies subject to these claims, and if we areunable to obtain a license on acceptable terms, license a substitutetechnology, or design new technology to avoid infringement, we could beprohibited from using or selling the infringing products or technologies and berequired to pay substantial damages. Such a result could have a materialadverse effect on our business.

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***We could be forced to spend significant time and moneyon products that contain, or are rumored to contain, design defects or errors.***

Becausethe design and production process for semiconductors is highly complex, we mayproduce products whose design deviates from published specifications. Inaddition, one or more of our products may be found to contain productiondefects after we have already shipped such products. These production defectscould be caused by either raw materials or errors in the production process. Iferrors or production defects are discovered after we have already shipped oneor more of our products in volume, we could be materially adversely affected inone or more of the following ways: 

•     replacements or recalls couldimpose substantial costs on us; 

•     rumors, false or otherwise,may be circulated by the press and other media, which could cause a decrease insales of our products; and 

•     customersor end users may file suits or assert other legal claims against us allegingdamages caused by defective products or errors in products. If we do notsuccessfully defend such suits, we could be required to pay substantialdamages. Even if we prevail in suits filed by customers or end users, we may berequired to expend significant funds in defense. 

***Changes in technologies or consumption patterns couldreduce the demand for our products.***

As a result oftechnological changes, from time to time our customers change the design oftheir products so as not to include our products, which may have a negativeimpact on our net sales. For example, in 1999 and 2000, a number of ourcustomers changed the designs of computer mouse pointing devices that theymanufactured, and as a result, these devices no longer contain our products.Because we do not have long-term supply contracts with most of our customers,changes in the designs of their products can have sudden and significantimpacts on our sales. For example, net sales of our computer mouse pointingdevices and other computer peripheral products decreased substantially fromapproximately $15.4 million in 2000 to approximately $4.9 million in 2001,approximately $2.4 million in 2002, approximately $0.7 million for 2003, approximately $0.1 million for 2004 and less than $0.1 for fiscal 2006.These reduced sales due to design changes have harmed us in the past, andadditional design changes could result in lower revenues in the future.

***We may forecast the future demand for our productsincorrectly and produce excess or insufficient inventories*** of particular products, which may adversely affect ourresults of operations.

Since we must order products and build inventorysubstantially in advance of product shipments, we may forecast incorrectly andproduce excess or insufficient inventories of particular products. The abilityof our customers to reschedule or cancel orders without significant penaltycould adversely affect our liquidity, as we may be unable to adjust ourpurchases from our wafer suppliers to match any customer changes andcancellations. As part of our business strategy, we maintain a substantialinventory of sorted wafers in a die bank but limit our investment in finishedgoods. We may have adequate wafer inventory to meet customer needs but may beunable to finish the manufacturing process prior to the delivery date specifiedby the customer. Demand for our products is volatile and customers often placeorders with short lead times. Our inventory may not be reduced by sufficientdemand of customer orders and in the future we may produce excess quantities ofour products.

It is our policy to fullywrite down all inventories that we do not expect to be sold in a reasonableperiod of time. During recent fiscal years, as a result of changes in estimateddemand for our various products, we have taken charges for write down ofinventories. For example, we recorded inventory write-down charges of $1.9million in December 31, 2004, for excess inventories associated with theclosure of our MOD II wafer fabrication facility in July 2004. We maysuffer reductions in values of our inventories in 

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thefuture and we may be unable to liquidate our inventory at acceptable prices. Tothe extent we have excess inventories of particular products, our operatingresults could be adversely affected by charges to cost of revenues that wewould be required to recognize due to significant reductions in demand for ourproducts or rapid declines in the market value of our inventory, resulting ininventory write downs or other adverse consequences.

***We have implemented significant cost cutting measures,and we may be required to implement additional cost cutting measures dependingupon our future revenues and operating results.***

Wehave implemented significant cost cutting measures in the past, includingduring the twelve months ended March 31, 2006. These cost cutting effortshave included: 

•     restructuring ourmanufacturing operations, which has included closing and subsequentlyoutsourcing all of our wafer fabrication and assembly operations andconsolidating probe and final test operations, as well as certain customerservice and accounting functions at our Philippines site; 

•     refocusing our strategicpriorities; 

•     reallocating personnel andresponsibilities to better utilize human resources; 

•     reducing our workforce; and 

•     instituting temporary officeand facility shutdowns. 

Cost cutting measures may not increase our efficiencyor lead to profitability. In the past we have reduced our spending on researchand development. Reducing research and development spending could harm ourability to introduce new products in the future. If our revenue or operatingresults significantly decline in the future, we may be required to institutefurther cost reduction measures.

From time to time, weevaluate our strategic alternatives with respect to our facilities and we maytake actions, such as our sales of certain assets of MOD II and the remainingassets of our MOD III subsidiary, which may result in the occurrence ofaccounting charges. Some or all of these charges may be non-cash. Such chargeswould have a negative impact on our GAAP profitability and may have a negativeimpact on our cash balance.

***We are subject to various environmental laws andregulations that could have a material adverse effect on us.***

Until 2005 we operated a wafer fabrication facility. Ourmanufacturing processes required us to use various hazardous substances, and,as a result, we are subject to a variety of environmental laws and regulationsgoverning the storage, use, emission, discharge and disposal of, and humanexposure to, such substances. In particular, the process of manufacturingsilicon wafers used large amounts of corrosive and other hazardous chemicalsand huge quantities of distilled, de-ionized water. Our failure to comply withpresent or future laws and regulations or the loss of any permit required toconduct our business could result in fines being imposed on us or otherpenalties. Any failure by us to control the use of, or adequately restrict thedischarge of, hazardous substances could subject us to future liabilities thatcould materially harm our business, have a materially adverse affect on ourfinancial condition and results of operations, including under laws andregulations that impose liability and clean-up responsibility for releases of hazardoussubstances into the environment.

Recently, laws and regulations have been enacted inseveral European Union member countries, including several jurisdictions inwhich we operate, restricting the presence of certain substances in electronicproducts and holding producers of those products financially responsible forthe collection, treatment, recycling and disposal of certain products. Specifically,the European Union has enacted the Restriction of the Use of Certain HazardousSubstances in Electrical and Electronic Equipment, or RoHS, 

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and the Waste Electricaland Electronic Equipment, or WEEE, directives. The RoHS directive prohibits theuse of certain substances, including lead, mercury, cadmium and chromium, incovered products placed on the market after July 1, 2006. The WEEEdirective obligates parties that place electrical and electronic equipment ontothe market in the European Union to clearly mark the equipment, register withand report to European Union regulators regarding distribution of theequipment, and provide a mechanism to recall and properly dispose of theequipment. Each European Union member country has enacted, or is expected tosoon enact, legislation clarifying what is and what is not covered by the WEEEdirective in that country. However, there is still some uncertainty in certainEuropean Union countries as to which party involved in the manufacture,distribution and sale of electronic equipment will be ultimately heldresponsible. If we are deemed to be a manufacturer of covered products, we maybe required to register as a producer in certain European Union countries, andincur financial responsibility with respect to products sold within theEuropean Union, including products of other manufacturers that have beenreplaced by our products. We may also incur substantial costs to change ourcontract partners manufacturing processes, redesign or reformulate, and obtainsubstitute components for, our products that are deemed covered products underthe ROHS directive. If we fail to timely provide RoHS-compliant products, wewill not be able to offer our products within European Union, and we may besubject to civil or criminal liabilities. Similar laws have been proposed andmay be enacted in other locations where we sell our products, including variousjurisdictions within the United States. We will need to ensure that we complywith such laws and regulations as they are enacted, and ensure, as appropriateor required, that our component suppliers also timely comply with such laws andregulations. If we fail to timely comply with such laws, we could facesanctions for such noncompliance and our customers further may refuse topurchase our products, which would have a materially adverse effect on ourbusiness, financial condition and results of operations.

With respect toenvironmental remediation, we could incur substantial costs for the clean up ofcontaminated properties, either those we own or operate or to which we havesent wastes in the past. Under certain of these laws and regulations, currentor previous owners or operators of property may be liable for cleanup costs andother damages without regard to whether they knew of, or caused, thecontamination. The presence of, or failure to remediate, contamination couldmaterially adversely affect the value of, and the ability to transfer orencumber, our property. In addition, we may be required to incur significantexpense in connection with governmental investigation of environmental oremployee health and safety matters.

***We may engage in acquisitions and other forms ofbusiness combinations or partnerships that could materially adversely affectour operating results, dilute our stockholders’ equity, or cause us to incuradditional debt or assume contingent liabilities.***

Toincrease our business and maintain our competitive position, we have madeacquisitions in the past and may do so in the future. Acquisitions and otherforms of business combinations or partnerships involve a number of risks thatcould harm our business and result in the acquired business not performing asexpected, including:

•     insufficient experience withtechnologies and markets in which the acquired or combined business isinvolved, which may be necessary to successfully operate and integrate thebusiness; 

•     problems integrating theacquired or combined operations, personnel, technologies or products with theexisting business and products; 

•     diversion of management timeand attention from our core business to the acquired or combined business; 

•     potential failure to retainkey technical, management, sales and other personnel of the acquired orcombined business; 

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•     difficulties in retainingrelationships with suppliers and customers of the acquired or combinedbusiness; and 

•     subsequent impairment of theacquired or combined assets, including intangible assets.

In addition, acquisitionsand other forms of business combinations or partnerships could requireinvestment of significant financial resources and may require us to obtainadditional equity financing, which may dilute our stockholders’ equity, or toincur additional indebtedness.

***Acts of war or terrorism could harm our business.***

The long-term effects ofpotential terrorist attacks on the world economy and our business are unknown,but could be material to our business. Terrorist acts or acts of war, whetherin the United States or abroad, also could cause damage or disruption to ourbusiness, our suppliers, our freight carriers, or our customers, or couldcreate political or economic instability, any of which could have a materialadverse effect on our business.

***Failure to achieve and maintain effective internalcontrol over financial reporting in accordance with rules of theSecurities and Exchange Commission promulgated under Section 404 of theSarbanes-Oxley Act or failure to maintain adequate disclosure controls andprocedures could harm our business and operating results and/or result in aloss of investor confidence in our financial reports, which could in turn havea material adverse effect on our business and stock price.***

Under rules of theSecurities and Exchange Commission promulgated under Section 404 of theSarbanes-Oxley Act of 2002, beginning with our Annual Report on Form 10-Kfor the fiscal year ended December 31, 2004, we were required to furnish areport by our management on our internal control over financial reporting.

**Sarbanes-Oxley Section 404:**

In the course of our assessment of the effectivenessof our internal control financial reporting as of December 31, 2004, weidentified two material weaknesses in our internal control over financialreporting which are more fully described under Item 9A, Controls and Proceduresin our Form 10-K for the year ended December 31, 2004.

In addition, in the course of our ongoing 2005evaluation of the effectiveness of the design and operation of our disclosurecontrols and procedures, we identified a failure to record and thereby disclosein our 2004 Form 10-K certain grants of options to purchase: (1) 160,000shares of our common stock at an exercise price of $12.44 and; (2) 45,884shares of our common stock at an exercise price of $5.20. These grants wereissued to our Chief Executive Officer in the quarter ended June 30, 2004as more fully described under Item 4, Controls and Procedures, of our Form 10-Qfor the period ended June 30, 2005. A footnote to the beneficial ownershiptable explaining the beneficial ownership of certain stock options held by ourCEO was also incorrect. This reporting deficiency and the above materialweaknesses in our internal control over financial reporting disclosedpreviously in our 2004 Form 10-K, as well as any other weaknesses ordeficiencies that may exist or hereafter arise or be identified, could harm ourbusiness and operating results, and could result in adverse publicity and aloss in investor confidence in the accuracy and completeness of our financialreports, which in turn could have a material adverse effect on our stock price,and, if such weaknesses are not properly remediated, could materially adverselyaffect our ability to report our financial results on a timely and accuratebasis.

Moreover, we operate with a relatively smallaccounting staffing level and use supplemental resources such as contractorsand consultants to provide additional accounting and finance support. The lossof accounting personnel, particularly our chief financial officer, couldmaterially adversely impact the 

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effectiveness of ourcontrol environment and our internal controls, including our internal controlsover financial reporting. Additionally, we have migrated certain accountingfunctions from the U.S. to our Philippines operations. Failure to properlyhire, train and supervise the work of our accounting staff, including those inthe Philippines, could materially adversely impact our control environment andour internal controls, including internal controls over financial reporting.

Although we believe thatwe have remediated these weaknesses and deficiencies and our disclosure controlfailure, we cannot assure you that this remediation has been successful or thatadditional deficiencies or weaknesses in our controls and procedures will notbe identified. In addition, we cannot assure you that our independentregistered public accounting firm will agree with our assessment that ourmaterial weaknesses have been remediated.

***Change in fiscal calendar and Sarbanes-Oxley Section 404report:***

On December 29, 2005, our Board of Directorsunanimously adopted resolutions to change our fiscal year end from December 31to March 31. We revised our fiscal year so that our audit work can beperformed during non-peak periods with our independent registered publicaccountants, which we believe will result in cost savings over the long-term.During the on-going reviews of our internal controls, during the three monthperiod ended December 31, 2005, we identified deficiencies in ourinformation technology controls, including the need to better segregate dutiesas it relates to the use of our Oracle Information Systems modules and toimprove our General Computing Controls compliance and documentation. We havecompleted a thorough review of our control environment and have madeimprovements to our information technology controls in the areas where thesedeficiencies were identified. Although remediation of our informationtechnology controls continue, our findings to date have not uncovered anyerrors, misstatements or acts of fraud that would lead us to conclude that wehave any material weaknesses as of March 31, 2006.

In December, 2005 theSecurities and Exchange Commission adopted a change in its accelerated filer rules suchthat a company with a market capitalization, that is the number of sharesoutstanding multiplied by its trading value per share, of less than $50 millionmay be considered a non-accelerated filer and as such is exempt from themanagement confirmation and independent registered public accountant’sattestation requirements under the Sarbanes-Oxley 404. At September 30,2005, our market capitalization was below this measure and as such we will notbe an accelerated filer for our fiscal year ended March 31, 2006 and willnot include the management certification and our independent registered publicaccounting firm attestation over internal controls over financial reporting inthis Form 10-K.

***Recently enacted and proposed changes in securitieslaws and regulations may increase our costs.***

The Sarbanes-Oxley Act of2002 that became law in July 2002 required changes in some of ourcorporate governance practices. The Act also requires the SEC to promulgate newrules on a variety of subjects. These new rules and regulations haveincreased our legal and financial compliance costs, and made some activitiesmore difficult, time consuming and/or more costly. We also expect that thesenew rules and regulations may make it more costly to obtain director andofficer liability insurance coverage, and we may be required to accept reducedcoverage or incur substantially higher costs to obtain coverage. These new rules andregulations could also make it more difficult for us to attract and retainqualified members of our board of directors, particularly to serve on our auditcommittee, and qualified executive officers.

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***Changes in accounting principles generally accepted inthe United States may materially adversely affect our reported financialresults or otherwise harm our business.***

We prepare our financialstatements in conformity with accounting principles generally accepted in theUnited States. These accounting principles are subject to interpretation by theFinancial Accounting Standards Board, the American Institute of CertifiedPublic Accountants, the Securities and Exchange Commission and various bodiesformed to interpret and create appropriate accounting policies. A change inthese policies or interpretations could have a significant effect on ourreported financial results, and could affect the reporting of transactionscompleted before the announcement of a change. For example, while currentaccounting rules allow us to exclude some expense of stock options fromour financial statements, effective for fiscal years beginning in 2007, theCompany will be required to include the expenses of these options and the 15%discount employees receive on purchase under the employee stock purchase planin the income statement in accordance with FAS 123R.  Technology companies generally, and ourcompany, specifically, rely heavily on stock options as a major component ofour employee compensation packages. Because we will soon be required to expenseoptions, we may be less likely to achieve profitability or we may have todecrease or eliminate options grants. Decreasing or eliminating option grantson our employee stock option program may negatively impact our ability toattract and retain qualified employees. The impact may materially adverselyaffect our reported financial results.

***Changes in our business conditions could result inimpairment of our goodwill.***

In accordance with SFASNo.142 *Accounting for Goodwill and Other Intangible Assets*the Company must perform at least an annual testing of the Company’s statedvalue of its net assets including goodwill and other intangible assets inrelation to the implied fair market value of the Company. If the Company’smarket capitalization or fair market value declines, we may be required torecord financial adjustments to the stated values of our goodwill and otherintangible assets resulting in a material adverse effect on our financialcondition and results of operations.

***Our North American distributor could emphasizecompeting products, and we may lose some of our customers as a result.***

In October 2002, weengaged Future Electronics as our exclusive full-service distributor in NorthAmerica. Additionally, Future Electronics provides distributor support to us inEurope and Asia on a non-exclusive basis. For the twelve months ended March 31,2006, Future purchases were approximately $18.6 million or 24% of netsales. For the twelve months ended December 31, 2004 and 2003, Futurepurchased approximately $19.3 million and $18.3 million or 20% and 18% of netsales, respectively. Future Electronics distributes products of our competitionthat may directly compete with our product offerings. If Future Electronicschooses to promote those products over our products, our operating resultscould be harmed significantly. In addition, if Future Electronics were toterminate our distribution agreement, we could experience a period ofsignificant interruption of our business while we obtained other distributionchannels.

***Provisions in our organizational documents andDelaware law could discourage acquisition proposals or delay a change incontrol that would be beneficial to our stockholders.***

Ouramended and restated certificate of incorporation and bylaws containanti-takeover provisions that could make it more difficult for a third party toacquire control of us even if that change in control would be beneficial to ourstockholders. These provisions include:

•     providing for a classifiedboard of directors with staggered terms; 

•     limiting the persons who maycall special meetings of stockholders; and 

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•     prohibiting stockholders fromtaking action by written consent.

In addition, provisions ofDelaware law may discourage, delay or prevent someone from acquiring or mergingwith us.

***Our directors, named executive officers and our twolargest stockholders, who beneficially own approximately 36% of our commonstock in the aggregate, may have interests that conflict with the interests ofour other stockholders.***

Our directors and namedexecutive officers, together with two large stockholders, UBS Willow Management,L.L.C., and funds managed by Capital Research and Management Companybeneficially owned approximately 36% of our outstanding common stock, in theaggregate, as of March 31, 2006. As a result of their ownership andpositions, our directors and named executive officers, together with UBS WillowManagement and Capital Research and Management Company, collectively are ableto significantly influence all matters requiring stockholder approval,including the election of directors and approval of significant corporatetransactions. Such concentration of ownership may also have the effect ofdelaying or preventing a change in control. If the ownership of our commonstock continues to be highly concentrated, it may prevent you and otherstockholders from influencing significant corporate decisions. The investmentobjectives of our largest institutional stockholders may differ from those ofour other stockholders, including our future public stockholders.

**ITEM 2.**                PROPERTIES

**San Jose,California**

Our corporate headquartersare located in a 41,000 square foot facility in San Jose, California, which weoccupy under a lease through January 31, 2008. There is no option toextend the lease beyond this date.

**Nampa, Idaho**

We currently own a 108,000square foot building and 13.03-acres of developed land located in Nampa,Idaho, which we call MOD II. In July 2004, MOD II manufacturing operationsceased. In October 2004 we sold substantially all of its manufacturingassets, which were located within the MOD II facility for $6 million. TheMOD II land and buildings are currently held for sale. In February 2006 wesold 19.9 acres of undeveloped land to Micron Technologies, Inc.

**Meridian, Idaho**

In May of 2004, weentered into a 5-year lease for a 15,500 square foot facility in Meridian,Idaho, which can be extended at our option for an additional 3 years. Thisfacility is used as our Idaho Technology Center and supports our foundrysupplier partnerships, product and design engineering, failure analysis andcustomer manufacturing support activities.

**Shanghai, China**

In February of 2004,we entered into a 3-year lease for a 5,900 square foot facility inShanghai, China, which can be extended for an optional term with 3 monthsadvanced notice. This facility is used as our China Design Center and supportsour design engineering and development activities, focused on the expandingAsian market.

**Bangalore, India**

We currently lease a17,710 square foot facility in Bangalore, India, under three separate leasesexpiring in December 2007, November 2008 and April 2010. Thisfacility is used as our India Design Center and supports our softwareengineering and tools development activities.

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**Manila, Philippines**

A majority of our producttesting, inventory warehousing and logistics, resides in a 64,000 square footfacility located in the Philippines. In October 2003, we executed a newlease agreement for the Philippines facility through March 2009.

**Short Term Leases**

We have short-term leases for sales offices located inthe U.S., Canada, England, Germany, Korea, Malaysia, and the People’s Republicof China (including Hong Kong), Singapore and Taiwan.

We believe that all of ourproperties currently are adequate to meet our needs.

**MOD III TransferredAssets to ZiLOG MOD III, Inc.**

In January 2002, we closed our MOD III facility,which is approximately 158,000 square feet building residing on 15 acres ofdeveloped land and 4 acres of undeveloped land. In connection with our plan ofreorganization, we transferred the assets of the MOD III facility to ZiLOG MODIII, Inc. In September of 2004, we sold substantially all of itsmanufacturing assets for $26.0 million to STMicroelectronics. The holdersof our former senior notes received $20.2 million in net proceeds fromthis sale in October of 2004.

In July of 2004, ZiLOG MOD III, Inc. sold its productionequipment to STMicroelectronics, Inc. At the completion of the sale inSeptember, 2004, ZiLOG, Inc. received approximately $4.9 million forreimbursement of sustaining costs incurred, which was recorded as an offset tospecial charges.

In February 2006, ZiLOG MOD III, Inc.completed the sale of its remaining assets to Micron Technology, Inc. fora total consideration net of closing costs of $4.6 million. These assetsincluded the dormant 8” wafer fabrication facility and associated land owned byZiLOG Mod III, Inc. and vacant property owned by ZiLOG, Inc. ZiLOGMOD III, Inc. shareholders have voted to liquidate the special purpose entityand distribute the remaining net proceeds to its Series A Preferredshareholders at the conclusion of that process. The distribution of the netproceeds includes $1.1 million to ZiLOG, Inc. for the vacantproperty, $0.7 million to ZiLOG, Inc. for reimbursement of sustainingand maintenance costs incurred and $0.1 million and $0.2 million setaside for estimated remaining sustaining costs and estimated liquidation costs,respectively. The remaining $2.5 million is anticipated to be distributedto holders of ZiLOG MOD III, Inc. Series A Preferred stock on theliquidation of MOD III, Inc. and has been recorded as a liability in theconsolidated financial statements at March 31, 2006.

**ITEM 3.     LEGAL PROCEEDINGS**

On August 11, 2005 Microchip Technology Inc.(Microchip) filed a patent infringement claim against us in the U.S. DistrictCourt of Arizona (case number CV05-2406-PHX-MHM). Microchip allegesthat we are infringing and currently infringes its patents numbered5,847,450, 6,696,316 and 6,483,183. Microchip claims that unspecified products,including our Z8 Encore! XP 4K Series of products, infringe these patentsand is seeking preliminary and permanent injunctive relief, unspecified damagesand costs including attorneys’ fees. We filed a response to the claims on September 15,2005 generally denying the claims and challenging the validity of the patents. OnJanuary 10, 2006, we filed a request for patent reexamination with theU.S. PTO which was granted in February and March for all threepatents. On March 13, 2006, we were informed that our motion to stay withthe Federal court of Arizona was granted until such time as Microchip isinformed of the outcome of the re-examinations.

We do not believe it is feasible to predict ordetermine the outcome or resolution of this litigation at this time. We believewe have meritorious defenses and will defend ourselves against these claimsvigorously. We may incur substantial expenses in our defense against theseclaims. In the event of a determination adverse to us, we may incur substantialmonetary liability, and be required to change our 

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business practices. Eitherof these consequences could have a material adverse effect on our financialposition, results of operations or cash flow.

The Company isparticipating in other litigation and responding to claims arising in theordinary course of business. The Company intends to defend itself vigorously inthese other matters. The Company’s management believes that it is unlikely thatthe outcome of these other matters will have a material adverse effect on theCompany’s financial statements, although there can be no assurance in thisregard.

**ITEM 4.**                SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS

None

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**PART II**

**ITEM 5.**                MARKETFOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUERPURCHASES OF EQUITY SECURITIES

The Company’s 2004 Omnibus Stock Incentive Plan (the “2004Plan”) was adopted by the compensation committee of our Board of Directors on December 17,2003 and approved by our stockholders on February 12, 2004. The 2004 Planbecame effective on March 10, 2004. The 2004 Plan authorizes the grant ofup to 1,500,000 shares of our common stock, par value $0.01.

The Company’s Employee Stock Purchase Plan (“2004 ESPP”)was adopted by the compensation committee of our Board of Directors on December 17,2003 and approved by our stockholders on February 12, 2004. The 2004 ESPPbecame effective on May 15, 2004. A total of 1,250,000 shares of commonstock have been reserved for issuance under the 2004 ESPP to eligibleemployees. At March 31, 2006 a total of 134,153 shares of our common stockhave been purchased under the 2004 ESPP, leaving a total of 1,115,847 sharesavailable to be purchased.

On February 18, 2004, our Board of Directorsapproved a reverse stock split in which every two shares of common stock wasconverted into one share of common stock, effective March 1, 2004. Allcommon shares and per-share figures presented herein have been retroactively restatedto reflect this one-for-two reverse stock split. In addition, we reclassified$200,000 from “Common stock” to “Additional paid-in capital” in the Company’sbalance sheet at both December 31, 2003 and 2002.

On March 12, 2004,our common stock was listed for trading on the NASDAQ National Market with aticker symbol of ZILG. On March 18, 2004, and subsequently on April 6,2004 through the exercise of an over allotment option, we raised approximately$24.4 million through the sale of 2,252,100 shares of our common stock ata price of $12.50 per share in a registered public offering of our stock.Subsequent to our May 2002 financial restructuring and prior to our March 2004stock offering, our stock was traded on the OTC-Bulletin board.

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**PRICE RANGE OF COMMONSTOCK**

**Our Common Stock**

Ourcommon stock commenced trading on the NASDAQ National Market on March 12,2004 under the symbol “ZILG.” Previously, our common stock traded on theOver-the-Counter Bulletin Board. The following table sets forth the high andlow last trading prices by quarter on the Over-the-Counter Bulletin Board orthe NASDAQ National Market (as adjusted to give effect to our reverse stocksplit), as applicable.

| ** **                                  | ** **   | **High**     | ** **   | **Low**      | ** **   |
|---------------------------------------------|--------------|--------------|--------------|--------------|--------------|
| ***2003  Calendar Year***                   | *** *** | *** *** | *** *** | *** *** | *** *** |
| First Quarter                               |         | $            | 6.40         |         | $            | 3.38 |   |
| Second Quarter                              |         | $            | 6.96         |         | $            | 3.32 |   |
| Third Quarter                               |         | $            | 8.00         |         | $            | 5.62 |   |
| Fourth Quarter                              |         | $            | 11.68        |         | $            | 6.70 |   |
| ***2004  Calendar Year***                   | *** *** | *** *** | *** *** | *** *** | *** *** |
| First Quarter                               |         | $            | 14.98        |         | $            | 10.44 |   |
| Second Quarter                              |         | $            | 13.85        |         | $            | 8.77 |   |
| Third Quarter                               |         | $            | 10.96        |         | $            | 7.35 |   |
| Fourth Quarter                              |         | $            | 8.00         |         | $            | 5.10 |   |
| ***2005  Transition Period***               | *** *** | *** *** | *** *** | *** *** | *** *** |
| January 1—March 27,  2005    |         | $            | 8.15         |         | $            | 4.96 |   |
| ***2006  Fiscal Year***                     | *** *** | *** *** | *** *** | *** *** | *** *** |
| April 1—June 30,  2005       |         | $            | 5.58         |         | $            | 3.58 |   |
| July 1—September 30,  2005   |         | $            | 4.49         |         | $            | 2.40 |   |
| October 1—December 31,  2005 |         | $            | 3.25         |         | $            | 2.35 |   |
| January 1—March 31,  2006    |         | $            | 3.23         |         | $            | 1.99 |   |

 

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**EQUITY COMPENSATIONPLAN INFORMATION**

Thefollowing is a summary of the shares reserved for issuance pursuant tooutstanding options, rights or warrants granted under our equity compensationplans as of March 31, 2006:

| **Plan Category**                                        | ** ** | ** ** | ** ** | **Number of securities  to be issued upon  exercise of  outstanding options,  warrants and rights  Column A** | ** ** | **Weighted-average  exercise price of  outstanding  options, warrants  and rights  Column B** | ** ** | **Number of securities  remaining available  for future issuance  under equity  compensation plans  (excluding securities  reflected in  column (A))** | ** ** |
|---------------------------------------------------------------|------------|------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity  compensation plans approved by security holders(1)(2) |       |       | 1,803,309  |                                                                                                                                                            |       |                                                                                                                   | $          | 6.50                                                                                                                                                                                                     |       |   |   | 1,121,381 |   |   |
| Equity  compensation plans not approved by security holders   |       |       | —     |                                                                                                                                                            |       |                                                                                                                   | —     |                                                                                                                                                                                                     |       |   | — |   |   |
| Total                                                         |       |       | 1,803,309  |                                                                                                                                                            |       |                                                                                                                   | $          | 6.50                                                                                                                                                                                                     |       |   |   | 1,121,381 |   |   |

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(1)          TheZiLOG 2002 Omnibus Stock Incentive Plan was originally approved under the termsof our plan of reorganization on May 13, 2002.

(2)          TheZiLOG 2004 Omnibus Stock Incentive Plan was approved by stockholders on February 12,2004.

See Note 12 of the notesto the consolidated financial statements for a discussion of related partytransactions. As of March 31, 2006, we had approximately 9 holders ofrecord of our common stock. We have not paid any dividends and currently intendto retain any future earnings for investment in our business.

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**ITEM 6.**                SELECTEDCONSOLIDATED FINANCIAL DATA

The following selected consolidated financial data setforth below should be read in conjunction with the section entitled“Management’s Discussion and Analysis of Financial Condition and Results ofOperations,” and our consolidated financial statements and the notes to thosestatements appearing elsewhere in this Form 10-K. The consolidatedstatement of operations data for the twelve months ended March 31, 2006and the three month transition period ended March 31, 2005 and theconsolidated balance sheet data as of March 31, 2006 and March 31,2005 are derived from our respective consolidated financial statements includedelsewhere in this Form 10-K which have been audited by ArmaninoMcKenna, LLP, an independent registered public accounting firm. Financialstatements and data related to the three month period ended March 31, 2004are unaudited. The consolidated statement of operations data for the twelvemonths ended December 31, 2004 and 2003 and the consolidated balance sheetdata as of  December 31, 2004 arederived from our respective consolidated financial statements includedelsewhere in this Form 10-K, which have been audited by KPMG, LLP,an independent registered public accounting firm.

Upon emergence from Chapter 11 proceedings in May,2002, we adopted fresh-start reporting in accordance with the AmericanInstitute of Certified Public Accountants Statement of Position 90-7,“Financial Reporting By Entities in Reorganization Under the Bankruptcy Code,”or SOP 90-7. In connection with the adoption of fresh-startreporting, our reorganization value has been allocated to our assets andliabilities on a basis which is substantially consistent with the purchasemethod of accounting. Our financial statements for periods subsequent toadoption of fresh-start reporting are not comparable with those prepared beforeour plan was confirmed because they are, in effect, those of a new entity.Consequently, the consolidated balance sheet data at March 31, 2006, March 31,2005, December 31, 2004, December 31, 2003, and December 31,2002 and at May 1, 2002 are labeled “Successor Company,” and reflects theeffect of our reorganization plan and the associated fresh-start adjustments.Periods presented prior to May 1, 2002 have been designated “PredecessorCompany.”

Although our plan of reorganization became effectiveon May 13, 2002, for financial reporting purposes, the effective date ofour plan of reorganization is considered to be April 30, 2002.

A black line has been drawn between the accompanyingfinancial statements to distinguish for accounting purposes between theSuccessor Company and the Predecessor Company.

We have included in-process research and developmentand goodwill amortization within “research and development” and “specialcharges and reorganization items,” respectively, of the Predecessor Companystatements of operations, whereas these items are each disclosed separately inthe Successor Company’s consolidated statement of operations data. The 2002Consolidated Statement of Operations has been combined as a matter ofconvenience. The combined results are not meant to be a presentation inaccordance with generally accepted accounting principles due to the change inbasis resulting from the completion of the reorganization plan and theapplication of fresh-start accounting during the period.

Effective December 29,2005, we changed our fiscal year end from December 31 to March 31.Our interim results are based on fiscal quarters of approximately thirteenweeks in duration ending on the closest Saturday to each calendar quarter end,with the exception of the last quarter, which ends on March 31 beginningin fiscal 2006. In accordance with the fiscal calendar in place at that time,the fiscal

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2005year ended on March 27, 2005 and the comparative period ended on March 28,2004. For financial reporting purposes and convenience of reference, fiscalperiods are labeled as ending on calendar month-end.
|                                                               | ** ** | **Successor  Company**            | ** ** | **Combined**             | ** ** | **Successor  Company**  | ** ** | **Predecessor  Company**  | ** ** | **Successor  Company**       | ** ** |
|---------------------------------------------------------------|------------|-----------------------------------|------------|--------------------------|------------|-------------------------|------------|---------------------------|------------|------------------------------|------------|
| ** **                                                    | ** ** | **Twelve Months Ended** | ** ** | **Eight  Months  Ended** | ** ** | **Four  Months  Ended** | ** ** | **Twelve  Months  Ended** | ** ** | **Three  Months Ended** | ** ** |
| **(In millions,  except per share data)** | ** ** | ** **                        | ** ** | **Mar. 31,  2006**  | ** ** | **Dec. 31,  2004** | ** ** | **Dec. 31,  2003**   | ** ** | **Dec. 31,  2002**      | ** ** | **Dec. 31,  2002** | ** ** | **Apr. 30,  2002** | ** ** | **Dec. 31,  2001** | ** ** | **Mar. 31,  2005** | ** ** | **Mar. 31,  2004** | ** ** |
| **Consolidated Statement of Operations Data:**                |       |                              |       |                     |       |                    |       |                      |       |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                               |            |                                   |            |                          |            |                         |            |                           |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
| Net sales                                                                                                        |   |   | $      | 78.8   |   |   |   | $      | 95.6   |   |   |   | $      | 103.6  |   |   |   | $      | 139.6  |   |   |   | $      | 93.6   |   |   |   | $      | 46.0   |   |   | $      | 172.3  |   |   | $      | 20.2   |   |   |   | $      | 26.0   |   |   |
|------------------------------------------------------------------------------------------------------------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|
| Cost of sales                                                                                                    |   |   | 45.4   |   |   |   | 52.2   |   |   |   | 55.2   |   |   |   | 77.3   |   |   |   | 51.2   |   |   |   | 26.1   |   |   | 130.1  |   |   | 12.5   |   |   |   | 12.6   |   |   |
| Cost of  sales—fresh-start inventory adjustment                                                             |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 3.9    |   |   |   | 3.9    |   |   |   | — |   |   | — |   |   | — |   |   |   | — |   |   |
| Gross margin                                                                                                     |   |   | 33.4   |   |   |   | 43.4   |   |   |   | 48.4   |   |   |   | 58.4   |   |   |   | 38.5   |   |   |   | 19.9   |   |   | 42.2   |   |   | 7.7    |   |   |   | 13.4   |   |   |
| Gross margin  percent of sales                                                                              |   |   | 42     | %      |   |   | 45     | %      |   |   | 47     | %      |   |   | 42     | %      |   |   | 41     | %      |   |   | 43     | %      |   | 24     | %      |   | 38     | %      |   |   | 52     | %      |   |
| Operating expenses:                                                                                              |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Research and  development                                                                                   |   |   | 21.0   |   |   |   | 20.9   |   |   |   | 18.0   |   |   |   | 17.9   |   |   |   | 11.1   |   |   |   | 6.8    |   |   | 28.7   |   |   | 5.2    |   |   |   | 5.1    |   |   |
| Selling, general  and administrative                                                                             |   |   | 23.7   |   |   |   | 29.6   |   |   |   | 27.6   |   |   |   | 33.4   |   |   |   | 22.6   |   |   |   | 10.8   |   |   | 46.1   |   |   | 7.4    |   |   |   | 6.8    |   |   |
| Special charges  and reorganization items(1), net                                                                |   |   | 2.4    |   |   |   | 5.9    |   |   |   | 3.8    |   |   |   | 9.7    |   |   |   | 2.8    |   |   |   | 6.9    |   |   | 54.3   |   |   | 0.4    |   |   |   | 0.5    |   |   |
| Amortization of  intangible assets                                                                               |   |   | 1.9    |   |   |   | 4.2    |   |   |   | 6.8    |   |   |   | 7.9    |   |   |   | 7.9    |   |   |   | — |   |   | — |   |   | 0.6    |   |   |   | 1.1    |   |   |
| In-process  research and development                                                                             |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 18.7   |   |   |   | 18.7   |   |   |   | — |   |   | — |   |   | — |   |   |   | — |   |   |
| Total operating  expenses                                                                                        |   |   | 49.0   |   |   |   | 60.6   |   |   |   | 56.2   |   |   |   | 87.6   |   |   |   | 63.1   |   |   |   | 24.5   |   |   | 129.1  |   |   | 13.6   |   |   |   | 13.5   |   |   |
| Operating loss                                                                                                   |   |   | (15.6  | )      |   |   | (17.2  | )      |   |   | (7.8   | )      |   |   | (29.2  | )      |   |   | (24.6  | )      |   |   | (4.6   | )      |   | (86.9  | )      |   | (5.9   | )      |   |   | (0.1   | )      |   |
| Other income (expense):                                                                                          |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Fresh-start  adjustments                                                                                         |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 83.7   |   |   |   | — |   |   |   | 83.7   |   |   | — |   |   | — |   |   |   | — |   |   |
| Net gain on  discharge of debt                                                                                   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 205.7  |   |   |   | — |   |   |   | 205.7  |   |   | — |   |   | — |   |   |   | — |   |   |
| Interest income                                                                                                  |   |   | 0.8    |   |   |   | 0.3    |   |   |   | 0.3    |   |   |   | 0.3    |   |   |   | 0.2    |   |   |   | 0.1    |   |   | 1.1    |   |   | 0.2    |   |   |   | 0.1    |   |   |
| Interest expense(2)                                                                                              |   |   | — |   |   |   | (0.2   | )      |   |   | (0.4   | )      |   |   | (5.5   | )      |   |   | (0.5   | )      |   |   | (5.0   | )      |   | (33.7  | )      |   | — |   |   |   | (0.1   | )      |   |
| Other, net                                                                                                       |   |   | (0.1   | )      |   |   | — |   |   |   | 0.5    |   |   |   | 0.6    |   |   |   | 0.5    |   |   |   | 0.1    |   |   | (0.8   | )      |   | (0.1   | )      |   |   | (0.1   | )      |   |
| Total other income    (expense)                                                                                  |   |   | 0.7    |   |   |   | 0.1    |   |   |   | 0.4    |   |   |   | 284.8  |   |   |   | 0.2    |   |   |   | 284.6  |   |   | (33.4  | )      |   | 0.1    |   |   |   | (0.1   | )      |   |
| Income (loss)  before reorganization items, provision (benefit) for income taxes, equity  method investment loss |   |   | (14.9  | )      |   |   | (17.1  | )      |   |   | (7.4   | )      |   |   | 255.6  |   |   |   | (24.4  | )      |   |   | 280.0  |   |   | (120.3 | )      |   | (5.8   | )      |   |   | (0.2   | )      |   |
| Reorganization  items                                                                                            |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 4.0    |   |   |   | — |   |   |   | 4.0    |   |   | — |   |   | — |   |   |   | — |   |   |
| Provision  (benefit) for income taxes                                                                            |   |   | 1.9    |   |   |   | 1.4    |   |   |   | (1.5   | )      |   |   | 1.7    |   |   |   | 1.6    |   |   |   | 0.1    |   |   | 0.5    |   |   | 0.8    |   |   |   | (0.2   | )      |   |
| Equity method  investment loss                                                                                   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   | 7.2    |   |   | — |   |   |   | — |   |   |
| Net income (loss)                                                                                                |   |   | (16.8  | )      |   |   | (18.5  | )      |   |   | (5.9   | )      |   |   | 249.9  |   |   |   | (26.0  | )      |   |   | 275.9  |   |   | (128.0 | )      |   | (6.6   | )      |   |   | — |   |   |
| Less: preferred  stock dividends accrued                                                                         |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 1.9    |   |   |   | — |   |   |   | 1.9    |   |   | 5.1    |   |   | — |   |   |   | — |   |   |
| Net income (loss)  attributable to common stockholders                                                           |   |   | $      | (16.8  | )      |   |   | $      | (18.5  | )      |   |   | $      | (5.9   | )      |   |   | $      | 248.0  |   |   |   | $      | (26.0  | )      |   |   | $      | 274.0  |   |   | $      | (133.1 | )      |   | $      | (6.6   | )      |   |   | $      | — |   |   |
| Basic and diluted  net loss per share(3)                                                                         |   |   | $      | (1.02  | )      |   |   | $      | (1.16  | )      |   |   | $      | (0.41  | )      |   |   |   |   |   |   | $      | (1.82  | )      |   |   |   |   |   |   |   |   | $      | (0.41  | )      |   |   | $      | — |   |   |
| Weighted-average  shares used in computing basic and diluted net loss per share(4)                               |   |   | 16.4   |   |   |   | 16.0   |   |   |   | 14.3   |   |   |   |   |   |   |   | 14.3   |   |   |   |   |   |   |   |   |   | 16.2   |   |   |   | 14.7   |   |   |

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(1)          Special charges andreorganization items consist of asset impairments, restructuring charges, netreimbursement of MOD III sustaining and maintenance costs and debtrestructuring fees in all periods presented.

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(2)          Excludes contractualinterest of $4.2 million in the four months ended April 30, 2002,which was not recorded during the reorganization.

(3)          Loss per share for thePredecessor Company is not presented because the common stock was not traded onan established trading market.

(4)          Sharedata has been restated for a 1 for 2 reverse split effected in 2004.
|                                       | ** ** | **As of March 31,** | ** ** | **As of December 31,** | ** ** |
|---------------------------------------|------------|------------------------------------|------------|---------------------------------------|------------|
| **(In millions)**                | ** ** | ** **                         | ** ** | **2006**                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| **Consolidated Balance Sheet  Data:** | ** ** | ** **                         | ** ** | ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash and cash  equivalents            |       | $                                  | 27.0       |                                  | $          | 33.6 |   | $ | 37.7 |   | $ | 22.0 |   | $ | 29.4 |   |
| Working capital                       |       | 22.9                               |       | 36.9                                  |       | 41.6 |   | 21.0 |   | 19.1 |   |
| Total assets                          |       | 71.6                               |       | 92.4                                  |       | 98.1 |   | 133.9 |   | 168.8 |   |
| Current  liabilities                  |       | 23.9                               |       | 25.3                                  |       | 24.9 |   | 27.4 |   | 35.1 |   |
| Total liabilities                     |       | 29.8                               |       | 34.6                                  |       | 34.2 |   | 43.2 |   | 72.0 |   |
| Stockholders’ equity             |       | 41.8                               |       | 57.8                                  |       | 63.9 |   | 60.7 |   | 66.8 |   |
|                                       |            |                                    |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**ITEM 7.**                MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

*Our actual resultsmay differ materially from those anticipated in these forward-lookingstatements as a result of various factors including those set forth in thesection entitled “Risk Factors” and in other sections of this Form 10-K.*

*The following ismanagement’s discussion and analysis of financial condition and results ofoperations of the Company and its subsidiaries for the twelve months ended March 31,2006,  December 31, 2004 and2003,  the three month transition periodended March 31, 2005 and the three months ended March 31, 2004 forcomparative purposes. This discussion and analysis should be read inconjunction with the section entitled “Selected Consolidated Financial Data”and the consolidated financial statements and notes thereto included elsewhereherein. Management’s discussion and analysis provides information concerningour business environment, consolidated results of operations and liquidity andcapital resources.*

*We prepare andrelease quarterly unaudited financial statements prepared in accordance withgenerally accepted accounting principles or GAAP. We also disclose and discussEBITDA as a measure of liquidity in our filings with the Securities andExchange Commission, earnings releases and investor conference calls. Webelieve the disclosure of such information helps investors more meaningfullyevaluate the results of our ongoing operations. However, we recommend thatinvestors carefully review the GAAP financial information included as part ofour Quarterly Reports on Form 10-Q, our Annual Reports on Form 10-K,and our quarterly earnings releases, compare GAAP financial information withthe pro forma financial results disclosed in our quarterly earnings releasesand investor calls, and read the associated reconciliation.*

*Effective December 29, 2005, we changed ourfiscal year end from December 31 to March 31. Our interim results arebased on fiscal quarters of thirteen weeks in duration ending on the lastSaturday of each calendar quarter with the exception of the last quarter, whichends on March 31 beginning in fiscal 2006. In accordance with the fiscalcalendar in place at that time, the fiscal 2005 year ended on March 27,2005 and the prior year comparative period ended on March 28, 2004. Forfinancial reporting purposes and convenience of reference, we have labeled ourinterim fiscal periods as ending on calendar month-end. The operating resultsfor any interim period are not necessarily indicative of results for anysubsequent period or the full fiscal year.*

**Overview**

Founded in 1974, we are aglobal supplier of 8-bit micrologic semiconductor devices. We design,develop and market various families of devices in this market segment. Using proprietarytechnology that we have developed over our 30-year operating history, weprovide semiconductor integrated circuit devices that our customers design intotheir end products. Our devices often include related application software andtypically combine a microprocessor with memory and various peripheral functionson a single device. Our products enable a broad range of consumer andindustrial electronics manufacturers to control the functions and performanceof their products. For example, some typical applications include devices thatcontrol the speed of a motor, infrared remote controls, security systems andbattery chargers. In addition to our micrologic devices, we sell otherintegrated circuit devices that have a wide variety of uses including theprocessing and transmission of information for communications and consumerelectronics products. These devices include serial communication controllers,modems, IrDA transceivers, television display controllers and personal computerperipheral controllers. Historically we have also performed wafer fabricationfoundry services for third parties, which were terminated in 2004.

**1998 through 2001**

Prior to February 1998, our common stock had beenpublicly traded on the New York Stock Exchange. On February 27, 1998, weconsummated a leveraged merger with an affiliate of Texas Pacific Group. Inconnection with that transaction we issued $280 million of our former 91¤2%Senior Secured 

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Notes due 2005 thatrequired us to make semi-annual interest payments of $13.3 million, and weceased having publicly traded equity securities. From 1998 until 2001, ourbusiness focus and research and development efforts moved from the traditional8 bit microcontroller market to development of a Cartezian family of 32-bitmicrologic products targeted for use in the data communication andtelecommunications end markets.

Commencing in 2000, our business and financial growthwas negatively affected by the extremely difficult business climate brought onby the severe downturn in the technology and semiconductor industries. As aresult of a rapid deterioration in the communications hardware market duringthe second half of 2000, our Cartezian family of products was never ultimatelybrought to market.

Like many companies in ourindustry, during the December quarter of 2000 we began to experiencedeclining sales. During the first half of 2001 our previous CEO resigned andour current CEO, Jim Thorburn, joined the Company to restructure ouroperations, financials and product portfolio with the goal of eliminating thedebt, positioning the Company for growth and returning the Company toprofitability. Under this leadership, we implemented a three-phase plan withthe objective of establishing and maintaining financial stability, reclaimingthe Company’s traditional 8 bit microcontroller markets and customers andinvesting in innovative products.

**2002 FinancialRestructuring and Reorganization**

In 2001, we explored a number of strategicalternatives with the assistance of our financial advisor, Lazard Frères &Co., LLC, and an informal group of holders of our senior notes. We concludedthat the best vehicle to achieve a restructuring of our senior notes wasthrough consummation of a voluntary pre-packaged plan of reorganization underChapter 11 of the United States Bankruptcy Code. On January 28, 2002, wecommenced solicitation of acceptances of a joint plan of reorganization, whichset forth a plan to reorganize our company and our subsidiary, ZiLOG-MOD III, Inc.

On February 28, 2002, we and our subsidiary,ZiLOG-MOD III, Inc., which we call MOD III, Inc., filed voluntarypetitions with the United States Bankruptcy Court for the Northern District ofCalifornia for reorganization under Chapter 11. The bankruptcy courtsubsequently confirmed MOD III, Inc.’s and our joint reorganization planby its order entered on April 30, 2002. The joint plan of reorganizationbecame effective on May 13, 2002, but for financial reporting purposes weuse May 1, 2002, as the date of emergence from bankruptcy. We refer to thecompany prior to emergence from bankruptcy as the “Predecessor Company” and tothe reorganized company as the “Successor Company.”

Pursuant to the joint reorganization plan, weextinguished $325.7 million of liabilities, which included $280.0 millionprincipal amount of our former 91¤2% SeniorSecured Notes due 2005, $27.2 million in accrued interest due on the notesand $18.5 million of dividends payable on our former series A preferredstock. The former note holders received substantially all of our new commonstock and a liquidation preference in the net proceeds on the sale of theassets held by MOD III, Inc. On May 1, 2002, we adopted “fresh-start”reporting proscribed by the American Institute of Certified Public Accountant’sStatement of Position 90-7, “Financial Reporting by Entities inReorganization Under the Bankruptcy Code,” and on that date the PredecessorCompany recorded a $205.7 million net gain on discharge of debt.

For additional informationregarding our 2002 reorganization and the subsequent implementation of freshstart reporting pursuant to Statement of Position 90-7 refer to thecaptions below under “2002 Financial Restructuring and Reorganization” and “CriticalAccounting Policies” in Management’s Discussion and Analysis of FinancialCondition and Results of Operations.

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**2004 Stock Offering**

On February 18, 2004, our Board of Directorsapproved a reverse stock split in which every two shares of common stock wasconverted into one share of common stock, effective March 1, 2004. All commonshares and per-share figures presented herein have been retroactively restatedto reflect this one-for-two reverse stock split.

On March 12, 2004,our common stock was listed for trading on the NASDAQ National Market with aticker symbol of ZILG. On March 18, 2004, and subsequently on April 6,2004 through exercise of the underwriters’ over allotment option, we raisedapproximately $24.4 million through the sale of 2,252,100 shares of ourcommon stock at a price of $12.50 per share in a registered public offering ofour stock. Subsequent to our May 2002 financial restructuring and prior toour March 2004 stock offering, our stock was traded on the OTC-Bulletinboard.

**2004 and 2006 AssetSales**

On April 16, 2004, we announced the closure ofour MOD II five-inch wafer manufacturing facility in Nampa, Idaho. Inassociation with this decision, we recorded net special charges of $6.9 millionreflecting the impairment of long lived assets and costs to cease operations,and $1.8 million for employee severance costs. MOD II production ceased onJuly 9, 2004 whereby the majority of the products previously manufacturedin MOD II were transferred to X-FAB, in Lubbock, Texas. We are now operatingunder our stated strategy as a fabless semiconductor company.

On September 24, 2004, we sold all of our wafermanufacturing equipment and certain other manufacturing support-related assetsof our MOD II facility in Nampa, Idaho, to STM for an aggregate cashconsideration of $5.9 million net of selling costs and expenses. A net gainof $1.7 million was recorded in connection with these sales. The remainingassets of MOD II primarily consist of land and buildings which have beenclassified as assets held for sale on our balance sheet as of March 31,2006.

In February 2006,ZiLOG MOD III, Inc., a special purpose subsidiary created for the economicbenefit of our former bondholders, completed the sale of the remaining assetsof MOD III to Micron Technology, Inc for a total consideration of $3.8 million.These assets included the dormant 8” wafer fabrication facility and associatedland owned by ZiLOG Mod III, Inc. ZiLOG MOD III, Inc.’s shareholdershave voted to liquidate the special purpose entity and distribute the remainingnet proceeds to its Series A Preferred shareholders at the conclusion ofthat process. The costs to liquidate ZiLOG Mod III, Inc. areestimated to be $0.2 million. We anticipate that approximately $2.5 millionwill be distributed to holders of ZiLOG Mod III, Inc. Series APreferred Stock on the liquidation of the subsidiary and accordingly thisestimated distribution amount due has been recorded in our consolidatedfinancial statements at March 31, 2006. A summary of the proceeds,transaction costs and distributions appears in Table 2, Item 2 under theheading MOD III Transferred Assets to ZiLOG MOD III, Inc.

**Stock RepurchasePrograms**

As of March 31,2006, total stock repurchases under the 2003, 2004 repurchase plans and otherpurchases total 1,087,388 shares with a net aggregate cost of $7.2 millionas summarized below:

| ** **        | ** ** | **Treasury Shares Outstanding** | ** ** |
|-------------------|------------|-------------------------------------------|------------|
| ** **        | ** ** | **3/31/06**                               | ** ** | **3/31/05** | ** ** | **12/31/04** | ** ** | **12/31/03** | ** ** |
| 2003 Plan         |       | 405,164                                   |       | 405,164 |   | 405,164 |   | 382,664 |   |
| 2004 Plan         |       | 572,100                                   |       | 572,100 |   | 572,100 |   | — |   |
| Other Repurchases |       | 110,124                                   |       | 92,735 |   | 92,735 |   | — |   |
| Ending Balance    |       | 1,087,388                                 |       | 1,069,999 |   | 1,069,999 |   | 382,664 |   |

 

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***2003 Stock Repurchases***

On April 17, 2003, our Board of Directorsapproved a stock repurchase program under which we could repurchase up to500,000 shares of our outstanding common stock at market value.

We generally had the right of first refusal torepurchase shares of common stock issued under our stock plan to certainemployees, former employees and contractors which expired on March 12,2004. This right of first refusal became exercisable when the shares wereoffered for sale or upon termination of employment.

Asummary of the activity under this program is as follows ($ in millions):

| ** **                                        | ** ** | **Shares** | ** ** | **Net  Cost** | ** ** | **Loan  Repayment** | ** **    |
|---------------------------------------------------|------------|------------|------------|---------------|------------|---------------------|---------------|
| 2003 repurchases  from open market                |       | 125,000    |       | $ 0.5    |       |                | $ — |   |   |
| 2003 repurchases  from former executive officer   |       | 50,000     |       | $ 0.2    |       |                | $ 0.1    |   |   |
| 2003 repurchases  from other and former employees |       | 207,664    |       | $ 0.6    |       |                | $ 0.5    |   |   |
| 2003 Total repurchases                            |       | 382,664    |       | $ 1.3    |       |                | $ 0.6    |   |   |
| 2004 repurchases  from other and former employees |       | 22,500     |       | $ 0.1    |       |                | $ 0.1    |   |   |
| Total repurchases  through March 31, 2006    |       | 405,164    |       | $ 1.4    |       |                | $ 0.7    |   |   |

 

As of March 31, 2006,the Company had repurchased 405,164 shares under this program at an aggregatecost of $2.1 million.

***2004 Stock Repurchase Program***

On July 29, 2004, ourBoard of Directors approved the 2004 stock repurchase program pursuant to whichwe could repurchase up to $5.0 million in market value of our outstandingshares of common stock. Pursuant to this program, during 2004 we purchased572,100 shares of our common stock at a net aggregate cost of $4.4 million.No other purchases have occurred under this program.

***Other Stock Repurchases***

On November 17, 2004, our Board of Directors, inconjunction with the resignation of a former officer, Michael Burger, approvedthe repurchase of 92,735 shares of common stock from Mr. Burger at a fairmarket purchase price of $6.20 per share in consideration for the repayment ofhis loans payable to us totaling $0.6 million.

During fiscal 2006, the company repurchased 17,389shares from former employees in consideration for the repayment of loanspayable to us totaling $0.1 million.

During the three monthtransition period ended March 31, 2005 there were no stock repurchases.

**Critical AccountingPolicies and Estimates**

We believe ourcritical accounting policies are as follows:

·       estimatingsales returns and allowances;

·       estimatingallowance for doubtful accounts;

·       estimatingwrite-downs of excess and obsolete inventories;

·       assetimpairments; and

·       fresh-startreporting.

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A brief description of each of these policies is setforth below.

On an on-going basis, weevaluate our estimates, including those related to sales returns, allowance fordoubtful accounts, inventory write-downs and asset impairments. We base ourestimates on historical trends and various other assumptions that we believe tobe reasonable at the time the estimates are made. Actual results could differfrom those estimates.

***Estimating Sales Returns and Allowances***

Our net sales to OEM customers consist of grossproduct sales reduced by expected future sales returns and allowances. Toestimate sales returns and price allowances, we analyze historical returns andallowance activity to establish a baseline reserve level. We then evaluatewhether there are any underlying product quality or other customer specificissues that require additional specific reserves above the baseline level.Because the reserve for sales returns and allowances is based on our judgmentsand estimates, our reserves may not be adequate to cover actual sales returnsand other allowances. If our reserves are not adequate, our net sales andaccounts receivable could be materially adversely affected.

Our net sales todistributors that have rights of return and/or price protection allowances onunsold merchandise held by them are deferred until such products are resold bythe distributors to end users of our devices. At the time that we recognizedistributor re-sales as revenue, we record a reserve for estimated priceadjustments that the distributors will reclaim from us on the merchandise theyresold to end users. These reserves are recorded as a reduction to our netsales and a reduction to our accounts receivable. To estimate this distributorprice adjustment reserve, we analyze our historical price adjustment payments,price adjustments taken by distributors but not processed by us and pendingprice adjustments that have been authorized by us but have not yet been claimedby our distributors. Because our distributor allowance reserve is based uponour judgments and estimates, such reserves may not be adequate to cover actualdistributor price allowances. If our reserves are not adequate, our net salesand accounts receivable could be materially adversely affected.

***Estimating Allowance for Doubtful Accounts***

We maintain an allowancefor losses we may incur as a result of our customers’ inability to makerequired payments. Any increase in the allowance results in a correspondingincrease in our selling, general and administrative expenses. In establishingthis allowance, and then evaluating the adequacy of the allowance for doubtfulaccounts, we consider the aging of our accounts receivable, historical baddebts, customer concentrations, customer credit-worthiness and, to a lesserextent, current economic trends and changes in our customer payment terms.Historically, we have not experienced material bad debt write-offs. If thefinancial condition of one or more of our customers unexpectedly deteriorates,resulting in their inability to make payments, or if we otherwise underestimatethe losses we incur as a result of our customers’ inability to pay us, we couldbe required to increase our allowance for doubtful accounts which couldmaterially adversely affect our operating results.

***Estimating Write-Downs of Excess and ObsoleteInventories***

Each inventory component,excluding raw materials, is assessed for excess or obsolescence by using analgorithm that we have established. This algorithm is based on historicaltrends, demand forecasts and inventory age. We review the result of thisalgorithm and generally reserve work-in-process inventories based upon agingand finished goods inventory quantities in excess of our current backlog orhistorical demand. In addition to analyzing the results of our reservealgorithm calculations, we also review known exposures, market conditions andother relevant factors to determine whether our inventory reserves areappropriate based on our best estimates. Reserves for excess and obsoleteinventories are reflected as a reduction to inventory values in theaccompanying consolidated balance sheets, and an increase in cost of 

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sales.If actual market conditions or customer demand patterns are less favorablethan, or inconsistent with our assumptions, we may be required to take furtherwrite-downs of our inventory value, which could materially adversely impact ourcost of sales and operating results.

***Asset Impairments***

Weapply the provisions of Statement of Financial Accounting Standards No. 144,“Accounting for the Impairment or Disposal of Long-Lived Assets” and Statementof Financial Accounting Standards No. 142, “Goodwill and Other IntangibleAssets.” We evaluate long-lived assets for possible impairment whenever eventsor changes in circumstances indicate that the carrying value may not berecoverable. Factors we consider important which could trigger an impairmentreview include the following:

·       significantchanges in the manner of our use of the acquired assets;

·       significantchanges in the strategy for our overall business; and

·       significantnegative industry or economic trends.

When we determine that thecarrying value of long-lived assets may not be recoverable based upon theexistence of one or more of the above indicators of impairment, and theundiscounted cash flows estimated to be generated by those assets are less thanthe asset’s carrying value, the carrying value of the assets are reduced totheir estimated fair value. The estimated fair value is usually determinedbased on an estimate of discounted future cash flows. Asset impairments arerecorded as a reduction in the asset value in our consolidated balance sheetsand as special charges in our consolidated statements of operations.

The intangible assetscreated by the adoption of fresh-start accounting on our emergence frombankruptcy in 2002, consist of existing technology and brand name, as well asexcess enterprise value, or goodwill. The existing technology and brand nameare being amortized based on a pattern-of-use method in proportion to theforecast discounted cash flows from such assets. The goodwill is not subject toamortization.

We evaluate existingtechnology and brand name whenever events and circumstances indicate that theirfair value may be less than their carrying value. Additionally, goodwill istested for impairment at least annually and more often if events andcircumstances indicate that its fair value may be less than its carrying value.We performed the annual impairment test for goodwill in the third quarter of fiscal2006, and we perform this test in the third quarter of each fiscal year unlessthe existence of triggering events indicates that an earlier review should beperformed.

Adjustments to recordimpairment of long-lived assets or intangible assets could have a materialadverse impact on our financial condition and results of operations in theperiod or periods in which such impairment is identified.

***Fresh-StartReporting***

On the completion of ourfinancial debt restructuring and emergence from Chapter 11 proceedings in May 2002,we adopted fresh-start reporting in accordance with SOP 90-7.Accordingly, for financial reporting purposes, we valued our assets andliabilities at fair value. With the assistance of our independent financialadvisor, Lazard Frères & Co., LLC, and in reliance upon variousvaluation methods, and other applicable ratios and economic industryinformation relevant to our industry and through negotiations with variouscreditor parties in interest, we estimated our equity value to be $90.0 millionas of May 13, 2002. This estimate of equity value was derived from aweighted average of three separate valuations methodologies: the first based ona comparable public company analysis; the second based on precedent transactionanalysis; and the third based on a discounted cash flow analysis. For thepurposes of the comparable public company analysis, Lazard analyzed the tradingmultiples of numerous public companies in the semiconductor industry, includingSemtech, Globespan and Mitel, amongst others as at 

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May 13,2002. The comparable public company analysis yielded a valuation range of $70-$87 million;Lazard weighted this analysis 35% in its estimated valuation. The precedenttransaction analysis yielded a valuation range of $88-$109 million;Lazard weighted this analysis 30% in its estimated valuation. The discounted cashflow analysis yielded a valuation range of $82-$106 million. Indetermining the discounted cash flow valuation range, Lazard considered threeyears of financial projections based on management’s best estimates at thetime, with terminal values ranging from six to eight times the final year’scash flow, and utilizing a discount factor of 28%. Lazard weighted thisanalysis 35% in its estimated valuation. These valuations were based on theunderlying assumptions and limitations set forth in their report. Theseassumptions include: the successful reorganization of our business and financesin a timely manner; the implementation of our business plan as a reorganizedentity; the accuracy of information supplied by management about our cash flowprojections; achievement of forecasted projections; market conditions as of December 31,2001 continuing through an assumed effective date of March 31, 2002; andthe plan of reorganization becoming effective in accordance with the estimatesand assumptions upon which the valuation was based.

In connection with theoverall revaluation of our assets and liabilities under fresh-start reporting,described above, we recorded a net gain of $83.7 million. The increases inthe carrying value of our intangible assets were based on three valuationapproaches, depending on the specific intangible asset to be valued: the incomeapproach, the cost approach and the market approach. The increases in carryingvalue of our tangible assets were based on physical inspections and written appraisalsthat included market data and cost approaches. Results would have varied underdifferent assumptions or conditions.

**Reporting Segments**

Beginning in May 2002,we have consolidated our business segments into one reportable segment toreflect the manner in which our chief operating decision-maker allocatesresources and assesses the performance of our business.

**Period Comparisons**

Our results of operations from May 1, 2002 andour consolidated balance sheets at December 31, 2003, December 31,2002 and May 1, 2002 are not comparable to our results of operations priorto May 1, 2002 and our consolidated balance sheet at December 31,2001, due to our adoption of “fresh-start” reporting upon our emergence frombankruptcy. Differences in our results of operations relate to depreciation ofproperty, plant and equipment, amortization of intangible assets, interestexpense and restructuring and reorganization expenses. Additionally, thesedifferences in our balance sheets relate to inventory, in-process research anddevelopment, property, plant and equipment, intangible assets, conversion ofsenior notes to common stock, and minority interest. Certain figures, such asnet sales and certain expenses were not affected by our adoption of fresh-startaccounting and, accordingly, we believe them to be comparable. To provide amore meaningful analysis, in the following discussion we have compared combinedresults of our Predecessor and Successor Company’s operations for fiscal year2002 to the Predecessor Company’s results for fiscal year 2001. Our combinedresults for 2002 are presented for convenience of annual comparison and are notmeant to be a presentation in accordance with generally accepted accountingprinciples.

Effective December 29,2005, we changed our fiscal year end from December 31 to March 31.Our interim results are based on fiscal quarters of approximately thirteenweeks in duration ending on the closest Saturday to each calendar quarter end,with the exception of the last quarter, which will end on March 31beginning in fiscal 2006. In accordance with the fiscal calendar in place atthat time, the fiscal 2005 year ended on March 27, 2005 and thecomparative period ended on March 28, 2004. For financial reportingpurposes and convenience of reference, fiscal periods are labeled as ending oncalendar month-end.

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**Results ofOperations**

Ournet sales by region, by channel, and by business line are summarized in dollarsfor each period indicated, as follows (in millions):

| ** **                           | ** ** | **Twelve Months Ended** | ** **  | **Three Months Ended** | ** ** |
|--------------------------------------|------------|-----------------------------------|-------------|----------------------------------|------------|
| ** **                           | ** ** | **Mar. 31,  2006**           | ** **  | **Dec. 31,  2004**          | ** ** | **Dec. 31,  2003** | ** ** | **Mar. 31,  2005** | ** ** | **Mar. 31,  2004** | ** ** |
| ** **                           | ** ** | ** **                        | ** **  | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** | **(unaudited)** | ** ** |
| **Net  sales by region:**            | ** ** |                              | ** **  | ** **                       |       |   | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Americas                             |       |                              | $ 31.9 | ** **                       |       |   | $ 49.4 | ** ** |   | $ 59.7 | ** ** |   | $ 9.4 | ** ** |   |   | $ 14.0 | ** ** |   |
| Asia (including Japan)               |       |                              | 36.4        | ** **                       |       |   | 33.5 | ** ** |   | 30.9 | ** ** |   | 8.2 | ** ** |   |   | 8.0 | ** ** |   |
| Europe                               |       |                              | 10.5        | ** **                       |       |   | 12.7 | ** ** |   | 13.0 | ** ** |   | 2.6 | ** ** |   |   | 4.0 | ** ** |   |
| **Net  sales**                       |       |                              | $ 78.8 | ** **                       |       |   | $ 95.6 | ** ** |   | $ 103.6 | ** ** |   | $ 20.2 | ** ** |   |   | $ 26.0 | ** ** |   |
| **Net  sales by channel:**           | ** ** |                              | ** **  | ** **                       |       |   | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| OEM                                  |       |                              | $ 34.8 | ** **                       |       |   | $ 44.7 | ** ** |   | $ 44.0 | ** ** |   | $ 10.1 | ** ** |   |   | $ 13.5 | ** ** |   |
| Distribution                         |       |                              | 44.0        | ** **                       |       |   | 47.3 | ** ** |   | 48.5 | ** ** |   | 10.1 | ** ** |   |   | 12.3 | ** ** |   |
| Foundry services                     |       |                              | —      | ** **                       |       |   | 3.6 | ** ** |   | 11.1 | ** ** |   | — | ** ** |   |   | 0.2 | ** ** |   |
| **Net  sales**                       |       |                              | $ 78.8 | ** **                       |       |   | $ 95.6 | ** ** |   | $ 103.6 | ** ** |   | $ 20.2 | ** ** |   |   | $ 26.0 | ** ** |   |
| **Net  sales by business line:**     | ** ** |                              | ** **  | ** **                       |       |   | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Micrologic                           |       |                              |        | ** **                       |       |   |   | ** ** |   | ** ** | ** ** |   |   | ** ** |   |   |   | ** ** |   |
| Flash                                |       |                              | $ 6.8  | ** **                       |       |   | $ 3.2 | ** ** |   | $   1.0 | ** ** |   | $ 1.1 | ** ** |   |   | $ 0.4 | ** ** |   |
| Non-Flash                            |       |                              | 53.4        | ** **                       |       |   | 65.1 | ** ** |   | 67.0 | ** ** |   | 13.7 | ** ** |   |   | 19.1 | ** ** |   |
| Micrologic                           |       |                              | 60.2        | ** **                       |       |   | 68.3 | ** ** |   | 68.0 | ** ** |   | 14.8 | ** ** |   |   | 19.5 | ** ** |   |
| Other Devices                        |       |                              |        | ** **                       |       |   |   | ** ** |   | ** ** | ** ** |   |   | ** ** |   |   |   | ** ** |   |
| Serial Communications Controllers    |       |                              | 12.8        | ** **                       |       |   | 14.4 | ** ** |   | 13.7 | ** ** |   | 2.8 | ** ** |   |   | 4.0 | ** ** |   |
| Modems                               |       |                              | 1.0         | ** **                       |       |   | 2.8 | ** ** |   | 3.1 | ** ** |   | 1.6 | ** ** |   |   | 0.6 | ** ** |   |
| IrDA Transceivers                    |       |                              | 1.1         | ** **                       |       |   | 2.1 | ** ** |   | 2.4 | ** ** |   | 0.3 | ** ** |   |   | 1.0 | ** ** |   |
| Television, PC Peripherals and Other |       |                              | 3.7         | ** **                       |       |   | 4.4 | ** ** |   | 5.3 | ** ** |   | 0.7 | ** ** |   |   | 0.7 | ** ** |   |
| Other Devices                        |       |                              | 18.6        | ** **                       |       |   | 23.7 | ** ** |   | 24.5 | ** ** |   | 5.4 | ** ** |   |   | 6.3 | ** ** |   |
| Subtotal—Base business          |       |                              | 78.8        | ** **                       |       |   | 92.0 | ** ** |   | 92.5 | ** ** |   | 20.2 | ** ** |   |   | 25.8 | ** ** |   |
| Foundry services                     |       |                              | —      | ** **                       |       |   | 3.6 | ** ** |   | 11.1 | ** ** |   | — | ** ** |   |   | 0.2 | ** ** |   |
| **Net sales**                        |       |                              | $ 78.8 | ** **                       |       |   | $ 95.6 | ** ** |   | $ 103.6 | ** ** |   | $ 20.2 | ** ** |   |   | $ 26.0 | ** ** |   |

 

**Other key indices**

Otherkey indices relevant in understanding our business and financial performanceinclude the following metrics:

| ** **                          | ** ** | **As of Mar. 31,** | ** ** | **As of Dec. 31,** | ** ** |
|-------------------------------------|------------|-----------------------------------|------------|-----------------------------------|------------|
| ** **                          | ** ** | **2006**                          | ** ** | **2005**                          | ** ** | **2004** | ** ** | **2003** | ** ** |
| Days sales  outstanding             |       |                              | 42         |                              |       |   | 56 |   |   |   | 38 |   |   |   | 46 |   |   |
| Net sales to  inventory ratio       |       |                              | 11         |                              |       |   | 8 |   |   |   | 8 |   |   |   | 11 |   |   |
| Weeks of  inventory at distributors |       |                              | 10         |                              |       |   | 13 |   |   |   | 13 |   |   |   | 14 |   |   |
| Current ratio                       |       |                              | 1.9        |                              |       |   | 2.5 |   |   |   | 2.7 |   |   |   | 1.8 |   |   |

 

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We calculate each of these key metrics based on annualresults of operations data and balance sheet data as of the end of the periodindicated. Each of these key metrics is described below:

Days sales outstanding, DSO, is a common metric usedto analyze how quickly our customers pay us. This metric is influenced largelyby the timing of our customer billings and collections. At March 31, 2006,DSO’s were 42 days, March 31, 2005 were 56 days as compared to 38 at December 31,2004. The March 31, 2006, DSO’s reflect a higher mix of distributioncustomers that generally tend to pay faster than the average of our OEMcustomers.

Net sales to inventory ratio is a metric we use toanalyze how quickly our investment in inventories is recovered by our sales.This metric may not be comparable to those other companies use to analyzeinventory and is not the same as a typical inventory turns ratio. Our net salesto inventory ratio increased to 11 times annual sales in fiscal 2006 reflectinghigher sales rates on our new Flash products and a continued reduction ininventory levels.

Weeks of inventory at distributors measures the levelof inventories on hand at our distributors relative to their end sales to theirend customers and as such is relative to the levels of sales we record fordistribution sales. We do not recognize revenue on shipments to distributorsuntil our distributors resell our products to end users. We generally target 10to 13 weeks of inventory in the distribution channel to allow thesedistributors to react to market demand and buffer the cycle time of reorderingnew product from us and awaiting delivery.

Current ratio representscurrent assets divided by current liabilities and is commonly used to assess acompany’s liquidity. The Company uses this ratio to make spendingdeterminations on discretionary items.

**Comparison ofFinancial Results**

***Twelve Months Ended March 31, 2006 and Year EndedDecember 31, 2004***

Unless otherwiseindicated, references in this section to 2006 are to the twelve months ended March 31,2006, and references to 2004 are to the twelve months ended December 31,2004.

***Net Sales***

Since 2001, we have refocused our business on our core8-bit micrologic portfolio of devices, and de-emphasized certain productofferings in our other devices business line. Beginning in 2002 we haveintroduced new products targeted at the growing 8 bit embedded flashmicrocontroller market lead by our Z8 Encore! and eZ80Acclaim! families ofproducts. Revenue from product sales to OEM customers is recognized upon titletransfer, which generally occurs upon shipment, net of appropriate allowancesfor returns and warranty costs that are recorded at the time revenue isrecognized. The Company recognizes revenue on sales to distributors who haverights of return and price protection on unsold merchandise held by them whenproducts are resold by the distributors to end-users, or as we refer to it, onthe sell through method.

Net sales were $78.8 million in 2006, as compared tonet sales of $95.6 million in 2004. Excluding foundry services, net sales forour base business were $78.8 million for 2006, as compared to $92.0 million in2004. Micrologic sales decreased in 2006 over 2004 which included an overalldecrease in non flash microcontrollers of $11.7 million partially offset by anincrease in net sales of our new flash-based products from $3.2 million in 2004to $6.8 million in 2006. Net sales of our embedded flash products continue toincrease reflecting higher levels of sales in Z8Encore!, Z8Encore!XP andEZ80Acclaim devices.

Net sales of our other devices decreased by $5.1million reflecting a $1.6 million decrease in serial communicationcontrollers, $1.8 million decrease in net sales of modem products, driven by atechnology migration by our largest modem OEM customer from a hardware-drivensolution to an internally 

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developed software-operated modem; and a $0.6 million decrease in net sales of our television andperipheral products. The television and peripheral products were de-emphasizedprior to 2001 and have continued to decline as customers have migrated awayfrom 8-bit analog devices to alternative solutions for digital TV.

There were no net salesfrom our foundry services in 2006 as compared to $3.6 million in 2004. Asstated previously, subsequent to the closure of our MOD II manufacturingfacility in Nampa, Idaho in July, 2004, foundry sales have been insignificant.

***Gross Margin***

Our cost of sales primarily represents the cost ofproducing our products, including wafer fabrication, assembly and test expenditures.Cost of sales fluctuates, depending on materials and services prices from ourvendors, manufacturing efficiency and productivity of our test operation,product mix, and product yield performance. Gross margin as a percent of netsales was 42% in 2006 as compared to 45% in 2004. Our gross margin decline in2006 reflects the reduction in sales of higher margin legacy products coupledwith the increase of flash-based microcontroller products which currentlygenerate lower gross margin than some of our more mature product offerings.Gross margins on these flash products continue to improve as sales demand andvolumes grow, allowing us to obtain lower wafer pricing from our suppliers. Additionally,we intend to improve the gross margins on our flash based microcontrollers aswe continue to expand the peripherals and feature sets integrated into thesemicrocontroller solutions.

We have focused on manufacturing cost controls, yieldenhancements and price management and have continued to consolidate and streamlineour manufacturing activities, closing our 8-inch MOD III wafer facilityin January, 2002 and our 5 inch MOD II wafer facility in July, 2004. We are nowfully fabless, and outsource all of our wafer manufacturing needs from foundriesin the United States and Taiwan. Additionally, we now have greater flexibilityto use lower geometry fab processes for design, allowing us to reduce thephysical size of our flash products which we believe will allow us to improveour margins on such products and may even allow us added access to the highervolume and lower priced Asian consumer markets for these products.

We have continued tomulti-source our product assembly activities with several Asian suppliers toenhance our supply source flexibility and obtain continued competitive vendorpricing.

***Research and Development Expenses***

Research and development expenses were $21.0 millionin 2006, as compared to $20.9 million in 2004. Our research and developmentefforts were, and continue to be, primarily directed towards development ofcore micrologic devices and associated design tool development, including ourZ8 Encore! and eZ80Acclaim! families of 8-bit embedded-flash micrologicdevices. Additionally we continue to focus our development on our Crimzonconsumer solutions family of products targeted at the Universal remote controlmarket and we also developed our newly announced 32 bit ARM architecture familyof products.

During 2004, we announcedthe opening of our China design center in Shanghai to allow us to more closelyalign to the growing Asian region and the rapidly growing China market. We alsoexpanded our software development group in Bangalore, India to support ourgrowing product portfolio especially for our remote control products.Additionally, we transferred our engineering groups from Nampa, Idaho to a newtechnology center in Meridian, Idaho. The group supports our design andsoftware development as well as foundry technology development.

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***Selling, General and Administrative Expenses***

Selling, general and administrativeexpenses were $23.7 million in 2006, as compared to $29.6 million in 2004. Thelower SG&A expenses in 2006 compared to 2004 is primarily due to savingsfrom cost reduction programs to reduce headcount in our sales and marketingsupport functions, as well as savings from the consolidation of certainadministrative functions in our Philippines operations. These savings werepartially offset by higher marketing costs associated with new products andtheir market introductions, increased costs to support Sarbanes-Oxleyactivities and incremental legal costs including costs related to the Microchiplawsuit.

***Special Charges***

Specialcharges for the twelve months ended March 31, 2006, three month transitionperiod ended March 31, 2005, and the twelve months ended December 31,2004 and 2003 were as follows (in millions):

| ** **                                                    | ** ** | **Twelve Months Ended** | ** ** | **Three  Months  Ended** | ** ** |
|---------------------------------------------------------------|------------|-----------------------------------|------------|--------------------------|------------|
| ** **                                                    | ** ** | **Mar. 31,  2006**           | ** ** | **Dec. 31,  2004**  | ** ** | **Dec. 31,  2003** | ** ** | **Mar. 31,  2005** | ** ** |
| **Asset  impairments:**                                       | ** ** |                              | ** ** | ** **               |       |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Test and probe equipment written-off                          |       |                              | $          | —                   |       |   |   | $ | — |   |   |   | $ | 0.2 | ** ** |   |   | $ | — | ** ** |   |
| MOD II asset impairment(a)                                    |       |                              | 0.5        |                     |       |   | 5.4 |   |   |   | — | ** ** |   |   | — | ** ** |   |
| MOD II assets, gain on sale of equipment(a)                   |       |                              | —     |                     |       |   | (1.7 | ) |   |   | — | ** ** |   |   | — | ** ** |   |
| Equity investment write-down                                  |       |                              | —     |                     |       |   | — |   |   |   | 0.2 | ** ** |   |   | — | ** ** |   |
| **Restructuring  of operations:**                             | ** ** |                              | ** ** | ** **               |       |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Employee severance and termination benefits, other            |       |                              | 1.7        |                     |       |   | 0.3 |   |   |   | 1.5 | ** ** |   |   | — | ** ** |   |
| MOD II employee severance and termination benefits            |       |                              | —     |                     |       |   | 1.8 |   |   |   | — | ** ** |   |   | — | ** ** |   |
| MOD II costs to close facility                                |       |                              | 0.7        |                     |       |   | 3.2 |   |   |   | — | ** ** |   |   | 0.3 | ** ** |   |
| MOD III sustaining costs for post-closure  maintenance        |       |                              | 0.4        |                     |       |   | 1.7 |   |   |   | 1.3 | ** ** |   |   | 0.1 | ** ** |   |
| MOD III reimbursement of maintenance costs(a)                 |       |                              | (0.8       | )                        |       |   | (4.9 | ) |   |   | — | ** ** |   |   | — | ** ** |   |
| **Professional  fees (reimbursement) for debt restructuring** |       |                              | (0.1       | )                        |       |   | 0.1 |   |   |   | 0.6 | ** ** |   |   | — | ** ** |   |
| Total Special Charges                                         |       |                              | $          | 2.4                      |       |   |   | $ | 5.9 |   |   |   | $ | 3.8 | ** ** |   |   | $ | 0.4 | ** ** |   |

 

(a)           Asset impairments andreimbursements were not included in the provision accruals in the followingtable.

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Thefollowing table details special charge accrual activity and ending accrualbalances for the year ended March 31, 2006, the three month transitionperiod ended March 31, 2005, and the year ended December 31, 2004.(in millions):

| ** **                                              | ** ** | **Severance  and  Termination  Benefits** | ** ** | **Debt  Restructuring** | ** ** | **MOD III  Closure  Costs** | ** ** | **MOD II  Closure  Costs** | ** ** | **Total** | ** ** |
|---------------------------------------------------------|------------|-------------------------------------------|------------|-------------------------|------------|----------------------------------|------------|---------------------------------|------------|-----------|------------|
| Balance at  December 31, 2003                      |       |                                      | —     |                    |       |                             | —     |                            |       |      | 0.1        |   |   |   | — |   |   | $ | 0.1 |   |
| Provisions to  special charges                          |       |                                      | 2.1        |                    |       |                             | 0.1        |                            |       |      | 1.7        |   |   |   | 3.2 |   |   | 7.1 |   |
| Provisions to  cost of sales relating to MOD II closure |       |                                      | 0.4        |                    |       |                             | —     |                            |       |      | —     |   |   |   | 0.1 |   |   | 0.5 |   |
| Cash payments                                           |       |                                      | (2.2       | )                       |       |                             | (0.1       | )                               |       |      | (1.8       | ) |   |   | (2.6 | ) |   | (6.7 | ) |
| Balance at  December 31, 2004                      |       |                                      | 0.3        |                    |       |                             | —     |                            |       |      | —     |   |   |   | 0.7 |   |   | $ | 1.0 |   |
| Cash payments                                           |       |                                      | (0.2       | )                       |       |                             | —     |                            |       |      | —     |   |   |   | (0.4) |   |   | (0.6 | ) |
| Balance at  March 31, 2005                         |       |                                      | 0.1        |                    |       |                             | —     |                            |       |      | —     |   |   |   | 0.3 |   |   | $ | 0.4 |   |
| Provisions to  special charges                          |       |                                      | 1.7        |                    |       |                             | (0.1       | )                               |       |      | 0.4        |   |   |   | 0.7 |   |   | 2.7 |   |
| Cash payments                                           |       |                                      | (1.8       | )                       |       |                             | 0.1        |                            |       |      | (0.4       | ) |   |   | (0.9 | ) |   | 3.0 |   |
| Balance at  March 31, 2006                         |       |                                      | $          | —                  |       |                             |       | $                               | —     |      |       |   | $ | — |   |   |   | $ | 0.1 |   |   | $ | 0.1 |   |
|                                                         |            |                                           |            |                         |            |                                  |            |                                 |            |           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

***Fiscal 2006 Activities***

In April 2005, the Company initiated a plan ofaction to consolidate certain of its support activities and transfer certain ofthese activities to its Philippines operations. These activities have resultedin lower overall support costs. The total severance and benefits cost of thisaction to date has been $1.7 million which has been recorded as special chargesrelated to a reduction-in-force and support activity consolidation implementedand effectively completed as of March 31, 2006. In addition, the Companycontinues to incur period expenses to sustain the dormant MOD II facilityincluded in assets held for sale on the balance sheet as of March 31,2006. Our estimates used to determine the fair value of MOD II land andbuildings that remain held for sale at March 31, 2006, are based on anindependent appraisal from a third party. There can be no assurance that thevalue we will realize from the ultimate sale or disposition of these assetswill be equal to the estimated fair values. If the ultimate net value realizedupon the disposition of the remaining MOD II assets is less than the carryingvalue of $1.8 million, our future results of operations could be materiallyadversely impacted.

During fiscal 2006, weincurred $2.4 million in special charges, including the net reimbursement of$0.8 million of MOD III sustaining and maintenance costs. ZiLOG MOD III, Inc.completed the sale of the remaining assets to Micron Technology, Inc. andthe shareholders have voted to liquidate the special purpose entity.

***Calendar 2004 Activities***

On April 16th, 2004, we announced the closure ofour MOD II five-inch wafer manufacturing facility in Nampa, Idaho and therelated transfer of MOD II production activities to our foundry partner, X-Fab,in Lubbock, Texas. MOD II ceased production operations on July 9, 2004. Asa result, in 2004, we incurred $1.8 million employee termination costs relatedto the termination of 144 employees, and sustaining costs for post-closuremaintenance of the MOD II facility and preparation to sell the equipment.Additionally, MOD III sustaining costs for post-closure maintenance incurred byus in 2004 totaled $1.7 million, which was offset in the consolidated statementof operations by approximately $4.9 million reimbursement for sustaining costsincurred since 2002 from the sale of the MOD III equipment toSTMicroelectronics in July, 2004.

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As a result of theclosure of MOD II, in 2004 we incurred the following special charges:

·       employeeseverance and termination costs of $1.8 million.

·       anasset impairment charge of $5.4 million related to the write-down of the MOD IIlong-lived assets.

·       anet gain on sale of assets of $1.7 million related to the subsequent sale ofthe MOD II wafer manufacturing equipment (and related assets) toSTMicroelectronics in fourth quarter of 2004; and

·       MODII costs of $3.2 million related to closure and maintenance of the facility.

The costs for MOD II and MOD III consist of utilities,taxes, insurance, and other maintenance costs required to maintain thefacilities in a condition required for the sale of the respective properties.

Approximately $0.1 millionof special charges during 2004 relate to third-party professional legal servicefees associated with our debt and equity restructuring of May 2002, and$0.3 million severance and termination benefits related to our continuedefforts to align infrastructure costs to business-level requirements.

***Stock-BasedCompensation***

During 2006 we recognized$0.7 million of stock-based compensation expense, as compared to $2.0 millionduring 2004, primarily in connection with the award of restricted stock andstock options to certain executives, employees and consultants at exerciseprices below their deemed fair market on the dates of award. This non-cashstock-based compensation expense is primarily included in our selling, generaland administrative expenses. Compensation expense for employee stock awards wasmeasured on the award date and is being recognized over the vesting period ofthese awards. During 2004, we issued stock below the then fair market value to Mr. Thorburnand cancelled restricted stock which was awarded during May 2002 alongwith other employee restricted stock and option awards, in accordance with ourshareholder approved plan of reorganization. Additionally, compliance with SFASNO.123 R requirements in fiscal 2007 will require us to record stock basedcompensation expense greater than current levels. (See recent accountingpronouncements)

***Amortization ofIntangible Assets***

Effective January 1,2002, we adopted the provisions of Statement of Financial Accounting Standards No. 142,“Goodwill and Other Intangible Assets” (“FAS 142”). Under FAS 142, goodwill andintangible assets with indefinite lives are not amortized, but are reviewedannually or more frequently if impairment indicators arise. Separableintangible assets that are deemed to have defined lives will continue to beamortized over their useful lives. In connection with our fresh-startreporting, separable intangible assets based on independent valuations werecreated with deemed defined lives. These intangible assets are being amortizedutilizing the pattern-of-use method over their estimated useful lives of 3 to 7years for current technology and ten years for brand name. We evaluate existingtechnology and brand name whenever events and circumstances indicate that theirfair value may be less than their carrying value and if appropriate, record animpairment charge. Additionally, goodwill is tested for impairment at leastannually and more often if events and circumstances indicate that its fairvalue may be less than its carrying value. We performed the annual impairmenttest for goodwill at September 30, 2004 and at March 31, 2006, and noimpairment charge was recorded as no impairment of the carrying value wasindicated. We perform this test in the third quarter of each fiscal year unlessthe existence of triggering events indicates that an earlier review should beperformed.

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Theseparable intangible assets identified in connection with fresh-startaccounting and included in the consolidated balance sheet are as follows (inmillions):

| ** **                         | ** ** | **Current  Technology** | ** ** | **Brand  Name** | ** ** | **Total** | ** ** |
|------------------------------------|------------|-------------------------|------------|-----------------|------------|-----------|------------|
| Gross carrying  amount             |       |                    | $          | 17.0            |       |      |       | $ | 9.2 |   |   | $ | 26.2 |   |
| Less:                              |       |                    |       |            |       |      |       |   |   |   |   |
| Accumulated  amortization          |       |                    | 16.5       |            |       |      | 4.9        |   |   | 21.4 |   |
| Book value at  March 31, 2006 |       |                    | $          | 0.5             |       |      |       | $ | 4.3 |   |   | $ | 4.8 |   |

 

Theanticipated remaining amortization schedule for these assets is as follows (inmillions):

| **Year** | ** ** | ** ** | ** ** | **Current  Technology** | ** ** | **Brand  Name** | ** ** | **Total  Amortization** | ** ** |
|----------|------------|------------|------------|-------------------------|------------|-----------------|------------|-------------------------|------------|
| 2007     |       |       | 0.3        |                    |       |            | 0.9        |                    |       |   | 1.2 |   |   |
| 2008     |       |       | 0.1        |                    |       |            | 0.8        |                    |       |   | 0.9 |   |   |
| 2009     |       |       | 0.1        |                    |       |            | 0.8        |                    |       |   | 0.9 |   |   |
| 2010     |       |       | —     |                    |       |            | 0.7        |                    |       |   | 0.7 |   |   |
| 2011     |       |       | —     |                    |       |            | 0.7        |                    |       |   | 0.7 |   |   |
| 2012     |       |       | 0.4        |                    |       |            | 0.4        |                    |       |   |   |   |   |
| Total    |       |       | $          | 0.5                     |       |            |       | $                       | 4.3        |   |   |   | $ | 4.8 |   |   |
|          |            |            |            |                         |            |                 |            |                         |            |  |  |  |  |  |  |  |  |  |

 

The amortization expensefor intangible assets recorded in 2006 was $1.9 million as compared to$4.2 million recorded in 2004. The amortization was recorded consistentwith the schedules and amounts determined at May, 2002.

***Other Expense***

Other expense was $0.1million in 2006 as compared to none in 2004. Other expense includes income orloss on the sale of securities, currency translation gains and losses and othermiscellaneous items.

***Interest Expense***

There was no interestexpense in 2006, as compared to $0.2 million in 2004. During 2004, our interestexpense was associated with debt outstanding on our revolving line of credit.The outstanding debt was repaid in 2004 and the facility expired on May 13,2005.

***Income Taxes***

Our provision for incometaxes during the twelve months ended March 31, 2006, and the year ended December 31,2004 reflects the estimated income tax rate for the year, including foreignincome taxes for the jurisdictions in which our business was profitable as wellas foreign withholding taxes and state minimum taxes. Additionally, theprovision includes non-cash amortization of deferred charges associated withthe Company’s legal entity structure. In accordance with fresh start reporting,future reductions in our valuation allowance will be recorded as a reduction tofresh-start goodwill. In addition, net deferred tax assets will only berecognized to the extent of deferred tax liabilities until such time as therealization of deferred tax assets becomes more likely than not.

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***Year Ended December 31, 2004 and Year Ended December 31,2003***

***Net Sales***

Net sales were $95.6 million in 2004, as compared tonet sales of $103.6 million in 2003. Excluding foundry services, net sales forour base business was $92.0 million for 2004, as compared to $92.5 million in2003.

Net sales of our other devices totaled $23.7 millionin 2004 as compared to $24.5 million in 2003. This decrease primarily reflectsa $0.9 million decrease in net sales of our television and peripheral products.The television and peripheral products were de-emphasized prior to 2001 andhave continued a steady decline as customers have migrated away from 8-bitanalog devices to alternative solutions.

Net sales from our foundryservices in 2004 were $3.6 million as compared to $11.1 million in 2003. Asstated previously, subsequent to the closure of our MOD II manufacturingfacility in Nampa, Idaho in July 2004, foundry sales have beeninsignificant.

***Gross Margin***

Gross margin as apercent of net sales was 45% in 2004, as compared to 47% in 2003. Our grossmargin in 2004 includes the impact of lower margins on our embedded flashproducts as well as a $2.5 million charge primarily related to excessinventories built in support of the closure of our MOD II manufacturingfacility. Details of these items are discussed below:

·       Ourembedded flash products were beginning the process of converting from designwin to sales. They were at volume levels that require higher purchased costs ofthe wafers from our suppliers which reduced our overall gross margins. In 2004we experienced the impact of higher wafer cost until we significantly increasedour production volume. Additionally, we have programs in development whichshould allow us to reduce the size of certain of these products and lower theoverall cost; and

·       $2.5 million in chargesprimarily associated with the reserve of certain inventory items built in ourMOD II wafer manufacturing facility prior to its closure in July, 2004 andtransfer of the production to our new wafer fab supplier, X-FAB in Lubbock,Texas. Inventories were built based on anticipated customer needs and wereestimated using historical run rates and judgments based on inputs andexpectations. The inventory builds were to protect our customers anddistributors from shortages of product during the transitional period. Thesereserves were recorded to reflect excess inventory over the anticipated needsin periods subsequent to December 31, 2003 and were based on anticipateddemand estimates for these products.

***Research and Development Expenses***

Research and developmentexpenses were $20.9 million in 2004, as compared to $18.0 million in 2003. Ourresearch and development efforts in both years were, and continue to be,primarily directed towards development of core micrologic devices andassociated design tool development, including our Z8 Encore! and eZ80Acclaim!families of 8-bit embedded-flash micrologic devices and our Crimzonconsumer solutions family of products focused on the Universal remote controlmarket. During 2004, we announced the opening of our China design center inShanghai to allow us to more closely align to the growing Asian region and therapidly growing China market. We also expanded our software development groupin Bangalore, India to support our growing product portfolio especially for ourremote control products. Additionally, we transferred our engineering groupsfrom Nampa, Idaho to a new technology center in Meridian, Idaho.

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***Selling, General and Administrative Expenses***

Selling, general andadministrative expenses were $29.6 million in 2004 as compared to $27.6 millionin 2003. The higher SG&A expenses in 2004 reflect the higher marketingcosts associated with new products and their market introductions, as well asthe incremental costs of compliance with Sarbanes-Oxley requirements.

***Special Charges and Reorganization Items***

***2004 Activities***

On April 16, 2004, we announced the closure ofour MOD II five-inch wafer manufacturing facility in Nampa, Idaho and therelated transfer of MOD II production activities to our foundry partner, X-Fab,in Lubbock, Texas. MOD II ceased production operations on July 9, 2004. Asa result, in 2004, we incurred $1.8 million employee termination costs relatedto the termination of 144 employees, and sustaining costs for post-closuremaintenance of the MOD II facility and preparation to sell the equipment.Additionally, MOD III sustaining costs for post-closure maintenance incurred byus in 2004 totaled $1.7 million, which was offset in the consolidated statementof operations by approximately $4.9 million reimbursement for sustaining costsincurred since 2002 from the sale of the MOD III equipment toSTMicroelectronics in July, 2004.

As a result of theclosure of MOD II, in 2004 we incurred the following special charges:

·       employeeseverance and termination costs of $1.8 million.

·       anasset impairment charge of $5.4 million related to the write-down of the MOD IIlong-lived assets.

·       anet gain on sale of assets of $1.7 million related to the subsequent sale ofthe MOD II wafer manufacturing equipment (and related assets) toSTMicroelectronics in fourth quarter of 2004; and

·       MODII costs of $3.2 million related to closure and maintenance of the facility.

The costs for MOD II and MOD III consist of utilities,taxes, insurance, and other maintenance costs required to maintain thefacilities in a condition required for the sale of the respective properties.

Approximately $0.1 millionof special charges during the year relate to third-party professional legalservice fees associated with our debt and equity restructuring of May 2002,and $0.3 million severance and termination benefits related to our continuedefforts to align infrastructure costs to business-level requirements.

***2003 Activities***

Special charges in 2003totaled $3.8 million and the primary components of these special charges were$1.5 million of employee severance and termination benefits related to thetermination of employees, $1.3 million of MOD III closure costs andprofessional fees of $0.6 million in connection with ongoing bankruptcy relatedcourt matters and our Securities and Exchange Commission S-1 registrationstatement for the registration of certain common stock required by our May 2002reorganization plan, which became effective in July 2003. The employeeseverance and termination benefits primarily relate to the elimination ofcertain manufacturing positions at our MOD II wafer fabrication facility andour Manila, Philippines test facility that took place in February and September 2003,respectively. The $1.3 million of MOD III closure costs were ongoing costs forthe maintenance of the idled MOD III eight-inch wafer manufacturing facility inNampa, Idaho. We also had long-lived asset impairments of $0.2 million and anequity investment impairment of $0.2 million.

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***Stock-Based Compensation***

During 2004 and 2003, werecognized, $2.0 million and $1.5 million of stock-based compensation expense,respectively, primarily in connection with the award of restricted stock andstock options to certain executives, employees and consultants at exerciseprices below their deemed fair market value for accounting purposes on thedates of award. This non-cash stock-based compensation expense is primarilyincluded in our selling, general and administrative expenses. Compensationexpense for employee stock awards was measured on the award date and will berecognized over each of the next two years as these awards vest. Based on theemployee restricted stock and option awards we made during May 2002, andcancellation of restricted stock and issuance of in the money options to Mr. Thorburnin 2004.

***Amortization of Intangible Assets***

Effective January 1,2002, we adopted the provisions of FASB Statement of Financial AccountingStandards No. 142, “Goodwill and Other Intangible Assets” (“FAS 142”).Under FAS 142, goodwill and intangible assets with indefinite lives are notamortized, but are reviewed annually or more frequently if impairmentindicators arise. Separable intangible assets that are deemed to have definedlives will continue to be amortized over their useful lives. In connection withour fresh-start reporting, separable intangible assets based on independentvaluations were created with deemed defined lives. These intangible assets arebeing amortized utilizing the pattern-of-use method over their estimated usefullives of 3 to 7 years for current technology and ten years for brand name. Weevaluate existing technology and brand name whenever events and circumstancesindicate that their fair value may be less than their carrying value.Additionally, goodwill is tested for impairment at least annually and moreoften if events and circumstances indicate that its fair value may be less thanits carrying value. We performed the annual impairment test for goodwill in thequarter ended September 30, 2004 and 2003 and no impairment charge wasrecorded as no impairment of the carrying value was indicated. We plan toperform this test in the third quarter of each year unless the existence oftriggering events indicates that an earlier review should be performed.

***Other Expense***

There was no other expensein 2004 as compared to $0.5 million in other income in 2003. Other incomeexpense includes income or loss on the sale of securities, currency translationgains and losses and other miscellaneous items.

***Interest Expense***

Interest expense was $0.2million in 2004, as compared to $0.4 million in 2003. During 2004, and 2003,our interest expense was associated with the outstanding debt on our revolvingline of credit.

***Income Taxes***

Our provision for incometaxes in 2004 and 2003 reflects the estimated income tax rate for the year,including foreign income taxes for the jurisdictions in which our business was profitableas well as foreign withholding taxes and state minimum taxes. In connectionwith the May 2002 reorganization plan, the subsequent cancellation of debtand issuance of new common shares to primarily new stockholders, we generatedsignificant income for book and tax purposes. This taxable income was offset bythe use of all available net operating losses, both current and carryforwardwith any remaining taxable income offset by reducing the tax attributes ofcertain of our non-current assets. Subsequent to the financial restructuring inMay 2002, we completed in 2003, a tax reorganization of our worldwidelegal entities.

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***Three Month Transition Period Ended March 31,2005 and Three Months Ended March 31, 2004***

***Net Sales***

Net sales were $20.2 million for the three monthsended March 31, 2005, as compared to $26.0 million for the same period of2004.

Net sales of our Micrologic devices decreased to $14.8million for the three months ended March 31, 2005 compared to $19.5million for the three months ended March 31, 2004. Our new embedded flashsales increased to $1.1 million for the three months ended March 31, 2005as compared to $0.4 million for the three months ended March 31, 2004. Theincreases in our flash sales were offset by declines in our non-flashmicrologic business of 28%. The decline in the non-flash micrologic productsreflects lower sales in our IR remote-control business, reflecting lower demandin the Satellite TV market, and reduced sales of our Z8 products, reflectingslower sales in the consumer and security markets and generally slower economicconditions.

Net sales of our other devices, which excludes Foundrysales, for the three months ended March 31, 2005, declined $0.9 million or14% to $5.4 million compared to $6.3 million for the same period of 2004. Thedecrease in net sales of other devices during the three months ended March 31,2005 compared to the three months ended March 31, 2004 reflects a decreasein sales of our Serial Communications Controllers and IRDA devices primarily tothe communications market offset by an increase in sales of our modem devices.

We had no sales related tofoundry services for the three months ended March 31, 2005, compared to$0.2 million for the same period of 2004 as we effectively exited this businesswhen we closed our MOD II 5-inch wafer manufacturing facility in July 2004and transferred production to our foundry supplier X-fab. This was the finalstage of our migration to a fully fab-less manufacturing model.

***Gross Margin***

Cost of sales primarilyrepresents manufacturing costs relating to wafer fabrication, package assemblyand product testing operations. Cost of sales fluctuates, depending onmaterials and services prices from our vendors, manufacturing productivity,product mix, equipment utilization and depreciation. Gross margin as a percentof net sales was 38% for the three months ended March 31, 2005, down fromgross margin of 52% for the same period of 2004. During the three months ended March 31,2005, our gross margin was materially adversely impacted by increased sales oflower margin modem devices, $0.3 million of product transfer costs associatedwith the closure of our MOD II wafer fab and under utilization of our testoperations as we lowered our production volumes and reduced our inventorylevels.

***Research and Development Expenses***

Research and developmentexpenses were $5.2 million for the three months ended March 31, 2005,reflecting a 2% increase from the $5.1 million in research and developmentexpenses reported for the three months ended March 31, 2004. Research anddevelopment spending reflected continued investments in new products, includingour latest line of Flash-based Microcontrollers, the Z8Encore!XPTM, IR remotecontrol and general purpose Microcontrollers. We have also invested heavily toadd peripheral features to our Z8Encore! and eZ80Acclaim! product lines as wellas new devices and software features for our Crimzon line of consumer solutionproducts.

***Selling, General and Administrative Expenses***

Selling, general andadministrative expenses increased to $7.4 million for the three months ended March 31,2005 from $6.8 million for the three months ended March 31, 2004. Theincrease in our selling, general and administrative spending reflects theimpact of additional expenses of approximately 

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$1.0 millionassociated with Sarbanes-Oxley compliance activities offset by reductions inspending including lower commissions on lower sales, lower payroll costsreflecting lower headcount, and lower program costs.

***Special Charges and Reorganization Items***

Specialcharges for each period indicated were as follows (in millions):

| ** **                                                              | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                              | ** ** | **March 31,  2005**         | ** ** | **March 31,  2004** | ** ** |
| **Restructuring of operations:**                                        |       |                             |       |   |   |   |   |   |   |
| Employee severance and termination benefits                             |       |                             | $          | — |   |   |   | $ | 0.1 |   |   |
| MOD II sustaining costs for post closure maintenance                    |       |                             | 0.3        |   |   |   | — |   |   |
| MOD III sustaining costs for post closure  maintenance, net of recovery |       |                             | 0.1        |   |   |   | 0.3 |   |   |
| Other                                                                   |       |                             | —     |   |   |   | 0.1 |   |   |
|                                                                    |       |                             | $          | 0.4 |   |   |   | $ | 0.5 |   |   |

 

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Thefollowing table summarizes activity in accrued special charges (in millions):

| ** **                              | ** ** | **Total**  | ** ** | **Severance  and   Termination  Benefits** | ** ** | **MOD II  Closure Costs** | ** ** |
|-----------------------------------------|------------|------------|------------|-------------------------------------------------|------------|-------------------------------------|------------|
| Balance at  December 31, 2004      |       | $ 1.0 |       |                                            | $ 0.3 |                                |       |   | $ 0.7 |   |   |
| Cash paid before  MOD III reimbursement |       | (0.6       | )          |                                            | (0.2       | )                                   |       |   | (0.4 | ) |   |
| Balance at  March 31, 2005         |       | $ 0.4 |       |                                            | $ 0.1 |                                |       |   | $ 0.3 |   |   |

 

During the three monthtransition period ended March 31, 2005, special charges totaled $0.4 million,comprised of $0.3 million and $0.1 million associated with sustainingcosts of our MOD II and MOD III wafer fabs. During the three months ended March 31,2004, we sold certain assets of MOD II totaling $0.1 million which wererecorded through special charges and certain assets of MOD III totaling $0.1 million,the recovery of which was recorded as an offset to the maintenance costs of thefacility.

***Stock-Based Compensation***

During the three monthsended March 31, 2005 and March 31, 2004, we recognized $0.3 millionand $0.4 million of stock-based compensation, respectively, in connection withthe award of restricted stock and stock options to certain executives,employees and consultants. Compensation expense for employee stock awards aremeasured on the award date and are recognized as these restrictions lapse. Chargesfor stock awards to consultants is measured as the awards vest and arerecognized over the periods that the restrictions lapse.

***Goodwill and Intangible Assets***

Amortization expense forintangible assets recorded in the three months ended March 31, 2005 was$0.6 million as compared to $1.1 million for the three months ended March 31,2004. The amortization was recorded consistent with the schedules and amountsdetermined at May, 2002.

***Income Taxes***

Our income tax provisionfor the three months ended March 31, 2005 reflects amortization ofdeferred tax charges and tax expense in its profitable foreign jurisdictions.Our income tax benefit for the quarter ended March 31, 2004 reflected ouranticipated effective tax rate for the entire year of 2004. Additionally, ourtax provision for the three months ended March 31, 2004 included taxableincome in the U.S. resulting from items that were expensed for book purposesbut were nondeductible for tax including amortization of intangible assets.

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**Quarterly Results(Unaudited)**

Thefollowing table presents unaudited quarterly financial information for each ofthe quarters in the eight-quarter period ended March 31, 2006, with theexception of the audited three month transition period ended March 31,2005. The Company’s fiscal year-end is March 31 effective with thereporting date of March 31, 2005, with interim results based on fiscalquarters of thirteen weeks of duration ending on the last Saturday of eachquarter. For financial reporting purposes and ease of reference, interim fiscalperiods are labeled as ending on calendar-month end.

| ** **                                        | ** ** | **For the Quarters Ended** | ** **   |
|---------------------------------------------------|------------|-------------------------------------------|--------------|
| ** **                                        | ** ** | **Mar. 31,  2006**                   | ** **   | **Dec. 31,  2005** | ** ** | **Sep. 30,  2005** | ** ** | **Jun. 30,  2005** | ** ** | **Mar. 31,  2005** | ** ** | **Dec. 31,  2004** | ** ** | **Sep. 30,  2004** | ** ** | **Jun. 30,  2004** | ** ** |
| ** **                                        | ** ** | **(In millions)**                    | ** **   |
| Net sales                                         |       |                                      | $ 20.1  |   |   |   | $ 17.6 |   |   |   | $ 20.5 |   |   |   | $ 20.6 |   |   |   | $ 20.2 |   |   |   | $ 18.9 |   |   |   | $ 22.8 |   |   |   | $ 27.9 |   |   |
| Cost of sales                                     |       |                                      | 11.3         |   |   |   | 9.7 |   |   |   | 12.4 |   |   |   | 12.0 |   |   |   | 12.5 |   |   |   | 13.0 |   |   |   | 12.4 |   |   |   | 14.2 |   |   |
| Gross margin                                      |       |                                      | 8.8          |   |   |   | 7.9 |   |   |   | 8.1 |   |   |   | 8.6 |   |   |   | 7.7 |   |   |   | 5.9 |   |   |   | 10.4 |   |   |   | 13.7 |   |   |
| Gross margin as a percentage of net sales    |       |                                      | 44           | % |   |   | 45 | % |   |   | 40 | % |   |   | 42 | % |   |   | 38 | % |   |   | 31 | % |   |   | 46 | % |   |   | 49 | % |   |
| Operating  Expenses:                              |       |                                      |         |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Research and development                          |       |                                      | 5.0          |   |   |   | 5.2 |   |   |   | 5.6 |   |   |   | 5.2 |   |   |   | 5.2 |   |   |   | 5.4 |   |   |   | 5.2 |   |   |   | 5.3 |   |   |
| Selling, general and administrative               |       |                                      | 6.0          |   |   |   | 5.0 |   |   |   | 5.6 |   |   |   | 7.1 |   |   |   | 7.4 |   |   |   | 7.8 |   |   |   | 7.2 |   |   |   | 7.7 |   |   |
| Special charges and  reorganization items    |       |                                      | (0.1         | ) |   |   | 0.3 |   |   |   | 0.7 |   |   |   | 1.5 |   |   |   | 0.4 |   |   |   | (0.4 | ) |   |   | (1.9 | ) |   |   | 7.7 |   |   |
| Amortization of intangible assets                 |       |                                      | 0.3          |   |   |   | 0.6 |   |   |   | 0.5 |   |   |   | 0.5 |   |   |   | 0.6 |   |   |   | 1.0 |   |   |   | 1.0 |   |   |   | 1.1 |   |   |
| Operating loss                                    |       |                                      | (2.4         | ) |   |   | (3.2 | ) |   |   | (4.3 | ) |   |   | (5.7 | ) |   |   | (5.9 | ) |   |   | (7.9 | ) |   |   | (1.1 | ) |   |   | (8.1 | ) |   |
| Other income  (expense):                          |       |                                      |         |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest income                                   |       |                                      | 0.2          |   |   |   | 0.2 |   |   |   | 0.2 |   |   |   | 0.2 |   |   |   | 0.2 |   |   |   | 0.1 |   |   |   | 0.1 |   |   |   | 0.1 |   |   |
| Interest expense                                  |       |                                      | —       |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | (0.1 | ) |   |   | (0.1 | ) |   |
| Other, net                                        |       |                                      | —       |   |   |   | (0.1 | ) |   |   | — |   |   |   | — |   |   |   | (0.1 | ) |   |   | 0.1 |   |   |   | — |   |   |   | — |   |   |
| Loss before provision (benefit) for income taxes  |       |                                      | (2.2         | ) |   |   | (3.1 | ) |   |   | (4.1 | ) |   |   | (5.5 | ) |   |   | (5.8 | ) |   |   | (7.7 | ) |   |   | (1.1 | ) |   |   | (8.1 | ) |   |
| Provision (benefit) for income taxes              |       |                                      | 0.6          |   |   |   | — |   |   |   | 0.7 |   |   |   | 0.6 |   |   |   | 0.8 |   |   |   | 1.6 |   |   |   | 0.9 |   |   |   | (0.9 | ) |   |
| Net loss                                          |       |                                      | $ (2.8  | ) |   |   | $ (3.1 | ) |   |   | $ (4.8 | ) |   |   | $ (6.1 | ) |   |   | $ (6.6 | ) |   |   | $ (9.3 | ) |   |   | $ (2.0 | ) |   |   | $ (7.2 | ) |   |
| Net loss per share—basic &  diluted |       |                                      | $ (0.16 | ) |   |   | $ (0.19 | ) |   |   | $ (0.29 | ) |   |   | $ (0.38 | ) |   |   | $ (0.41 | ) |   |   | $ (0.57 | ) |   |   | $ (0.12 | ) |   |   | $ (0.44 | ) |   |

 

Our net sales declined in the September and December quartersin 2004 reflecting an overall decline in business activities and the end of ourfoundry business after closing our MOD II wafer facility in July 2004.

Overall, our gross margin as a percentage of net salesgenerally improved on a sequential quarterly basis from the quarter ended December 31,2004 through the quarter ended March 31, 2006. In quarter ended December 31,2004, we recorded a $1.9 million charge associated excess inventory stemmingprimarily from the bridge inventory builds prior to closing MOD II as well aslower margins on our embedded flash sales as we began to increase our sales ofthese new products. Gross margins on these flash products continue to improveas sales demand and volume increases allowing us to obtain lower wafer pricingfrom our suppliers.

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Our research and development expenses have remainedrelatively consistent since the June quarter of 2004 reflecting ourproduct development efforts on our new embedded flash-based microcontrollerdevices, our remote control devices and our new 32 bit ARM based products.Additionally, we have added a development design center in Shanghai, China forsupport of the growing Asian market, which was opened in September 2004and we have expanded our Bangalore, India software development center for theincreased needs of our growing remote control product portfolio. Also, in June 2004,we opened a new technology development center in Meridian, Idaho to support ourdesign capabilities and our wafer fabrication sourcing strategies.

Our selling, general and administrative expenses weregenerally lower during the quarterly periods of 2006 as compared with 2005 and2004 levels primarily due to savings from cost reduction programs to reduceheadcount in our sales and marketing support functions, as well as savings fromthe transition and consolidation of certain administrative functions in ourPhilippines operations. These savings were partially offset by costs to supportSarbanes-Oxley activities and incremental costs associated with the Microchiplawsuit as well as higher legal and administrative costs in the quarter ended June 30,2004 associated with implementation and administration of employee stock planssubsequent to our registered public offering.

Ourspecial charges for the eight quarterly periods ended March 31, 2006 aresummarized below:

| ** **                                           | ** ** | **For the Quarters Ended** | ** **  |
|------------------------------------------------------|------------|-------------------------------------------|-------------|
| ** **                                           | ** ** | **Mar. 31  2006**                    | ** **  | **Dec. 31,  2005** | ** ** | **Sep. 30,  2005** | ** ** | **Jun. 30,  2005** | ** ** | **Mar 31,  2005** | ** ** | **Dec. 31  2004** | ** ** | **Sep. 30,  2004** | ** ** | **Jun. 30,  2004** | ** ** |
| **Asset impairments:**                               | ** ** |                                      | ** **  | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| MOD II assets write-down, net                        |       |                                      | $ 0.5  |   |   |   | $ — | ** ** |   |   | $ — | ** ** |   |   | $  — |   |   |   | $ — | ** ** |   |   | $ (1.7 | ) |   |   | $  — |   |   |   | $ 5.4 | ** ** |   |
| **Restructuring of operations:**                     | ** ** |                                      | ** **  | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Employee severance and termination benefits, other   |       |                                      | 0.1         |   |   |   | 0.1 | ** ** |   |   | 0.5 | ** ** |   |   | 1.1 |   |   |   | — | ** ** |   |   | 0.2 |   |   |   | — |   |   |   | — | ** ** |   |
| MOD II employee severance and termination benefits   |       |                                      | —      |   |   |   | — | ** ** |   |   | — | ** ** |   |   | — |   |   |   | — | ** ** |   |   | — |   |   |   | — |   |   |   | 1.8 | ** ** |   |
| MOD II sustaining cost for post-closure maintenance  |       |                                      | 0.1         |   |   |   | 0.1 | ** ** |   |   | 0.1 | ** ** |   |   | 0.3 |   |   |   | 0.3 | ** ** |   |   | 0.8 |   |   |   | 2.3 |   |   |   | 0.1 | ** ** |   |
| MOD III sustaining cost for post-closure maintenance |       |                                      | —      |   |   |   | 0.1 | ** ** |   |   | 0.1 | ** ** |   |   | 0.2 |   |   |   | 0.1 | ** ** |   |   | 0.4 |   |   |   | 0.6 |   |   |   | 0.4 | ** ** |   |
| MOD III reimbursement of maintenance costs           |       |                                      | (0.7        | ) |   |   | — | ** ** |   |   | — | ** ** |   |   | — |   |   |   | — | ** ** |   |   | (0.1 | ) |   |   | (4.8 | ) |   |   | — | ** ** |   |
| **Professional  fees for debt restructuring**        |       |                                      | (0.1        | ) |   |   | — | ** ** |   |   | — | ** ** |   |   | (0.1 | ) |   |   | — | ** ** |   |   | — |   |   |   | — |   |   |   | — | ** ** |   |
| **Total**                                            |       |                                      | $ (0.1 | ) |   |   | $ 0.3 | ** ** |   |   | $ 0.7 | ** ** |   |   | $ 1.5 |   |   |   | $ 0.4 | ** ** |   |   | $ (0.4 | ) |   |   | $ (1.9 | ) |   |   | $ 7.7 | ** ** |   |

 

As previously discussed,we have refocused our business around our 8 bit microcontroller productstrategy and moving to a fabless model for manufacturing. The special chargesover these periods have generally been aligned around this strategy.Additionally, we have continued to resize our support organizations to a lowersales base in an effort to scale down these organizations and focus theactivities around these strategies.

***Liquidity andCapital Resources***

We previously had athree-year $15.0 million senior secured revolving credit facility with acommercial lender which expired May 13, 2005 and was not renewed. Underthe facility, the borrowings bore interest at a rate per annum equal, at ouroption, to the commercial lender’s stated prime rate or LIBOR, plus 2.5%. Weelected the LIBOR interest rate option, which, as of December 31, 2004 was4.6%. As of December 31, 2004, we had no outstanding borrowings under thefacility and had issued standby letters of credit of $0.2 million.

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At March 31, 2006, wehad cash and cash equivalents of $27 million, compared to $37.7 millionat December 31, 2004 and $33.6 million at March 31, 2005. Cashand cash equivalents consist primarily of cash in bank accounts and moneymarket accounts.

***Cash flows fromoperating activities***

During fiscal 2006, cashused by operating activities of $6.4 million primarily reflects our netloss of $16.8 million offset by non-cash charges of $7.6 million andcertain net asset and liability changes of $2.8 million. Non-cash chargesinclude increases related to amortization of fresh start intangibles of $1.9 million,$2.6 million in depreciation and other amortization charges, goodwilladjustments of $1.9 million, stock-based amortization expense of $0.7 millionand an asset impairment charge on our remaining assets held for sale of $0.5 million.Reduction of inventories of $3.0 million, reduction of accounts receivableof $2.9 million, and a reduction of prepaid expenses and other current andnon-current assets of $2.1 million all provided cash from operatingactivities and were offset by decreases in accounts payable of $1.7 millionand accrued and other current and non-current liabilities of $3.6 million.

During 2004, cash used byoperating activities of $0.5 million primarily reflected our net loss of$18.5 million offset by net non-cash charges of  $11.5 million and certain net asset andliability changes totaling $6.5 million. Non-cash charges included $8.3 millionin goodwill adjustments, $4.2 million for amortization of fresh startintangible assets, $3.0 million in depreciation and other amortizationcharges, $5.6 million of asset impairments and loss on disposal of assets,and stock-based compensation expense of $2.0 million, offset by reductionsrelated to deferred income tax assets and liabilities of $9.9 million anda net gain on the sales of MOD II assets of $1.7 million. Reductions inaccounts receivable of $3.0 million, prepaid expenses of $2.8 million,  an increase in accounts payable of $3.7 millionand accrued and other liabilities of $0.9 million provided cash fromoperating activities in 2004 and were offset by a use of cash for the increaseof inventories of $2.5 million and reduction in deferred income onshipments to distributors of $1.4 million.

During the three monthsended March 31, 2005, our cash used by operating activities primarilyreflected the net loss of $6.6 million offset by non-cash charges of $1.5 millionand certain net asset and liability changes of $1.0 million. Non-cashcharges included amortization of intangible assets of $0.6 million,depreciation and other amortization of $0.6 million and $0.3 millionof stock-based compensation expenses. The reduction in inventories of $1.5 million,reduction of prepaid expenses and other current and non-current assets of $1.6 millionand an increase of $1.2 million in accrued and other current andnon-current liabilities all provided cash from operations and were offset by anincrease in accounts receivable of $2.5 million and a reduction ofaccounts payable of $0.8 million.

***Cash flows frominvesting activities***

Cash used by investingactivities in fiscal 2006 of $0.3 million, reflects capital expendituresof $4.2 million and  reimbursementof MOD III sustaining costs of $0.7 million offset by the proceeds fromthe disposal MOD III assets and assets held for sale of $4.6 million. Thecapital expenditures primarily reflect the addition of test capacity driven byincreased demand of our new flash based products and software purchases relatedto the upgrade of manufacturing software and hardware and software related tocontinued research and development investments.

Cash used by investing activitiesin 2004 reflected the proceeds from the disposal of MODII assets of $5.9 millionoffset by capital expenditures of $4.4 million. In 2004, capitalexpenditures reflected software purchases for our expanding research anddevelopment group and included design circuit software support.

Cash used by investingactivities was $0.2 million and $0.7 million for the three monthperiods ended March 31, 2005 and 2004, respectively. Cash used forinvesting activities in both of these periods reflects capital expenditures forbuilding improvements, software and equipment. Cash used by investingactivities 

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duringthe three month transition period ended March 31, 2005, also includes thecash received from the sale of MOD II assets.

***Cash flows fromfinancing activities***

Cash provided by financingactivities was $0.1 million in fiscal 2006 as compared to cash provided of$14.7 million in 2004 and $0.2 million for the three months ended March 31,2005. Cash provided by financing activities in 2006 reflects cash used for thepurchases of common stock of $0.1 million offset by proceeds from thesales of common stock under employee stock purchase and stock option plans of$0.2 million.

Cash provided by financingactivities of $14.7 million in 2004 reflected the net proceeds from publicstock offerings of $24.4 million and from the sale of common stock underemployee stock purchase and stock option plans of $0.5 million offset bythe repayment of short-term debt related to the revolving credit facility of$5.0 million and purchases of common stock of $5.2 million.

Cash provided by financing activities of $0.2 millionin the three months ended March 31, 2005, reflected the proceeds from thesale of common stock under employee stock and stock option purchase plans.

**Off-Balance Sheet Arrangements**

**As of March 31, 2006, we arenot involved in any off-balance sheet arrangements, as defined inItem 3(a)(4)(ii) of SEC Regulation S-K.**

**Non-GAAP EBITDA Measure**

The EBITDA figurespresented below reflect a non-GAAP measure of our liquidity. EBITDA reflectsour net income adjusted for certain non-cash items, interest and income taxes.

Our EBITDA,reconciled to cash provided (used) by operations (the most directly comparablemeasure of liquidity under generally accepted accounting principles) for eachunaudited period presented, with the exception of the audited three monthtransition ended March 31, 2005,  isas follows (in millions):

| ** **                                                               | ** ** | **For the Quarters Ended** | ** **  |
|--------------------------------------------------------------------------|------------|-------------------------------------------|-------------|
| ** **                                                               | ** ** | **Mar. 31  2006**                    | ** **  | **Dec. 31,  2005** | ** ** | **Sep 30,  2005** | ** ** | **Jun. 30,  2005** | ** ** | **Mar 31,  2005** | ** ** | **Dec. 31  2004** | ** ** | **Sep. 30,  2004** | ** ** | **June 30,  2004** | ** ** |
| ** **                                                               | ** ** | **(in millions)**                    | ** **  |
| Reconciliation of net income (loss) to EBITDA:                           |       |                                      |        |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net loss                                                                 |       |                                      | $ (2.8 | ) |   |   | $ (3.1 | ) |   |   | $ (4.8 | ) |   |   | $ (6.1 | ) |   |   | $ (6.6 | ) |   |   | $ (9.3 | ) |   |   | $ (2.0 | ) |   |   | $ (7.2 | ) |   |
| Depreciation and  amortization                                           |       |                                      | 0.9         |   |   |   | 1.3 |   |   |   | 1.2 |   |   |   | 1.1 |   |   |   | 1.2 |   |   |   | 1.6 |   |   |   | 1.7 |   |   |   | 1.6 |   |   |
| Interest expense  (income), net                                          |       |                                      | (0.2        | ) |   |   | (0.2 | ) |   |   | (0.2 | ) |   |   | (0.2 | ) |   |   | (0.2 | ) |   |   | (0.1 | ) |   |   | — |   |   |   | — |   |   |
| Provision  (benefit) for income taxes                                    |       |                                      | 0.6         |   |   |   | — |   |   |   | 0.7 |   |   |   | 0.6 |   |   |   | 0.8 |   |   |   | 1.6 |   |   |   | 0.9 |   |   |   | (0.9 | ) |   |
| EBITDA                                                                   |       |                                      | $ (1.5 | ) |   |   | $ (2.0 | ) |   |   | $ (3.1 | ) |   |   | $ (4.6 | ) |   |   | $ (4.8 | ) |   |   | $ (6.2 | ) |   |   | $ 0.6 |   |   |   | $ (6.5 | ) |   |
| Reconciliation of EBITDA to net cash by operating  activities cash flow: |       |                                      |        |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| EBITDA                                                                   |       |                                      | $ (1.5 | ) |   |   | $ (2.0 | ) |   |   | $ (3.1 | ) |   |   | $ (4.6 | ) |   |   | $ (4.8 | ) |   |   | $ (6.2 | ) |   |   | $ 0.6 |   |   |   | $ (6.5 | ) |   |
| Interest income  (expense), net                                          |       |                                      | 0.2         |   |   |   | 0.2 |   |   |   | 0.2 |   |   |   | 0.2 |   |   |   | 0.2 |   |   |   | 0.1 |   |   |   | — |   |   |   | — |   |   |
| Benefit  (provision) for income taxes                                    |       |                                      | (0.6        | ) |   |   | — |   |   |   | (0.7 | ) |   |   | (0.6 | ) |   |   | (0.8 | ) |   |   | (1.6 | ) |   |   | (0.9 | ) |   |   | 0.9 |   |   |
| Goodwill  adjustment and liabilities                                     |       |                                      | 1.5         |   |   |   | 0.4 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Deferred income  tax assets and liabilities                              |       |                                      | —      |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 0.1 |   |   |   | (6.8 | ) |   |   | (2.5 | ) |   |
| Asset impairments                                                        |       |                                      | 0.5         |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 0.1 |   |   |   | 0.1 |   |   |   | 5.4 |   |   |
| Stock-based  compensation                                                |       |                                      | 0.1         |   |   |   | 0.1 |   |   |   | 0.1 |   |   |   | 0.4 |   |   |   | 0.3 |   |   |   | 0.5 |   |   |   | 0.5 |   |   |   | 0.6 |   |   |
| Net gain on sale  of MODII assets held for sale                          |       |                                      | —      |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | (1.7 | ) |   |   | — |   |   |   | — |   |   |
| Changes in  operating assets and liabilities                             |       |                                      | (0.9        | ) |   |   | (0.6 | ) |   |   | 1.2 |   |   |   | 3.1 |   |   |   | 1.0 |   |   |   | 1.8 |   |   |   | 17.1 |   |   |   | 0.1 |   |   |
| Net cash provided  (used) by operating activities                        |       |                                      | $ (0.7 | ) |   |   | $ (1.9 | ) |   |   | $ (2.3 | ) |   |   | $ (1.5 | ) |   |   | $ (4.1 | ) |   |   | $ (6.9 | ) |   |   | $ 10.6 |   |   |   | $ (2.0 | ) |   |

 

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Our expected cash needs for fiscal 2007 primarilyrepresent working capital and capital expenditures.

As of March 31, 2006we had no firm commitments for capital expenditures. We currently estimatefiscal 2007 capital expenditures will be approximately 3% - 4% of sales,primarily for test equipment, and internal use software. Decisions related tohow much cash is used for investing are influenced by the expected amount ofcash to be provided by operations. We currently anticipate that available cashand cash to be used by operating activities will be adequate to satisfy ourcash requirements for at least the next twelve months.

***Contractual Obligations***

We lease certain of our facilities and equipment undernon-cancelable operating leases, which expire in fiscal 2007 through fiscal2011. These facility lease agreements generally provide for base rental rateswhich increase at various times during the terms of the leases and also providefor renewal options at fair market rental value. We are also responsible forcommon area maintenance charges on certain office leases which are not includedin the table below. These charges are generally less than 10% of base rents.Total operating lease expense, including month-to-month rentals, wereapproximately $2.4 million, $2.6 million, and $2.7 million,respectively, for the fiscal years 2006, 2004 and 2003 and $0.6 millionand $0.7 million for the three months ended March 31, 2005 and 2004,respectively.

Wegenerally make purchases under cancelable purchase orders and do not enter intolong-term supply agreements. Certain of our wafer foundry, assembly, materialssuppliers, software vendors and support tool manufacturers requirenon-cancelable purchase orders since they often provide products and servicestailored to our specifications. Summarized in the table below are minimumfuture commitments under operating leases and non-cancelable purchaseobligations as of March 31, 2006 (in millions):

| ** **                   | ** ** | ** **  | ** ** | **Payment due by period** | ** ** |
|------------------------------|------------|-------------|------------|------------------------------------------|------------|
| ** **                   | ** ** | **Total**   | ** ** | **Within  1 year**                  | ** ** | **1-3  years** | ** ** | **3-5  years** | ** ** |
| Operating lease  obligations |       | $ 5.3  |       |                                     | $ 2.0 |   |   |   | $ 2.8 |   |   |   | $ 0.5 |   |   |
| Purchase  obligations        |       | 7.1         |       |                                     | 6.9        |   |   |   | 0.2 |   |   |   | — |   |   |
| Total                        |       | $ 12.4 |       |                                     | $ 8.9 |   |   |   | $ 3.0 |   |   |   | $ 0.5 |   |   |

 

From time to time we haveagreed to indemnify and hold harmless certain customers for potentialallegations of infringement of intellectual property rights and patents arisingfrom the use of our products. During the ordinary course of business, incertain limited circumstances, we have agreed to reimburse the indemnifiedparty for losses suffered or incurred by the indemnified party, generallyparties with which we have commercial relations, in connection with certainintellectual property infringement claims by any third party with respect toits products and services. We have indemnification arrangements that limit ournet contingent obligation to pay for defense costs, if any, up to a maximum of$500,000. To date, there have not been any costs incurred in connection withsuch indemnification arrangements; therefore, there is no accrual of suchamounts at March 31, 2006. We disclose indemnification liabilitiesaccording to FASB Staff Position FIN45-1, “Accounting for IntellectualProperty Infringement Indemnifications under FAS Interpretation No. 45.”Under FAS No. 5, “Loss Contingencies,” a claim would be accrued when aloss is probable and the amount can be reasonably estimated. At March 31,2006, no such amounts are accrued.

**Effects ofInflation and Changing Prices**

We believe that inflationand/or deflation had a minimal impact on our overall operations during theperiods presented in this report.

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**Seasonality**

Sales typically increasein the quarter ended June 30 and peak in the quarter endedSeptember 30 driven by increased holiday demand from our customers in thehome entertainment and consumer products markets. Our sales are generally lowerin the quarter ended March 31 and December 31 compared to theremainder of the fiscal year as was evident in the December quarter 2005and 2004. In 2004, our quarterly trend was significantly impacted by theclosure of our fab and the subsequent decline in foundry service sales as wellas general slowing economics in the second half of 2004.We believe that thishistorical seasonal trend could also be impacted on an ongoing basis by generaleconomic conditions and reduction in sales of our legacy and other productportfolios. Additionally, general world-wide economic, political and regionalinstabilities may impact our results of operations in any given period.

**Recent AccountingPronouncements**

In December 2004, the FASB issued SFASNo. 123R, “Share-Based Payment.” SFAS 123R requires employee stock optionsand rights to purchase shares under stock participation plans to be accountedfor under the fair value method, and eliminates the ability to account forthese instruments under the intrinsic value method prescribed by APB OpinionNo. 25, as allowed under the original provisions of SFAS No. 123.SFAS No. 123R requires the use of an option pricing model for estimatingfair value, which is amortized to expense over the service periods. Therequirements of SFAS No. 123R are effective for fiscal periods beginningafter June 15, 2005. SFAS No. 123R allows for either prospectiverecognition of compensation expense or retrospective recognition, which may beback to the original issuance of SFAS No. 123R or only to interim periodsin the year of adoption. We are currently evaluating these transition methodsand the potential impact on our consolidated financial statements.

In March 2005, theFASB issued FSP No. FIN 46(R)-5, “Implicit Variable Interests underFASB Interpretation No. 46 (revised December 2003).” FSP FIN 46(R)-5addresses whether a reporting enterprise should consider whether it holds animplicit interest in a variable interest entity or potential variable interestentity when specific conditions exist. The provisions of FSP FIN 46(R)-5are applicable for reporting periods beginning after March 3, 2005). Weadopted FIN 46R on January 1, 2004, which resulted in the de-consolidationof our subsidiary, ZiLOG MOD III, Inc. Subsequently a significant portionof the assets were sold and management received authorization from thestockholders of ZiLOG MOD III, Inc to sell the remaining assets withoutfurther stockholder approval and consequently the final results of ZiLOG MODIII, Inc. were included in our financial results.

**2002 FinancialRestructuring and Reorganization**

Prior to February 1998, our common stock had beenpublicly traded on the New York Stock Exchange under the symbol “ZLG.” On February 27,1998, we consummated a merger with an affiliate of Texas Pacific Group, and inconnection with that transaction, we issued $280.0 million of our former 91¤2%Senior Secured Notes due 2005, and we ceased having publicly traded equity.Since 2000, our business and financial growth had been negatively affected bythe extremely difficult business climate in which we have been operating. Weexplored a number of strategic alternatives with the assistance of ourfinancial advisor, Lazard Frères & Co., LLC, and an informal group ofholders of our senior notes who collectively held or managed approximately$165.0 million in principal amount of our senior notes.

During the course of discussions, we concluded thatthe best vehicle to achieve a restructuring of our senior notes was throughconsummation of a voluntary pre-packaged plan of reorganization under Chapter11 of the United States Bankruptcy Code. On January 28, 2002, we commencedsolicitation of acceptances of a joint plan of reorganization, which set fortha plan to reorganize our company and our subsidiary, ZiLOG-MOD III, Inc.

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We solicited acceptances of this joint plan from theholders of our senior notes and preferred stock. As permitted by bankruptcycourt rules, we did not solicit votes from holders of our old common stock. Inconnection with this solicitation, we entered into lock-up agreements withmembers of the informal group of our note holders. Under the lock-upagreements, the members of the informal group agreed, among other things andsubject to certain conditions, to vote to accept the plan of reorganization.

The voting period for the solicitation ended on February 26,2002. Holders of approximately $221.0 million of our senior notes acceptedthe plan of reorganization, and none rejected the plan. All of the holders ofour preferred stock who voted also accepted the plan of reorganization.

On February 28, 2002, we and our subsidiary,ZiLOG-MOD III, Inc., filed voluntary petitions with the United StatesBankruptcy Court for the Northern District of California for reorganizationunder Chapter 11. The bankruptcy court subsequently confirmed MOD III, Inc.’sand our joint reorganization plan by its order entered on April 30, 2002.The joint plan of reorganization became effective on May 13, 2002, but forfinancial reporting purposes we use May 1, 2002, as the date of emergencefrom bankruptcy. We refer to the company prior to emergence from bankruptcy asthe “Predecessor Company” and to the reorganized company as the “SuccessorCompany.”

Pursuant to the joint reorganization plan, weextinguished $325.7 million of liabilities, which included $280.0 millionprincipal amount of our former 91¤2% SeniorSecured Notes due 2005, $27.2 million in accrued interest due on the notesand $18.5 million of dividends payable on our former series A preferredstock. The former note holders received substantially all of our new commonstock and a liquidation preference in the net proceeds on the sale of theassets held by MOD III, Inc. The former equity holders received anaggregate $200,000 in cash. All debt and equity securities of the PredecessorCompany were cancelled. As a consequence of these events, the PredecessorCompany recorded a $205.7 million net gain on discharge of debt.

On May 1, 2002, we adopted “fresh-start”reporting prescribed by the American Institute of Certified Public Accountant’sStatement of Position 90-7, “Financial Reporting by Entities inReorganization Under the Bankruptcy Code,” or SOP 90-7. Fresh-startreporting was appropriate because our former note holders receivedsubstantially all of our new common stock and the reorganization value of theassets of the Successor Company were less than the total pre-petitionliabilities plus post-petition liabilities.

SOP 90-7 required us to establish areorganization value upon our adoption of fresh-start reporting. With theassistance of our independent financial advisor, Lazard Frères & Co.,LLC, we estimated our reorganization value derived from a weighted average ofthree separate valuation methodologies; the first based on a comparable publiccompany analysis, the second based on precedent transaction analysis and thethird based on discounted cash flow analysis. These valuations indicated arange of reorganization values between $70 million and $109 million,based on the underlying assumptions and limitations set forth in theiranalysis.

These assumptions include: the successfulreorganization of our business and finances in a timely manner; theimplementation of our business plan as a reorganized entity; the accuracy ofinformation supplied by management about our business and our prospects;achievement of forecasted projections; market conditions as of December 31,2001 continuing through an assumed effective date of March 31, 2002; andthe plan of reorganization becoming effective in accordance with the estimatesand assumptions upon which the valuation was based. In agreement with theinformal committee of note holders, and with the approval of the bankruptcycourt, we established a reorganization equity value of $90.0 million as ofMay 1, 2002 for purposes of applying fresh-start reporting. Theprojections we and our advisors used for estimating the Company’sreorganization value were made as of May 13, 2002 and were based on anadjusted EBITDA measure of liquidity (see Liquidity and Capital Resourcessection). For the year ended December 31, 2002, our adjusted EBITDAexceeded the projections we and our advisors used to determine therecapitalization value of the Successor Company. For the years ended December 31,2003 

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and 2004 our adjustedEBITDA was less than the amounts projected in determining our recapitalizationvalue. Overall, we believe that our projections of future results used indetermining our recapitalization value were reasonable based on informationavailable at the time.

Fresh-start reporting requires that we also record ourassets at fair value upon adoption. Consequently, we engaged Key Assets asindependent appraisers to assist management in valuation of our tangible assetsand we engaged another independent appraisal firm to determine the fair value ofour intangible assets and inventories. Key Assets was selected for the MOD IIappraisal based on their expertise as resellers and appraisers of usedsemiconductor manufacturing equipment. The Key Assets appraisal resulted in a$13.1 million increase in property, plant and equipment related to ourfive-inch wafer fabrication facility. The valuation undertaken by Key Assetsfor fresh-start reporting included a physical inspection of the assets andassigned fair value to property, plant and equipment in Nampa, Idaho related toour five-inch wafer fabrication facility (MOD II) and our data center, as wellas an adjacent 20 acre parcel of undeveloped land assuming a willing buyerand a willing seller and not under distressed sale conditions. Fair value wasdetermined based on the current replacement cost for similar wafer fabricationcapacity, considering the age, condition and other pertinent factors of the MODII assets. Replacement cost was determined for most of the MOD II assets basedon a market approach and considering such factors as recent sales prices forsimilar used equipment, dealer listings, and interviews with dealers whospecialize in the sale of used semiconductor manufacturing equipment. For thosepieces of equipment where a used-asset market does not exist, replacement costwas estimated based on the new asset cost, less estimated accumulateddepreciation to reflect physical deterioration, functional obsolescence andeconomic obsolescence.

Although MOD II representsa unique group of assets that would only have utility to a select number ofsemiconductor manufacturing companies, we believed that MOD II could have beensold for the fair market value as determined by the Key Assets appraisal.Previously, our five-inch wafer fabrication facility had been separately heldfor sale at a negotiated selling price of $3.0 million, based on anon-binding purchase offer received from a potential buyer in December 2000.Management agreed to the terms of the December 2000 purchase offer forseveral reasons including: monetary and human cost savings compared withclosing and decommissioning the facility, as well as terminating the employees;and the acquirer was also willing to assure an uninterrupted source of supplyof wafers manufactured in the MOD II facility until alternative sources couldbe qualified. Following a change in strategy, the MOD II assets were put backinto service in June 2001. In June 2001, management determined thatthe fair value of the MOD II assets was $3.0 million. We did not obtain anindependent appraisal of MOD II in June of 2001, but determined that thefair value of MOD II had not changed materially during the six-month periodbetween the non-binding purchase offer received in December 2000 and thedecision to place MOD II back into service in June of 2001. This decisionwas made after consideration of the shift in our strategy to refocus on ourcore 8-bit micrologic business developed under the leadership of our newchief executive officer, as well as financial difficulties the Company wasexperiencing at the time, and the relatively short period of time betweenreceiving the non-binding purchase offer and our decision to place MOD II backinto service.

Theappraisal process also resulted in a $3.9 million increase in inventoriesheld by us and our distributors to reflect fair value at May 1, 2002. Wealso identified several separable intangible assets that were valued andrecorded as part of our fresh-start reporting as follows (in millions):

| Existing  technology                 |   | $17.0 |   |
|--------------------------------------|--------|-------|--------|
| In-process research  and development |   | 18.7  |   |
| Brand name                           |   | 9.2   |   |
| Total separable  intangible assets   |   | $44.9 |   |

 

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We recorded a gain of $83.7 million in thePredecessor Company’s financial statements in connection with the fresh-startadjustments referred to above. Additionally, we recorded goodwill, with anindefinite life, in the aggregate amount of $26.7 million.

The in-process research and development was expensedon May 1, 2002. The inventory was amortized over two months consistentwith the turnover of our inventory. The brand name and existing technology wasamortized using the pattern-of-use method consistent with underlying discountedcash flows supporting the assets. The goodwill was not amortized but is subjectto ongoing impairment reviews consistent with Statement of Financial AccountingStandards No. 142, “Goodwill and Other Intangible Assets.” See the sectionentitled “Recent Accounting Pronouncements” below for more information on SFAS No. 142.

With the assistance of professional appraisers, ourcurrent technology was valued using the “Income Approach.” Under the IncomeApproach, fair value reflects the present value of the projected cash flowsthat are expected to be generated by the products incorporating the currenttechnology. The projected revenues and expenses used in the Income Approach arebased upon what our management expects the technology to generate over the lifeof its products. The cash flows earned by the products represent a return onall of the assets purchased with the technology and employed in the generationof those cash flows, including tangible assets as well as identifiableintangible assets. The total return earned by the products must provide areturn on each acquired asset that is consistent with the value and the relativerisk of that asset. To separately value the current technology, the value andrequired rate of return for other identifiable assets must be determined. Therequired returns on these other assets are “charged to” (deducted from) thecash flow in the model to determine the returns specifically earned by thecurrent technology. The residual return is earned by the technology. As part ofthis analysis, we determined individual rates of return applicable to eachfresh-start assets or asset classes, and estimated the effective “capitalcharge” to be applied to the cash flows generated by the acquired currenttechnology. Capital charges were made for returns related to the following:current assets of 6%; fixed assets of 10%; and workforce-in-place of 15%.

We believe that theZiLOG trade name is well known within the semiconductor industry and that wewill realize economic benefit from the name and it is considered separable inaccordance with SFAS 141. Our appraisers utilized the Relief from Royalty, orRFR, approach in the valuation of the ZiLOG trade name. To determine theappropriate royalty rate, we:

·       consideredprevailing rates for similar properties; and

·       reliedon the experience of our professional appraisers.

The analysis indicated an appropriate pre-tax royaltyrate of 1.5%. The avoided royalty cost was determined by applying this rate,adjusted for tax affects, to the Company’s expected revenue. Therefore, theroyalty rate was applied to five years of management’s revenue forecasts. Theavoided royalty costs were discounted to find the present value of avoided cashflows from royalties. In identifying the discount rate to be used to calculatethe present value of the avoided royalties we considered the variability of theprojected royalties. We applied a discount rate of 20% to the projectedroyalties.

As with the current technology, our appraisers used anIncome Approach to value in-process research and development, or IPR&D.Under the income approach, fair value reflects the present value of the projectedfree cash flows that will be generated by the products, incorporating thetechnologies under development, assuming they will be successfully completed.The projected revenues used in the income approach are based upon the revenuesexpected to be generated upon completion of the projects and the beginning ofcommercial sales, as estimated by ZiLOG’s management. The projections assumedthat the technologies would be successful, and that the product’s developmentand commercialization will meet management’s time schedule. As with currenttechnology, the cash flows generated by the IPR&D 

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technologies represent areturn on all of the assets purchased with the technologies and employed in thegeneration of those cash flows, including tangible as well as identifiableintangible assets. The total return earned by the new technologies must providea return on each asset purchased that is consistent with the value and therelative risk of that asset. The returns required by each asset have been shownpreviously in “Current Technology,” which is a separable intangible assetincluded in the consolidated balance sheet. We determined the applicablediscount rates to be used in the valuation of the in-process technologies basedon the risks of an investment in ZiLOG. The discount rate applicable to ZiLOGas a whole is not necessarily the rate that is applicable to the currenttechnology or to the IPR&D when considered in isolation. The rate of returnrequired by in-process technology typically has a higher risk profile thancurrent technology and depends upon the stage of completion. An overall aftertax discount rate of 35% was therefore applied to the cash flows expected to begenerated by these products incorporating technology currently underdevelopment.

On July 16, 2004, the shareholders of MOD III, Inc.approved the sale of substantially all of the manufacturing equipment of MODIII, Inc. to STMicroelectronics, Inc. for an aggregate amount of$26.0 million. The sale closed and was funded on July 16, 2004. In September 2004,MOD III, Inc. paid dividends and redeemed a portion of the 28,000Preferred Series A shares outstanding for a net consideration ofapproximately $20.2 million after paying for reimbursements totalingapproximately $4.9 million to us and $0.9 million for transactioncosts related to the sale, including brokerage fees, legal fees and otherprofessional services costs. Reimbursements to us were to pay certain costs ofmaintaining MOD III, Inc. in a saleable condition on MOD III, Inc.’sbehalf that had been previously recorded in special charges and credits (seeNote 4, 2004 Special Charges).

On September 27, 2004, we announced the sale ofall of our wafer manufacturing equipment and related assets of our MOD IIfacility in Nampa, Idaho, to STMicroelectronics, Inc. for an aggregateconsideration of $5.9 million net of selling costs and expenses whichresulted in a gain on assets held for sale of $1.7 million. On completionof the sale, the remaining assets of MOD II consisted of land and buildingswith a carrying value of $3.6 million classified as assets held for saleon the Company’s balance sheet as of December 31, 2004. We havesubsequently sold $0.2M of miscellaneous equipment, $1.1million of vacant landand recorded additional impairment charges of $0.5 million. The currentcarrying value of MOD II assets held for sale as of March 31, 2006 is $1.8 million.

On February 16, 2006, ZiLOG MOD III, Inc. aspecial purpose entity created largely for the economic benefit of our formerbondholders, completed the sale of certain assets and sold substantially all ofits remaining assets to Micron Technology, Inc for a total consideration of$3.8 million. These assets included the dormant 8” wafer fabricationfacility and associated undeveloped land. The cost of the transaction was $0.3 millionand has been apportioned on a prorated basis to the related assets sold.

This transactionrepresents the sale of the remaining assets of ZiLOG Mod III Inc. and, as such,ZiLOG MOD III, Inc. shareholders have voted to liquidate the specialpurpose entity and distribute the remaining net proceeds to its Series APreferred shareholders at the conclusion of that process. The costs toliquidate ZiLOG Mod III, Inc. are estimated to be $0.2 million. It isanticipated that approximately $2.5 million will be distributed to holdersof ZiLOG Mod III, Inc. Series A Preferred Stock on the liquidation ofthe subsidiary and accordingly, this estimated distribution amount due has beenrecorded in the consolidated financial statements of the Company at March 31,2006. The estimated distribution to the ZiLOG Mod III, Inc. shareholdersis net of reimbursement to ZiLOG of costs it has incurred totalingapproximately $0.8 million. These costs include sustaining costs incurredby ZiLOG on behalf of ZiLOG Mod III, Inc. since the last sale of assetsand distribution to Series A Preferred shareholders in 2004.

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**ITEM 7A.**     QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

**Interest Rate Risk**

Our exposure to market risk for changes in interestrates relates primarily to our short-term investment portfolio. We do not usederivative financial investments in our investment portfolio. Our primaryinvestment objectives are to preserve capital and maintain liquidity. Theseobjectives are met by investing in high-quality credit issuances and limitingthe amount of credit exposure to any one company. Our policy is to mitigatedefault risk by investing in only the highest quality securities and monitoringthe credit ratings of such investments. As of March 31, 2006, our cash andcash equivalents of $27.0 million were invested in bank time deposits andmoney market funds. We have no significant cash flow exposure due to ratechanges for our cash equivalents as these instruments have very shortmaturities.

The tablebelow presents principal amounts and related interest rates for our cashequivalents as of March 31, 2006 (dollars in millions):

| ** **            | ** ** | **Carrying  Value** | ** ** | **Fair  Value** | ** ** |
|-----------------------|------------|---------------------|------------|-----------------|------------|
| Cash Equivalents:     |       |                |       |            |       |   |   |
| Fixed rate            |       |                | $          | 27.0            |       |   | $ | 27.0 |   |
| Average interest rate |       |                | 3.2        | %               |       | — |   |
|                       |            |                     |            |                 |            |  |  |  |  |

 

*ForeignCurrency Exchange Risk.**  *We transact business in various foreign countries,but the vast majority of our consolidated net sales and purchases aredenominated in U.S. dollars. Currently, we do not employ a foreign currencyhedging program to mitigate our foreign currency exchange risk as foreigncurrency transactions and we believe the risks to date have not beensignificant. We maintain local currency bank accounts in our internationaloffices to facilitate payment of local operating costs.

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**ITEM 8.**                FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA

Thefollowing financial statements and supplementary data are provided herein:

|                                                                                                                                                                                                                             | **Page** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|----------|
| Report of Armanino McKenna LLP, Independent Registered  Public Accounting Firm                                                                                                                                              | 69       |
| Report of KMPG LLP, Independent Registered Public  Accounting Firm                                                                                                                                                          | 70       |
| Consolidated  Balance Sheets as of March 31, 2006, March 31, 2005 and  December 31, 2004                                                                                                                     | 71       |
| Consolidated Statements of Operations for the twelve  months ended March 31, 2006, December 31, 2004 and  December 31, 2003, and the three month transition period ended  March 31, 2005                | 72       |
| Consolidated Statements of Cash Flows for the twelve  months ended March 31, 2006, December 31, 2004 and  December 31, 2003, and the three month transition period ended  March 31, 2005                | 73       |
| Consolidated Statements of Stockholders’ Equity for  the twelve months ended March 31, 2006, December 31, 2004 and  December 31, 2003, and the three month transition period ended  March 31, 2005 | 74       |
| Notes to Consolidated Financial Statements                                                                                                                                                                                  | 75       |

 

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**REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

The Board of Directors and Stockholders of ZiLOG, Inc.

We have audited the accompanying consolidated balancesheets of ZiLOG, Inc. and subsidiaries (the Company) as of March 31,2006 and March 31, 2005, and the related consolidated statements ofoperations, stockholders’ equity (deficiency), and cash flows for the twelvemonths ended March 31, 2006, and the three month transition period ended March 31,2005. In connection with our audits of the consolidated financial statements,we have also audited the financial statement schedule listed in Item 15a (2).These consolidated financial statements and related financial statementschedule are the responsibility of the Company’s management. Our responsibilityis to express an opinion on these consolidated financial statements based onour audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes consideration of internal control overfinancial reporting as a basis for designing audit procedures that are appropriatein the circumstances, but not for the purpose of expressing an opinion on theeffectiveness of the Company’s internal control over financial reporting. Anaudit includes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements. An audit also includes assessing theaccounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation. We believethat our audits provide a reasonable basis for our opinion.

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of ZiLOG, Inc. and subsidiariesas of March 31, 2006, and March 31, 2005, and the results of their operationsand their cash flows for the twelve months ended March 31, 2006 andthe three month transition period ended March 31, 2005, in conformity withU.S. generally accepted accounting principles. Also, in our opinion, therelated financial statement schedule, when considered in relation to theconsolidated financial statements taken as a whole presents fairly, in allmaterial aspects, the information set forth therein.

/s/ Armanino McKenna LLP

San Ramon, California

June 26, 2006

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

The Board of Directors and StockholdersZiLOG, Inc.:

We have audited the accompanying consolidated balancesheet of ZiLOG, Inc. and subsidiaries (the Company) as of December 31,2004, and the related consolidated statements of operations, stockholders’equity, and cash flows for each of the years in the two-year period ended December 31,2004. In connection with our audits of the consolidated financial statements,we have also audited the financial statement schedule listed in Item 15a(2).These consolidated financial statements and related financial statementschedule are the responsibility of the Company’s management. Our responsibilityis to express an opinion on these consolidated financial statements based onour audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of ZiLOG, Inc. and subsidiariesas of December 31, 2004, and the results of their operations and theircash flows for each of the years in the two-year period ended December 31,2004, in conformity with U.S. generally accepted accounting principles. Also,in our opinion, the related financial statement schedule, when considered inrelation to the consolidated financial statements taken as a whole presentsfairly, in all material aspects, the information set forth therein.

/s/ KPMG LLP

Mountain View, California

March 29, 2005

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**ZiLOG, INC.CONSOLIDATED BALANCE SHEETS(In millions)**

| ** **                                                                                                                                                                                                                       | ** ** | **Mar. 31,** | ** ** | **Mar. 31,** | ** ** | **Dec. 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-------------------|------------|-------------------|------------|
| ** **                                                                                                                                                                                                                       | ** ** | **2006**          | ** ** | **2005**          | ** ** | **2004**          | ** ** |
| **ASSETS**                                                                                                                                                                                                                       | ** ** |              | ** ** | ** **        |       |              | ** ** | ** ** |   | ** ** | ** ** |
| Current assets:                                                                                                                                                                                                                  |       |              |       |              |       |              |       |   |   |   |   |
| Cash and cash equivalents                                                                                                                                                                                                        |       |              | $          | 27.0              |       |              |       | $ | 33.6 |   |   | $ | 37.7 |   |
| Accounts receivable, less allowance for doubtful  accounts of $0.2 at March 31, 2006 and 2005 and $0.3 at  December 31, 2004                                                                                           |       |              | 9.6        |              |       |              | 12.5       |   |   | 10.0 |   |
| Inventories, net                                                                                                                                                                                                                 |       |              | 7.6        |              |       |              | 10.6       |   |   | 12.1 |   |
| Deferred income taxes                                                                                                                                                                                                            |       |              | 0.4        |              |       |              | 2.7        |   |   | 2.7 |   |
| Prepaid expenses and other current assets                                                                                                                                                                                        |       |              | 2.2        |              |       |              | 2.8        |   |   | 4.0 |   |
| Total current assets                                                                                                                                                                                                             |       |              | 46.8       |              |       |              | 62.2       |   |   | 66.5 |   |
| Assets held for sale                                                                                                                                                                                                             |       |              | 1.8        |              |       |              | 3.4        |   |   | 3.6 |   |
| Property, plant  and equipment, net                                                                                                                                                                                              |       |              | 7.5        |              |       |              | 5.9        |   |   | 6.1 |   |
| Goodwill                                                                                                                                                                                                                         |       |              | 6.7        |              |       |              | 8.6        |   |   | 8.6 |   |
| Intangible  assets, net                                                                                                                                                                                                          |       |              | 4.8        |              |       |              | 6.7        |   |   | 7.3 |   |
| Other assets                                                                                                                                                                                                                     |       |              | 4.0        |              |       |              | 5.6        |   |   | 6.0 |   |
| Total assets                                                                                                                                                                                                                     |       |              | $          | 71.6              |       |              |       | $ | 92.4 |   |   | $ | 98.1 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                   | ** ** |              | ** ** | ** **        |       |              | ** ** | ** ** |   | ** ** | ** ** |
| Current liabilities:                                                                                                                                                                                                             |       |              |       |              |       |              |       |   |   |   |   |
| Accounts payable                                                                                                                                                                                                                 |       |              | $          | 9.9               |       |              |       | $ | 11.5 |   |   | $ | 12.3 |   |
| Accrued compensation and employee benefits                                                                                                                                                                                       |       |              | 2.5        |              |       |              | 3.0        |   |   | 2.6 |   |
| Payable to ZiLOG-Mod III Inc. Series A  Preferred shareholders                                                                                                                                                              |       |              | 2.5        |              |       |              | —     |   |   | — |   |
| Other accrued liabilities                                                                                                                                                                                                        |       |              | 2.9        |              |       |              | 4.8        |   |   | 4.0 |   |
| Deferred income on shipments to distributors                                                                                                                                                                                     |       |              | 6.1        |              |       |              | 6.0        |   |   | 6.0 |   |
| Total current liabilities                                                                                                                                                                                                        |       |              | 23.9       |              |       |              | 25.3       |   |   | 24.9 |   |
| Deferred taxes  liability                                                                                                                                                                                                        |       |              | 0.4        |              |       |              | 2.7        |   |   | 2.7 |   |
| Other non-current  liabilities                                                                                                                                                                                                   |       |              | 5.5        |              |       |              | 6.6        |   |   | 6.6 |   |
| Total liabilities                                                                                                                                                                                                                |       |              | 29.8       |              |       |              | 34.6       |   |   | 34.2 |   |
| Stockholders’  equity:                                                                                                                                                                                                      |       |              |       |              |       |              |       |   |   |   |   |
| Common stock, $0.01 par value; 60.0 million shares  authorized: 16.6 million, 16.3 million and 16.2 million shares issued  and outstanding at March 31, 2006, March 31, 2005 and December 31,  2004, respectively |       |              | 0.2        |              |       |              | 0.2        |   |   | 0.2 |   |
| Deferred stock compensation                                                                                                                                                                                                      |       |              | (0.6       | )                 |       |              | (0.4       | ) |   | (0.7 | ) |
| Additional paid-in capital                                                                                                                                                                                                       |       |              | 123.2      |              |       |              | 122.1      |   |   | 121.9 |   |
| Treasury stock                                                                                                                                                                                                                   |       |              | (7.2       | )                 |       |              | (7.1       | ) |   | (7.1 | ) |
| Accumulated deficit                                                                                                                                                                                                              |       |              | (73.8      | )                 |       |              | (57.0      | ) |   | (50.4 | ) |
| Total stockholders’ equity                                                                                                                                                                                                  |       |              | 41.8       |              |       |              | 57.8       |   |   | 63.9 |   |
| Total liabilities and  stockholders’ equity                                                                                                                                                                                 |       |              | $          | 71.6              |       |              |       | $ | 92.4 |   |   | $ | 98.1 |   |

 

See accompanying notes to the consolidated financial statements.

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**ZiLOG, INC.CONSOLIDATED STATEMENTS OF OPERATIONS(In millions, except per share data)**

| ** **                                                                      | ** ** | **Twelve Months Ended** | ** ** | **Three  Months  Ended** | ** ** |
|---------------------------------------------------------------------------------|------------|-----------------------------------|------------|--------------------------|------------|
| ** **                                                                      | ** ** | **Mar. 31,  2006**           | ** ** | **Dec. 31,  2004**  | ** ** | **Dec. 31,  2003** | ** ** | **Mar. 31,  2005** | ** ** |
| Net sales                                                                       |       |                              | $          | 78.8                     |       |   |   | $ | 95.6 |   |   | $ | 103.6 |   |   | $ | 20.2 |   |   |
| Cost of sales                                                                   |       |                              | 45.4       |                     |       |   | 52.2 |   |   | 55.2 |   |   | 12.5 |   |   |
| Gross margin                                                                    |       |                              | 33.4       |                     |       |   | 43.4 |   |   | 48.4 |   |   | 7.7 |   |   |
| Operating Expenses:                                                             |       |                              |       |                     |       |   |   |   |   |   |   |   |   |   |   |
| Research and development                                                        |       |                              | 21.0       |                     |       |   | 20.9 |   |   | 18.0 |   |   | 5.2 |   |   |
| Selling, general and administrative                                             |       |                              | 23.7       |                     |       |   | 29.6 |   |   | 27.6 |   |   | 7.4 |   |   |
| Special charges and reorganization items, net                                   |       |                              | 2.4        |                     |       |   | 5.9 |   |   | 3.8 |   |   | 0.4 |   |   |
| Amortization of intangible assets                                               |       |                              | 1.9        |                     |       |   | 4.2 |   |   | 6.8 |   |   | 0.6 |   |   |
| Total operating  expenses                                                       |       |                              | 49.0       |                     |       |   | 60.6 |   |   | 56.2 |   |   | 13.6 |   |   |
| Operating loss                                                                  |       |                              | (15.6      | )                        |       |   | (17.2 | ) |   | (7.8 | ) |   | (5.9 | ) |   |
| Other income  (expense):                                                        |       |                              |       |                     |       |   |   |   |   |   |   |   |   |   |   |
| Interest income                                                                 |       |                              | 0.8        |                     |       |   | 0.3 |   |   | 0.3 |   |   | 0.2 |   |   |
| Interest expense                                                                |       |                              | —     |                     |       |   | (0.2 | ) |   | (0.4 | ) |   | — |   |   |
| Other, net                                                                      |       |                              | (0.1       | )                        |       |   | — |   |   | 0.5 |   |   | (0.1 | ) |   |
| Total other  income                                                             |       |                              | 0.7        |                     |       |   | 0.1 |   |   | 0.4 |   |   | 0.1 |   |   |
| Loss before provision (benefit) for income taxes                                |       |                              | (14.9      | )                        |       |   | (17.1 | ) |   | (7.4 | ) |   | (5.8 | ) |   |
| Provision  (benefit) for income taxes                                           |       |                              | 1.9        |                     |       |   | 1.4 |   |   | (1.5 | ) |   | 0.8 |   |   |
| Net loss                                                                        |       |                              | $          | (16.8                    | )          |   |   | $ | (18.5 | ) |   | $ | (5.9 | ) |   | $ | (6.6 | ) |   |
| Basic and diluted  net loss per share                                           |       |                              | $          | 1.02                     |       |   |   | $ | (1.16 | ) |   | $ | (0.41 | ) |   | $ | (0.41 | ) |   |
| Weighted-average shares  used in computing basic and diluted net loss per share |       |                              | 16.4       |                     |       |   | 16.0 |   |   | 14.3 |   |   | 16.2 |   |   |

 

See accompanying notes to the consolidated financial statements.

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**ZiLOG, INC.CONSOLIDATED STATEMENTS OF CASH FLOWS(In millions)**

| ** **                                                                               | ** ** | **Twelve Months Ended** | ** ** | **Three  Months  Ended** | ** ** |
|------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|--------------------------|------------|
| ** **                                                                               | ** ** | **Mar. 31,  2006**           | ** ** | **Dec. 31,  2004**  | ** ** | **Dec. 31,  2003** | ** ** | **Mar. 31,  2005** | ** ** |
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                                                | ** ** |                              | ** ** | ** **               |       |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Net loss                                                                                 |       |                              | $          | (16.8                    | )          |   |   | $ | (18.5 | ) |   |   | $ | (5.9 | ) |   |   | $ | (6.6 | ) |   |
| Adjustment to reconcile net loss to net cash used by  operating activities:              |       |                              |       |                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Amortization of  fresh-start intangibles                                                 |       |                              | 1.9        |                     |       |   | 4.2 |   |   |   | 6.8 |   |   |   | 0.6 |   |   |
| Depreciation and other  amortization                                                     |       |                              | 2.6        |                     |       |   | 3.0 |   |   |   | 5.5 |   |   |   | 0.6 |   |   |
| Deferred income tax  assets and liabilities                                              |       |                              | —     |                     |       |   | (9.9 | ) |   |   | (12.4 | ) |   |   | — |   |   |
| Goodwill adjustment                                                                      |       |                              | 1.9        |                     |       |   | 8.3 |   |   |   | 17.7 |   |   |   | — |   |   |
| Loss on disposal of  fixed assets                                                        |       |                              | —     |                     |       |   | 0.2 |   |   |   | — |   |   |   | — |   |   |
| Asset impairments                                                                        |       |                              | 0.5        |                     |       |   | 5.4 |   |   |   | 0.4 |   |   |   | — |   |   |
| Net gain of sale of MOD  II assets held for sale                                         |       |                              | —     |                     |       |   | (1.7 | ) |   |   | — |   |   |   | — |   |   |
| Stock-based compensation                                                                 |       |                              | 0.7        |                     |       |   | 2.0 |   |   |   | 1.5 |   |   |   | 0.3 |   |   |
| Current change in operating assets and liabilities:                                      |       |                              |       |                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Accounts receivable, net                                                                 |       |                              | 2.9        |                     |       |   | 3.0 |   |   |   | (2.2 | ) |   |   | (2.5 | ) |   |
| Inventories                                                                              |       |                              | 3.0        |                     |       |   | (2.5 | ) |   |   | 1.1 |   |   |   | 1.5 |   |   |
| Prepaid expenses and  other current and non-current assets                               |       |                              | 2.1        |                     |       |   | 2.8 |   |   |   | — |   |   |   | 1.6 |   |   |
| Accounts payable                                                                         |       |                              | (1.7       | )                        |       |   | 3.7 |   |   |   | (1.6 | ) |   |   | (0.8 | ) |   |
| Deferred income on  shipments to distributors                                            |       |                              | 0.1        |                     |       |   | (1.4 | ) |   |   | — |   |   |   | — |   |   |
| Accrued and other  current and non-current liabilities                                   |       |                              | (3.6       | )                        |       |   | 0.9 |   |   |   | (12.8 | ) |   |   | 1.2 |   |   |
| Net cash used by  operating activities                                                   |       |                              | (6.4       | )                        |       |   | (0.5 | ) |   |   | (1.9 | ) |   |   | (4.1 | ) |   |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                                |       |                              |       |                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Proceeds from disposal  of assets held for sale & MOD III assets           |       |                              | 4.6        |                     |       |   | 5.9 |   |   |   | — |   |   |   | 0.2 |   |   |
| Net reimbursement of MOD  III sustaining                                                 |       |                              | (0.7       | )                        |       |   | — |   |   |   | — |   |   |   | — |   |   |
| Capital expenditures                                                                     |       |                              | (4.2       | )                        |       |   | (4.4 | ) |   |   | (1.9 | ) |   |   | (0.4 | ) |   |
| Net cash provided (used)  by investing activities                                        |       |                              | (0.3       | )                        |       |   | 1.5 |   |   |   | (1.9 | ) |   |   | (0.2 | ) |   |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                                |       |                              |       |                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Repayment of short-term  debt                                                            |       |                              | —     |                     |       |   | (5.0 | ) |   |   | (1.9 | ) |   |   | — |   |   |
| Purchase of common stock                                                                 |       |                              | (0.1       | )                        |       |   | (5.2 | ) |   |   | (1.9 | ) |   |   | — |   |   |
| Proceeds from public  stock offering, net of offering costs                              |       |                              | —     |                     |       |   | 24.4 |   |   |   | — |   |   |   | — |   |   |
| Proceeds from sales of  common stock per employee stock purchase plans and stock options |       |                              | 0.2        |                     |       |   | 0.5 |   |   |   | 0.2 |   |   |   | 0.2 |   |   |
| Net cash provided (used)  by financing activities                                        |       |                              | 0.1        |                     |       |   | 14.7 |   |   |   | (3.6 | ) |   |   | 0.2 |   |   |
| Increase (decrease) in  cash and cash equivalents                                        |       |                              | (6.6       | )                        |       |   | 15.7 |   |   |   | (7.4 | ) |   |   | (4.1 | ) |   |
| Cash and cash  equivalents at beginning of period                                        |       |                              | 33.6       |                     |       |   | 22.0 |   |   |   | 29.4 |   |   |   | 37.7 |   |   |
| Cash and cash  equivalents at end of period                                              |       |                              | $          | 27.0                     |       |   |   | $ | 37.7 |   |   |   | $ | 22.0 |   |   |   | $ | 33.6 |   |   |
| **SUPPLEMENTAL DISCLOSURE OF CASH FLOW  INFORMATIONS:**                                  |       |                              |       |                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest paid during the  period                                                         |       |                              | $          | —                   |       |   |   | $ | 0.3 |   |   |   | $ | 0.4 |   |   |   | $ | — |   |   |
| Income taxes paid during  the period                                                     |       |                              | $          | 0.2                      |       |   |   | $ | 1.5 |   |   |   | $ | 1.8 |   |   |   | $ | 0.1 |   |   |
| **SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING  AND FINANCING ACTIVITIES:**             |       |                              |       |                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Dollar value of shares repurchased through employee  loan cancellations                  |       |                              | $          | —                   |       |   |   | $ | 0.6 |   |   |   | $ | 0.7 |   |   |   | $ | 0.1 |   |   |

 

See accompanying notes to the consolidated financial statements.

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**ZiLOG, INC.CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIENCY)(In millions)**

| ** **                                                                        | ** ** | **Common Stock** | ** ** | **Deferred  Stock  Compen-** | ** ** | **Additional  Paid-in** | ** ** | **Treasury** | ** ** | **Accumu-  lated** | ** ** | **Total  Stock-  holders’  Equity** | ** ** |
|-----------------------------------------------------------------------------------|------------|-----------------------|------------|------------------------------|------------|-------------------------|------------|--------------|------------|--------------------|------------|------------------------------------------|------------|
| ** **                                                                        | ** ** | **Shares**            | ** ** | **Amount**                   | ** ** | **sation**              | ** ** | **Capital**  | ** ** | **Stock**          | ** ** | **Deficit**                              | ** ** | **(Deficiency)** | ** ** |
| Balance at December 31, 2002                                                 |       |                  | 14.9       |                         |       |                    | $          | 0.1          |       |               |       | $                                        | (4.6       | ) |   |   | $ | 97.3 |   |   |   | — |   |   |   | $ | (26.0 | ) |   |   | $ | 66.8 |   |   |
| Issuance of common stock under stock option plans,  including tax benefit of $0.1 |       |                  | —     |                         |       |                    | —     |         |       |               | —     |                                     |       |   | 0.2 |   |   |   | — |   |   |   | — |   |   |   | 0.2 |   |   |
| Amortization of deferred stock compensation                                       |       |                  | —     |                         |       |                    | —     |         |       |               | 1.2        |                                     |       |   | 0.3 |   |   |   | — |   |   |   | — |   |   |   | 1.5 |   |   |
| Deferred stock compensation cancellations                                         |       |                  | —     |                         |       |                    | —     |         |       |               | 1.4        |                                     |       |   | (1.4 | ) |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Purchase of treasury shares                                                       |       |                  | (0.4       | )                            |       |                    | —     |         |       |               | —     |                                     |       |   | — |   |   |   | (1.9 | ) |   |   | — |   |   |   | (1.9 | ) |   |
| Net loss and comprehensive loss                                                   |       |                  | —     |                         |       |                    | —     |         |       |               | —     |                                     |       |   | — |   |   |   | — |   |   |   | (5.9 | ) |   |   | (5.9 | ) |   |
| Balance at December 31, 2003                                                 |       |                  | 14.5       |                         |       |                    | $          | 0.1          |       |               |       | $                                        | (2.0       | ) |   |   | $ | 96.4 |   |   |   | $ | (1.9 | ) |   |   | $ | (31.9 | ) |   |   | $ | 60.7 |   |   |
| Common stock issued in public offering, net of  offering costs                    |       |                  | 2.3        |                         |       |                    | —     |         |       |               | —     |                                     |       |   | 24.4 |   |   |   | — |   |   |   | — |   |   |   | 24.4 |   |   |
| Issuance of common stock under stock option plans                                 |       |                  | —     |                         |       |                    | —     |         |       |               | —     |                                     |       |   | 0.1 |   |   |   | — |   |   |   | — |   |   |   | 0.1 |   |   |
| Issuance of common stock under employee stock  purchase plan                      |       |                  | 0.1        |                         |       |                    | 0.1        |         |       |               | —     |                                     |       |   | 0.3 |   |   |   | — |   |   |   | — |   |   |   | 0.4 |   |   |
| Deferred stock compensation                                                       |       |                  | —     |                         |       |                    | —     |         |       |               | (0.5       | )                                        |       |   | 0.5 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Deferred stock compensation cancellations                                         |       |                  | —     |                         |       |                    | —     |         |       |               | 0.2        |                                     |       |   | (0.2 | ) |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Amortization of deferred stock compensation                                       |       |                  | —     |                         |       |                    | —     |         |       |               | 1.6        |                                     |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 1.6 |   |   |
| Purchase of treasury shares                                                       |       |                  | (0.7       | )                            |       |                    | —     |         |       |               | —     |                                     |       |   | — |   |   |   | (5.2 | ) |   |   | — |   |   |   | (5.2 | ) |   |
| Stock-based compensation expense                                                  |       |                  | —     |                         |       |                    | —     |         |       |               | —     |                                     |       |   | 0.4 |   |   |   | — |   |   |   | — |   |   |   | 0.4 |   |   |
| Net loss and comprehensive loss                                                   |       |                  | —     |                         |       |                    | —     |         |       |               | —     |                                     |       |   | — |   |   |   | — |   |   |   | (18.5 | ) |   |   | (18.5 | ) |   |
| Balance at December 31, 2004                                                 |       |                  | 16.2       |                         |       |                    | $          | 0.2          |       |               |       | $                                        | (0.7       | ) |   |   | $ | 121.9 |   |   |   | $ | (7.1 | ) |   |   | $ | (50.4 | ) |   |   | $ | 63.9 |   |   |
| Issuance of common stock under stock option   plans                               |       |                  | 0.03       |                         |       |                    | —     |         |       |               | —     |                                     |       |   | 0.1 |   |   |   | — |   |   |   | — |   |   |   | 0.1 |   |   |
| Issuance of common stock under employee stock  purchase plan                      |       |                  | 0.02       |                         |       |                    | —     |         |       |               | —     |                                     |       |   | 0.1 |   |   |   | — |   |   |   | — |   |   |   | 0.1 |   |   |
| Amortization of deferred stock compensation                                       |       |                  | —     |                         |       |                    | —     |         |       |               | 0.3        |                                     |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 0.3 |   |   |
| Net loss and comprehensive loss                                                   |       |                  | —     |                         |       |                    | —     |         |       |               | —     |                                     |       |   | — |   |   |   | — |   |   |   | (6.6 | ) |   |   | (6.6 | ) |   |
| Balance at March 31, 2005 (Transition Period)                                |       |                  | 16.3       |                         |       |                    | $          | 0.2          |       |               |       | $                                        | (0.4       | ) |   |   | $ | 122.1 |   |   |   | $ | (7.1 | ) |   |   | $ | (57.0 | ) |   |   | $ | 57.8 |   |   |
| Issuance of restricted shares                                                     |       |                  | 0.2        |                         |       |                    | —     |         |       |               | (0.6       | )                                        |       |   | 0.6 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Issuance of common stock under employee stock  purchase plan                      |       |                  | 0.1        |                         |       |                    | —     |         |       |               | —     |                                     |       |   | 0.2 |   |   |   | — |   |   |   | — |   |   |   | 0.2 |   |   |
| Deferred stock compensation cancellations                                         |       |                  | —     |                         |       |                    | —     |         |       |               | 0.1        |                                     |       |   | (0.1 | ) |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Amortization of deferred stock compensation                                       |       |                  | —     |                         |       |                    | —     |         |       |               | 0.2        |                                     |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 0.2 |   |   |
| Amortization of restricted shares                                                 |       |                  | —     |                         |       |                    | —     |         |       |               | 0.1        |                                     |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 0.1 |   |   |
| Purchase of treasury shares                                                       |       |                  | —     |                         |       |                    | —     |         |       |               | —     |                                     |       |   | — |   |   |   | (0.1 | ) |   |   | — |   |   |   | (0.1 | ) |   |
| Stock-based compensation expense                                                  |       |                  | —     |                         |       |                    | —     |         |       |               | —     |                                     |       |   | 0.4 |   |   |   | — |   |   |   | — |   |   |   | 0.4 |   |   |
| Net loss and comprehensive loss                                                   |       |                  | —     |                         |       |                    | —     |         |       |               | —     |                                     |       |   | — |   |   |   | — |   |   |   | (16.8 | ) |   |   | (16.8 | ) |   |
| Balance at  March 31, 2006                                                   |       |                  | 16.6       |                         |       |                    | $          | 0.2          |       |               |       | $                                        | (0.6       | ) |   |   | $ | 123.2 |   |   |   | $ | (7.2 | ) |   |   | $ | (73.8 | ) |   |   | $ | 41.8 |   |   |

 

See accompanying notes to the consolidated financial statements.

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**ZiLOG,INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**NOTE 1.**             DESCRIPTIONOF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

***Nature of Business***

ZiLOG, Inc. (“ZiLOG”or the “Company”) is a worldwide supplier of semiconductor products. TheCompany designs, develops and markets various families of products in supportof the micrologic semiconductor market segment. Using proprietary technology,ZiLOG continues to provide semiconductor devices that its customers design intotheir end products. These devices typically combine a microprocessor memory,and input and output functions on a single device. ZiLOG’s micrologic devicesenable a broad range of consumer and industrial electronics manufacturers tocontrol the functions and performance of their products. ZiLOG’s other devicesand foundry services have a wide variety of uses including the processing andtransmission of information for data communications, telecommunications andconsumer electronics companies.

***Basis ofPresentation***

The consolidated financialstatements include the accounts of ZiLOG, Inc. and its subsidiaries. Allsignificant transactions and accounts between the Company and thesesubsidiaries have been eliminated in consolidation.

***Fresh-StartReporting***

On February 28, 2002,ZiLOG filed and received confirmation from the United States Bankruptcy Courtfor the Northern District of California of its and ZiLOG-MOD III, Inc.’s (“MODIII, Inc.”) joint reorganization plan (the “Reorganization Plan”) filedpursuant to Chapter 11 of the United States Bankruptcy Code. The ReorganizationPlan became effective on May 13, 2002.

As a result of the court’sconfirmation of ZiLOG’s Reorganization Plan, the Company adjusted its financialstatements as prescribed by the American Institute of Certified Public AccountantsStatement of Position 90-7, “Financial Reporting By Entities inReorganization Under the Bankruptcy Code” (SOP 90-7). The reportingrequirements of SOP 90-7 are referred to as “fresh-start” reporting,which resulted in material changes to ZiLOG’s Consolidated Balance Sheet asreported for the year ended December 31, 2002. This approach requires therecording of assets and liabilities at fair values, the valuation of equitybased on the reorganization value of the ongoing business and the recording ofintangible assets including goodwill (see Note 2).

***Change in FiscalYear End***

Effective December 29,2005, the Company changed its fiscal year end from December 31 to March 31with interim results based on fiscal quarters of approximately thirteen weeksin duration ending on the closest Saturday to each calendar quarter end, withthe exception of the last quarter, which ends on March 31 beginning infiscal 2006. In accordance with the fiscal calendar in place at that time, thenew fiscal 2005 year ended on March 27 and the comparative 2004 periodended on March 28. For financial reporting purposes and convenience ofreference, interim fiscal periods are labeled as ending on calendar month-end. Theoperating results for any period are not necessarily indicative of results forany subsequent period or the full fiscal year.

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***Revenue Recognition***

Revenue from product salesto Original Equipment Manufacturers (“OEM”) customers is recognized whenevidence of an agreement exists, customers or their agents receive the productand title transfers, and collection of amounts due is reasonably assured. Appropriateallowances for returns, discounts and warranty costs are recorded concurrentwith revenue recognition.

The Company also licensestechnology for certain of its products and receives payment in the form ofroyalties. Typically, licensees provide shipment and royalty information whenthe payment is remitted, usually 60 days subsequent to the end of the quartershipments are made. As such, the Company records these royalty revenues asmicrologic net sales when the cash is received from the licensees.

Revenue on shipments todistributors who have rights of return and price protection on unsoldmerchandise held by them, is deferred until products are resold by the distributorsto end users. Although revenue is deferred until resale, title of products soldto distributors transfers upon shipment. Accordingly, shipments to distributorsare reflected in the consolidated balance sheets as accounts receivable and areduction of inventories at the time of shipment. Deferred revenue and thecorresponding cost of sales on shipments to distributors are reflected in theconsolidated balance sheet on a net basis as “Deferred income on shipments todistributors.”

***Cash and Cash Equivalents***

Cash and cash equivalentsconsist of bank deposits and money market funds, which are readily convertibleto cash and have maturities of three months or less at the time of acquisition.

***FairValue of Financial Instruments, Concentration of Credit Risk***

Cash and cash equivalentsconsist primarily of cash in bank accounts and money market accounts. Thecarrying amount on the balance sheet for cash and cash equivalents at March 31,2006, March 31, 2005, December 31, 2004, and December 31, 2003 were $27.0million, $33.6 million, $37.7 million and $22.0 million, respectively, whichapproximates fair value, due to their short maturities.

The carrying value of theCompany’s financial instruments, including cash and cash equivalents, accountsreceivable, accounts payable and current liabilities, approximates fair valuedue to their relatively short maturities. Financial instruments that subjectthe Company to concentrations of credit risk consist primarily of cash and cashequivalents and accounts receivable. The Company maintains its cash and cashequivalents and investments with high quality financial institutions. TheCompany’s customer base is located primarily in North America, Europe and Asia.The Company performs ongoing credit evaluations of its customers’ financialcondition and limits its exposure to financial losses by limiting the amount ofcredit extended whenever deemed necessary and generally does not requirecollateral. As of March 31, 2006, there were two customers with net accountsreceivable comprising more than 10% of total net accounts receivable.

***Accounts Receivableand Allowances***

The Company maintains anallowance for losses it may incur as a result of its customers’ inability tomake required payments. Any increase in the allowance results in acorresponding increase in selling, general and administrative expenses. Inestablishing this allowance and evaluating the adequacy of the allowance fordoubtful accounts, the Company considers the aging of accounts receivable,historical bad debts, customer concentrations, customer credit-worthiness and,to a lesser extent, current economic trends and changes in customer paymentterms.

The Company’s sales to OEMcustomers consist of gross product sales reduced by expected future salesreturns and allowances. To estimate sales returns and price allowances, theCompany analyzes historical returns and allowance activity to establish abaseline reserve level. The Company then evaluates 

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whetherthere are any underlying product quality or other customer specific issues thatrequire additional specific reserves above the baseline level.

The Company’s net sales todistributors that have rights of return and/or price protection allowances onunsold merchandise held by them are deferred until such products are resold bythe distributors to end users. At the time that the Company recognizesdistributor re-sales as revenue, it records a reserve for estimated priceadjustments that the distributors may reclaim from the Company on themerchandise they resold to end users. These reserves are recorded as areduction to net sales and a reduction to accounts receivable. To estimate thisdistributor price adjustment reserve, the Company analyzes its historical priceadjustment payments, price adjustments taken by distributors but not processedby the Company and pending price adjustments that have been authorized by theCompany but have not yet been claimed by its distributors.

***Inventories***

Inventoriesare stated at the lower of cost (which approximates actual cost on a first-in,first-out basis) or market. Provisions, when required, are made to reduceinventory values from cost to their estimated net realizable values. It ispossible that estimates of net realizable value can change in the short-term.Inventory reserves for excess and obsolete inventory are released only uponsale, scrap or other disposition of reserved inventory. Inventories, net ofprovisions, consist of the following

(In millions):

| ** **      | ** ** | **Mar. 31,** | ** ** | **Mar. 31,** | ** ** | **Dec. 31,** | ** ** |
|-----------------|------------|-------------------|------------|-------------------|------------|-------------------|------------|
| ** **      | ** ** | **2006**          | ** ** | **2005**          | ** ** | **2004**          | ** ** |
| Raw materials   |       |              | $          | 0.8               |       |              |       | $ | 0.6 |   |   |   | $ | 0.7 |   |   |
| Work-in-process |       |              | 7.3        |              |       |              | 11.3       |   |   |   | 12.2 |   |   |
| Finished goods  |       |              | 5.0        |              |       |              | 6.0        |   |   |   | 6.2 |   |   |
| Gross Inventory |       |              | 13.1       |              |       |              | 17.9       |   |   |   | 19.1 |   |   |
| Reserves        |       |              | (5.5       | )                 |       |              | (7.3       | ) |   |   | (7.0 | ) |   |
| Net Inventory   |       |              | $          | 7.6               |       |              |       | $ | 10.6 |   |   |   | $ | 12.1 |   |   |

 

***Property, Plant andEquipment***

Property, plant andequipment were revalued at May 1, 2002 in accordance with the adoption offresh-start reporting and SOP 90-F. At that time, accumulateddepreciation was offset against cost and the resulting net book value wasadjusted to the fair values. For periods prior to May 1, 2002 and foradditions purchased after this date, property, plant and equipment are statedat cost. Depreciation is computed using the straight-line method over theestimated economic lives of the assets, which are generally between three andseven years for machinery and equipment and 30 years for buildings.

Weapply the provisions of Statement of Financial Accounting Standards No. 144,“Accounting for the Impairment or Disposal of Long-Lived Assets” and Statementof Financial Accounting Standards No. 142, “Goodwill and Other IntangibleAssets.” We evaluate long-lived assets for possible impairment whenever eventsor changes in circumstances indicate that the carrying value may not berecoverable. Factors we consider important which could trigger an impairmentreview include the following:

·       significantchanges in the manner of our use of the acquired assets;

·       significantchanges in the strategy for our overall business; and

·       significantnegative industry or economic trends.

When we determine that thecarrying value of long-lived assets may not be recoverable based upon theexistence of one or more of the above indicators of impairment, and theundiscounted cash flows estimated to be generated by those assets are less thanthe asset’s carrying value, the carrying value of the 

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assetsare reduced to their estimated fair value. The estimated fair value is usuallydetermined based on an estimate of discounted future cash flows. Assetimpairments are recorded as a reduction in the asset value in our consolidatedbalance sheets and as special charges in our consolidated statements ofoperations.

The intangible assetscreated by the adoption of fresh-start accounting on our emergence frombankruptcy in 2002, consist of existing technology and brand name, as well asexcess enterprise value, or goodwill. The existing technology and brand nameare being amortized based on a pattern-of-use method in proportion to theforecast discounted cash flows from such assets. The goodwill is not subject toamortization.

We evaluate existingtechnology and brand name whenever events and circumstances indicate that theirfair value may be less than their carrying value. Additionally, goodwill istested for impairment at least annually and more often if events andcircumstances indicate that its fair value may be less than its carrying value.We performed the annual impairment test for goodwill in the third quarter of2004, and we perform this test in the third quarter of each fiscal year unlessthe existence of triggering events indicates that an earlier review should beperformed.

Adjustments to recordimpairment of long-lived assets or intangible assets could have a materialadverse impact on our financial condition and results of operations in theperiod or periods in which such impairment is identified.

Significant impairments ofproperty, plant and equipment were recorded in 2004 due to the write-down ofthe Company’s MOD II five-inch wafer fabrication facility in Nampa, Idahoto its expected realizable value (see Note 3) and subsequent transfer toassets held for sale. Amortization of leasehold improvements is computed usingthe shorter of the remaining terms of the leases or the estimated economiclives of the improvements. Depreciation expense of property, plant andequipment was $2.6 million, $0.6 million, $3.0 million, and $5.5 millionfor the twelve months ended March 31, 2006, three month transition periodended March 31, 2005, and the years ended December 31, 2004 and 2003,respectively. The Company did not have any assets leased under capital leasesduring the periods indicated.

Property,plant and equipment consist of the following (in millions):

| ** **                                      | ** ** | **Mar. 31,  2006** | ** ** | **Mar. 31,   2005** | ** ** | **Dec. 31,  2004** | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|-------------------------------|------------|-------------------------|------------|
| Property, plant & equipment at cost:   |       |                    |       |                          |       |                    |       |   |   |   |   |
| Land, buildings and  leasehold improvements     |       |                    | $          | 2.6                           |       |                    | $          | 2.5 |   |   | $ | 1.2 |   |   |
| Machinery and equipment                         |       |                    | 11.0       |                          |       | 10.2                    |       |   | 11.0 |   |   |
|                                            |       |                    | 13.6       |                          |       | 12.7                    |       |   | 12.2 |   |   |
| Less accumulated  depreciation and amortization |       |                    | (6.1       | )                             |       | (6.8                    | )          |   | (6.1 | ) |   |
| Net property, plant and equipment               |       |                    | $          | 7.5                           |       |                    | $          | 5.9 |   |   | $ | 6.1 |   |   |

 

***Other Accrued Liabilities***

Thefollowing table further details “other accrued liabilities” (in millions):

| ** **                   | ** ** | **Mar. 31,  2006** | ** ** | **Mar. 31,  2005** | ** ** | **Dec. 31,  2004** | ** ** |
|------------------------------|------------|-------------------------|------------|-------------------------|------------|-------------------------|------------|
| Income taxes payable         |       |                    | $          | 0.5                     |       |                    |       | $ | 1.2 |   |   |   | $ | 0.3 |   |   |
| Accrued audit fees           |       |                    | 0.2        |                    |       |                    | 0.7        |   |   |   | 0.8 |   |   |
| Accrued legal costs          |       |                    | 1.0        |                    |       |                    | 1.0        |   |   |   | 1.0 |   |   |
| Accrued restructuring  costs |       |                    | 0.1        |                    |       |                    | 0.4        |   |   |   | 0.8 |   |   |
| Other                        |       |                    | 1.1        |                    |       |                    | 1.5        |   |   |   | 1.1 |   |   |
| Other accrued liabilities    |       |                    | $          | 2.9                     |       |                    |       | $ | 4.8 |   |   |   | $ | 4.0 |   |   |

 

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***Use of Estimates***

The preparation of consolidatedfinancial statements in conformity with accounting principles generallyaccepted in the United States requires management to make estimates andassumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of financialstatements and the reported amounts of net sales and expense during thereporting periods. Significant estimates made in preparing these financialstatements include, but are not limited to, excess and obsolete inventories,tax valuation allowance, allowance for doubtful accounts and sales returns andallowances. Actual results could differ from those estimates.

***AdvertisingExpenses***

The Company accounts foradvertising costs as expense for the period in which they are incurred.Advertising expenses were approximately $1.4 million, $0.2 million,$1.5 million, and $1.0 million, for the twelve months ended March 31,2006, three month transition period ended March 31, 2005 and the yearsended December 31, 2004 and 2003, respectively. Advertising costs areincluded in selling, general and administrative expenses in the accompanyingconsolidated statements of operations.

***Shipping Costs***

Shipping costs areincluded in cost of sales.

***Research andDevelopment Expenses***

The Company’s policy is torecord all research and development expenditures with no future alternativeuse, as period expenses, when incurred. Research and development expendituresincurred and expensed were $21.0 million for the twelve months ended March 31,2006, $5.2 million for the three months ended March 31, 2005 and$20.9 million and $18.0 million for the twelve months ended December 31,2004 and 2003, respectively.

***Stock Awards***

The Company accounts foremployee stock awards in accordance with Accounting Principles Board Opinion No. 25,“Accounting for Stock Issued to Employees,” and related interpretationsincluding FASB Interpretation No. 44, “Accounting for Certain TransactionsInvolving Stock Compensation—an Interpretation of APB No. 25,” to accountfor its fixed plan options. Under this method, compensation expense is recordedon the date of grant only if the current market price of the underlying stock exceedsthe exercise price. SFAS 123, “Accounting for Stock-Based Compensation,” asamended by SFAS 148, “Accounting for Stock-Based Compensation—Transitionand Disclosure,” established accounting and disclosure requirements using afair-value method of accounting, and the Company has adopted only the disclosurerequirements of SFAS 148. For purposes of both financial statement and proforma disclosure, the amortization of the stock-based compensation is allocatedover the vesting period on a straight-line basis. The Company has applied theprinciples of FTB 97-1, “Accounting under Statement 123 for CertainEmployee Stock Purchase Plans with a Look-Back Option.” Under this technicalbulletin, the fair value method of accounting is used to account for sharesissued to employees under the Company’s employee stock purchase plan. For stockoption grants issued with an exercise price equal to the fair market value ofthe stock at the date of the grant, the Company recognizes no compensationexpense.

Forthe period between May 13, 2002, the effective date of the Company’s plan ofreorganization and March 11, 2004, the Company’s common stock was tradedon the Over -the-Counter Bulletin Board. As a result of our public offering ofstock, our common stock commenced trading on the NASDAQ National Market on March 12,2004 under the symbol “ZILG”. Generally, stock option awards for the financialperiods presented were granted based on the closing price of the relevantmarket on the day of the grant 

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approved by the Board of Directors. However, certainequity based grants which have required recording of compensation expense wereapproved as follows:

(i)            OnMay 13, 2002, in accordance with the shareholder approved plan of re-organization,the Company granted certain options and restricted shares to employees(excluding its CEO) at grant prices below the fair market value at the time ofthe grants.

(ii)        OnMay 13, 2002, in accordance with the shareholder approved plan of re-organization,the Company granted certain restricted shares to its CEO in accordance with hisemployment agreement at grant prices equal to par value of $0.01 per share withcertain vesting schedules. Subsequent to the enactment of Sarbanes—Oxley act of2002, the Company converted the remaining unvested restricted shares with grantprices of $0.01 to the then, equivalent fair market value numbers of options atnew grant prices of $2.00 and $5.20. All of these restricted shares and optionswere fully vested at March 31, 2006.

(iii)    OnNovember 10, 2005, a total of 220,000 restricted shares were granted tothe CEO and certain executive officers in conjunction with change in controlagreements. These grants were priced at par value of $0.01 per share and vestsat the earlier of 3 years from grant date or change in ownership of thecompany, whichever is the earliest.

***Pro Forma Stock-Based Compensation***

Thetable below illustrates the effect on net loss if the fair-value based methodhad been applied to all outstanding and unvested awards in each period (inmillions):

| ** **                                                                                                         | ** ** | **Twelve  Months   Ended  Mar 31** | ** ** | **Twelve   Months   Ended  Dec. 31,** | ** ** | **Three   Months   Ended  Mar. 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                                         | ** ** | **2006**                                     | ** ** | **2004**                                             | ** ** | **2003**                                            | ** ** | **2005** | ** ** |
| Net loss, as reported                                                                                              |       |                                         | $(16.8     | )                                                    |       | $(18.5                                              | )          | $(5.9 | ) |   | $(6.6 | ) |   |
| Add: stock-based  employee compensation expense included in reported net loss                                      |       |                                         | 0.7        |                                                 |       | 2.0                                                 |       | 1.5 |   |   | 0.3 |   |   |
| Deduct: total  stock-based employee compensation expense determined under fair-value-based  method for all rewards |       |                                         | (2.0       | )                                                    |       | (4.3                                                | )          | (2.5 | ) |   | (0.7 | ) |   |
| Net loss—pro forma                                                                                            |       |                                         | $(18.1     | )                                                    |       | $(20.8                                              | )          | $(6.9 | ) |   | $(7.0 | ) |   |
| Loss Per Share                                                                                                     |       |                                         |       |                                                 |       |                                                |       |   |   |   |   |   |   |
| Basic and diluted—as  reported                                                                                |       |                                         | $(1.02     | )                                                    |       | $(1.16                                              | )          | $(0.41 | ) |   | $(0.41 | ) |   |
| Basic and diluted—pro  forma                                                                                  |       |                                         | (1.10      | )                                                    |       | (1.30                                               | )          | (0.48 | ) |   | (0.43 | ) |   |
| Number of shares used in computing loss per share                                                                  |       |                                         |       |                                                 |       |                                                |       |   |   |   |   |   |   |
| Basic and diluted—as  reported                                                                                |       |                                         | 16.4       |                                                 |       | 16.0                                                |       | 14.3 |   |   | 16.2 |   |   |
| Basic and diluted—pro forma                                                                                   |       |                                         | 16.4       |                                                 |       | 16.0                                                |       | 14.3 |   |   | 16.2 |   |   |

 

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Thefair value of options granted was estimated at the date of grant using theBlack Scholes option pricing model. The following weighted-average assumptionswere used:

| ** **                              | ** ** | **Twelve  Months  Ended  Mar. 31,** | ** ** | **Twelve  Months  Ended  Dec. 31,** | ** ** | **Three  Months  Ended  Mar. 31,** | ** ** |
|-----------------------------------------|------------|------------------------------------------|------------|------------------------------------------|------------|-----------------------------------------|------------|
| ** **                              | ** ** | **2006**                                 | ** ** | **2004**                                 | ** ** | **2003**                                | ** ** | **2005** | ** ** |
| Annual average  risk-free interest rate |       |                                     | 4.9        | %                                        |       | 3.4                                     | %          | 3.0 | % |   | 3.4 | % |   |
| Estimated life in  years                |       |                                     | 5          |                                     |       | 5                                       |       | 5 |   |   | 5 |   |   |
| Dividend yield                          |       |                                     | 0.0        | %                                        |       | 0.0                                     | %          | 0.0 | % |   | 0.0 | % |   |
| Volatility                              |       |                                     | 54.2       | %                                        |       | 51.8                                    | %          | 66.5 | % |   | 52.2 | % |   |

 

Theweighted-average fair value of options granted and weighted-average fair valueof employee stock purchases are as follows:

| ** **                                                                                                     | ** ** | **Twelve  Months  Ended  Mar. 31,** | ** ** | **Twelve  Months  Ended  Dec. 31,** | ** ** | **Three  Months  Ended  Mar. 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                                                                     | ** ** | **2006**                                 | ** ** | **2004**                                 | ** ** | **2003**                                | ** ** | **2005** | ** ** |
| Weighted-average  fair value of options granted during the period                                              |       |                                     | $2.80      |                                     |       | $9.77                                   |       | $5.60 |   |   | $5.07 |   |   |
| Weighted-average fair  value of employee stock purchases under employee stock purchase plan during  the period |       |                                     | $3.05      |                                     |       | $6.09                                   |       | $5.52 |   |   | $4.70 |   |   |

 

Thefair value of shares purchased under the 2004 Employee Stock Purchase Plan wasestimated at the date of each offering period, using the Black-Scholes pricingmodel. The following assumptions were used:

| ** **               | ** ** | **Twelve  Months  Ended  Mar. 31,** | ** ** | **Twelve  Months  Ended  Dec. 31,** | ** ** | **Three  Months  Ended  Mar. 31,** | ** ** |
|--------------------------|------------|------------------------------------------|------------|------------------------------------------|------------|-----------------------------------------|------------|
| ** **               | ** ** | **2006**                                 | ** ** | **2004**                                 | ** ** | **2003**                                | ** ** | **2005** | ** ** |
| Risk-free  interest rate |       |                                     | 3.92       | %                                        |       | 1.81  to 2.75%                          |       |   | — |   |   |   | 3.4 | % |   |
| Estimated life in  years |       |                                     | 0.5        |                                     |       | 0.5                                     |       |   | — |   |   |   | 0.5 |   |   |
| Dividend yield           |       |                                     | 0.0        | %                                        |       | 0.0%                                    |       |   | — |   |   |   | 0.0 | % |   |
| Volatility               |       |                                     | 54.2       | %                                        |       | 50.7%                                   |       |   | — |   |   |   | 52.2 | % |   |

 

***Recent Accounting Pronouncements***

In December 2004, theFASB issued SFAS No. 123R, “Share-Based Payment.” SFAS 123R requiresemployee stock options and rights to purchase shares under stock participationplans to be accounted for under the fair value method, and eliminates the abilityto account for these instruments under the intrinsic value method prescribed byAPB Opinion No. 25, as allowed under the original provisions of SFAS No. 123.SFAS No. 123R requires the use of an option pricing model for estimatingfair value, which is amortized to expense over the service periods. Therequirements of SFAS No. 123R are effective for fiscal periods beginningin 2006. SFAS No. 123R allows for either prospective recognition ofcompensation expense or retrospective recognition, which may be back to theoriginal issuance of SFAS No. 123R or only to interim periods in the yearof adoption. The Company is currently evaluating the impact adopting SFAS No. 123R,but expects the adoption of SFAS No. 123R will result in significant stockcompensation expense.

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**NOTE 2.   GOODWILLAND INTANGIBLE ASSETS**

Effective January 1, 2002, the Company adoptedthe provisions of Statement of Financial Accounting Standards No. 142, “Goodwilland Other Intangible Assets” (“SFAS 142”). At the time of adoption, the Companyhad no amounts of goodwill recorded in the balance sheet. Therefore the initialadoption had no material effect to the Company.

Under SFAS 142, goodwill and intangible assets withindefinite lives are not amortized, but are reviewed annually or morefrequently if impairment indicators arise. The Company did not have anyimpairment of goodwill in the twelve months ended March 31, 2006, thethree month transition period ended March 31 2005, the years ended December 31,2004, and 2003. In connection with its reorganization in 2002, the Companyrecorded a valuation allowance against deferred tax assets and recordeddeferred income tax liabilities and income tax contingencies in accordance withStatement of Financial Accounting Standards No. 5 “Accounting forContingencies.” These tax contingencies were primarily attributable to theCompany’s reorganization of MOD III. During 2004 and 2003, the Companyreassessed and updated its deferred income tax liabilities and income tax contingenciesrequirements and reduced the associated liabilities as an adjustment togoodwill as presented in the table below. In addition, reductions in thevaluation allowance that was established under fresh-start reporting are alsorecorded as a reduction in the carrying value of goodwill.

Changesin the carrying value of goodwill for the twelve months ended March 31,2006, three month transition period ended March 31 2005, years ended December 31,2004 and 2003 are as follows (in millions):

| Balance at  April 30, 2002           |   | $      | — |   |
|-------------------------------------------|--------|--------|--------|--------|
| Establishment of  goodwill under SOP 90-7 |   | 34.6   |   |
| Balance at December 31, 2002         |   | 34.6   |   |
| Goodwill  adjustments during 2003         |   | (17.7  | )      |
| Balance at December 31, 2003         |   | 16.9   |   |
| Goodwill adjustments  during 2004         |   | (8.3   | )      |
| Balance at December 31, 2004         |   | 8.6    |   |
| Goodwill  adjustments during 2005         |   | — |   |
| Balance at March 31, 2005            |   | 8.6    |   |
| Goodwill  adjustments during 2006         |   | (1.9   | )      |
| Balance at  March 31, 2006           |   | $      | 6.7    |   |

 

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Intangibleassets established in connection with the Company’s fresh-start reporting,separable intangible assets that are deemed to have defined lives (primarilyrelated to existing technology and brand name), are being amortized utilizingthe pattern-of-use method over estimated useful lives ranging from 3 to10 years. Changes in the carrying value of separable intangible assets forthe twelve months ended March 31, 2006, three month transition periodended March 31, 2005, and the years ended December 31, 2004 and 2003are as follows (in millions):

| ** **                                               | ** ** | **Existing  Technology** | ** ** | **Brand  Name** | ** ** | **Total  Amortization** | ** ** |
|----------------------------------------------------------|------------|--------------------------|------------|-----------------|------------|-------------------------|------------|
| Balance at  December 31, 2002                       |       |                     | 10.2       |            |       |                    | 8.1        |   |   |   | 18.3 |   |   |
| Amortization for  year ended December 31, 2003      |       |                     | (5.5       | )               |       |                    | (1.3       | ) |   |   | (6.8 | ) |   |
| Balance at December 31, 2003                        |       |                     | 4.7        |            |       |                    | 6.8        |   |   |   | 11.5 |   |   |
| Amortization for  the year ended December 31, 2004  |       |                     | (2.9       | )               |       |                    | (1.3       | ) |   |   | (4.2 | ) |   |
| Balance at December 31, 2004                        |       |                     | 1.8        |            |       |                    | 5.5        |   |   |   | 7.3 |   |   |
| Amortization for  three months ended March 31, 2005 |       |                     | (0.4       | )               |       |                    | (0.2       | ) |   |   | (0.6 | ) |   |
| Balance at March 31, 2005                           |       |                     | 1.4        |            |       |                    | 5.3        |   |   |   | 6.7 |   |   |
| Amortization for  the year ended March 31, 2006     |       |                     | (0.9       | )               |       |                    | (1.0       | ) |   |   | (1.9 | ) |   |
| Balance at  March 31, 2006                          |       |                     | $          | 0.5             |       |                    |       | $ | 4.3 |   |   |   | $ | 4.8 |   |   |
|                                                          |            |                          |            |                 |            |                         |            |  |  |  |  |  |  |  |  |  |

 

The anticipatedamortization schedule for the remaining years of these separable intangibleassets is as follows (in millions):

| **Year** | ** ** | ** ** | ** ** | **Current  Technology** | ** ** | **Brand  Name** | ** ** | **Total  Amortization** | ** ** |
|----------|------------|------------|------------|-------------------------|------------|-----------------|------------|-------------------------|------------|
| 2007     |       |       | 0.3        |                    |       |            | 0.9        |                    |       |   | 1.2 |   |   |
| 2008     |       |       | 0.1        |                    |       |            | 0.8        |                    |       |   | 0.9 |   |   |
| 2009     |       |       | 0.1        |                    |       |            | 0.8        |                    |       |   | 0.9 |   |   |
| 2010     |       |       | —     |                    |       |            | 0.7        |                    |       |   | 0.7 |   |   |
| 2011     |       |       | —     |                    |       |            | 0.7        |                    |       |   | 0.7 |   |   |
| 2012     |       |       |       |                    |       |            | 0.4        |                    |       |   | 0.4 |   |   |
| Total    |       |       | $          | 0.5                     |       |            |       | $                       | 4.3        |   |   |   | $ | 4.8 |   |   |
|          |            |            |            |                         |            |                 |            |                         |            |  |  |  |  |  |  |  |  |  |

 

**NOTE 3.   MODIII AND MOD II EQUIPMENT**

We adopted FIN 46R on January 1, 2004, whichresulted in the de-consolidation of our subsidiary, ZiLOG MOD III Inc.Subsequently a significant portion of the assets were sold and managementreceived authorization from the stockholders of MOD III, Inc. to sell theremaining assets without further stockholder approval and consequently thefinal results of ZiLOG MOD III Inc. were included in our financialresults.

On April 16, 2004, the Company announced theclosure of its MOD II five-inch wafer manufacturing facility in Nampa, Idaho.In association with this decision, the Company recorded net special charges of$6.9 million reflecting the impairment of long lived assets and costs to ceaseoperations, and $1.8 million for employee severance costs. MOD II productionceased on July 9, 2004 whereby the majority of the products previouslymanufactured in MOD II were transferred to X-FAB, in Lubbock, Texas. TheCompany is now operating under our stated strategy as a fabless semiconductorcompany.

On September 24, 2004, the Company sold all ofits wafer manufacturing equipment and certain other manufacturingsupport-related assets of our MOD II facility in Nampa, Idaho, toSTMicroelectronics for an aggregate cash consideration of $5.9 million net ofselling costs and expenses. The Company recorded a net gain of $1.7 million inconnection with these sales. The remaining assets of MOD II primarily consistof 

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land and buildings whichhave been classified as assets held for sale on the Company’s balance sheet at March 31,2006.

In July of 2004, ZiLOG MOD III,Inc. sold its production equipment to ST Microelectronics, Inc. At thecompletion of the sale in September, 2004, ZiLOG, Inc. received approximately$4.9 million for reimbursement of sustaining costs incurred, which was recordedas an offset to special charges.

In February 2006, ZiLOGMOD III, Inc. completed the sale of its remaining assets to Micron Technology,Inc for a total consideration net of closing costs of $4.6 million. Theseassets included the dormant 8” wafer fabrication facility and associated landowned by ZiLOG Mod III Inc. and vacant property owned by ZiLOG, Inc. ZiLOG MODIII, Inc. shareholders have voted to liquidate the special purpose entity anddistribute the remaining net proceeds to its Series A Preferredshareholders at the conclusion of that process. The distribution of the netproceeds includes $1.1 million to ZiLOG, Inc for the vacant property, $0.7million to ZiLOG, Inc. for reimbursement of sustaining and maintenance costsincurred and $0.1 million and $0.2 million set aside for estimatedremaining sustaining costs and estimated liquidation costs, respectively. Theremaining $2.5 million is anticipated to be distributed to holders of ZiLOG ModIII, Inc. Series A Preferred Stock on the liquidation of MOD III, Inc. andhas been recorded as a liability in the consolidated financial statements atMarch 31, 2006.

**NOTE 4.   SPECIALCHARGES AND REORGANIZATION ITEMS**

***Fiscal 2006 Special Charges Analysis***

During the three monthsended June 30, 2005, the Company initiated a plan of action to consolidatecertain of its support activities and transfer certain of these activities toits Philippines operations. These activities have resulted in lower overallsupport costs. The total severance and benefits cost of this action to date hasbeen $1.7 million which has been recorded as special charges related to areduction-in-force and support activity consolidation implemented during thetwelve months ended March 31, 2006, and the remaining amount will berecorded over the required service periods of the employees to be terminatedand is expected to be completed during the quarter ending March 31, 2006.In addition, the Company continues to incur period expenses to sustain theremaining assets held for sale on the balance sheet as of June 30, 2006totaling $1.8 million. There can be no assurance that the value we will realizefrom the ultimate sale or disposition of these assets will be equal to theestimated fair values. If the ultimate net value realized upon the dispositionof the remaining MOD II assets is less than the estimated fair value, theCompany’s future results of operations could be materially adversely impacted.

***2004 Special Charges Analysis***

On April 16, 2004, the Company announced theclosure of its MOD II five-inch wafer manufacturing facility in Nampa, Idahoand the related transfer of MOD II production activities to its foundrypartner, X-Fab, in Lubbock, Texas. MOD II ceased production operations on July 9,2004. As a result, in 2004, the Company incurred $3.2 million in sustainingcosts for post-closure maintenance of the MOD II facility. Additionally, MODIII sustaining costs for post-closure maintenance incurred by the Companytotaled $1.7 million, which was offset by approximately $4.9 millionreimbursement for these costs from the sale of the MOD III equipment toSTMicroelectronics, Inc. in July, 2004.

As a result of the closure of MOD II in 2004, theCompany incurred the following additional special charges: (1) employeeseverance and termination benefits of approximately $1.8 million related to thetermination of 144 employees, and; (2) an asset impairment charge of $5.4million related to the write-down of the MOD II long-lived assets and thesubsequent gain on sale of assets of $1.7 million related to the sale of thewafer manufacturing equipment and related assets to STMicroelectronics, Inc.in the fourth quarter of 2004.

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The costs for MOD II and MOD III consist of utilities,taxes, insurance, and other maintenance costs required to maintain thefacilities in a condition required for the sale of the respective properties.

Approximately $0.1 million of special charges duringthe year relate to third-party professional legal service fees associated withthe Company’s debt and equity restructuring of May 2002, and $0.3 millionseverance and termination benefits related to the Company’s continued effortsto align infrastructure costs to business-level requirements.

The Company’s estimatesused to determine the fair value of MOD II land and buildings held for sale asof December 31, 2004, which was $3.6 million, were based on an independentappraisal from a third party.

***2003 Special Charges Analysis***

Special charges in 2003 totaled $3.8 million and theprimary components of these special charges were $1.5 million of employeeseverance and termination benefits, $1.3 million of MOD III closure costs andprofessional fees of $0.6 million in connection with the Company’s bankruptcyrelated legal proceedings and Securities and Exchange Commission S-1registration statement for the registration of certain common stock required bythe May 2002 reorganization plan, which became effective in July 2003.The employee severance and termination benefits primarily relate to theelimination of manufacturing positions at the Company’s MOD II waferfabrication facility and the Manila, Philippines test facility that took placein February and September 2003, respectively. The $1.3 million of MODIII closure costs were ongoing costs for the maintenance of the idled MOD IIIeight-inch wafer manufacturing facility in Nampa, Idaho. The Company also hadlong-lived asset impairments of $0.2 million and an equity investmentimpairment of $0.2 million.

Thefollowing table details the beginning accrual balance as of December 31,2003 and the special charge accrual activity and ending accrual balances forthe year ended March 31, 2006, the three month transition period ended March 31,2005, and the year ended December 31, 2004. (in millions):

| ** **                                                                  | ** ** | **Severance and  Termination  Benefits** | ** ** | **Debt  Restructuring** | ** ** | **MOD III  Closure  Costs** | ** ** | **MOD II  Closure  Costs** | ** ** | **Total** | ** ** |
|-----------------------------------------------------------------------------|------------|-----------------------------------------------|------------|-------------------------|------------|----------------------------------|------------|---------------------------------|------------|-----------|------------|
| Balance at  Dec. 31, 2003                                              |       |                                          | —     |                    |       |                             | —     |                            |       |      | 0.1        |   |   |   | — |   |   | 0.1 |   |
| Provisions to  special charges                                              |       |                                          | 2.1        |                    |       |                             | 0.1        |                            |       |      | 1.7        |   |   |   | 3.2 |   |   | 7.1 |   |
| Provisions to  cost of sales relating to MOD II closure for retention bonus |       |                                          | 0.4        |                    |       |                             | —     |                            |       |      | —     |   |   |   | 0.1 |   |   | 0.5 |   |
| Cash payments                                                               |       |                                          | (2.2       | )                       |       |                             | (0.1       | )                               |       |      | (1.8       | ) |   |   | (2.6 | ) |   | (6.7 | ) |
| Balance at  Dec. 31, 2004                                              |       |                                          | 0.3        |                    |       |                             | —     |                            |       |      | —     |   |   |   | 0.7 |   |   | 1.0 |   |
| Cash payments                                                               |       |                                          | (0.2       | )                       |       |                             | —     |                            |       |      | —     |   |   |   | (0.4 | ) |   | (0.6 | ) |
| Balance at Mar  31, 2005                                                    |       |                                          | 0.1        |                    |       |                             | —     | )                               |       |      | —     |   |   |   | 0.3 |   |   | 0.4 |   |
| Provisions to  special charges                                              |       |                                          | 1.7        |                    |       |                             | (0.1       | )                               |       |      | 0.4        |   |   |   | 0.7 |   |   | 2.7 |   |
| Cash payments                                                               |       |                                          | (1.8       | )                       |       |                             | 0.1        |                            |       |      | (0.4       | ) |   |   | (0.9 | ) |   | (3.0 | ) |
| Balance at Mar. 31,  2006                                              |       |                                          | $          | —                  |       |                             |       | $                               | —     |      |       |   | $ | — |   |   |   | $ | 0.1 |   |   | $ | 0.1 |   |
|                                                                             |            |                                               |            |                         |            |                                  |            |                                 |            |           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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Specialcharges for the twelve months ended March 31, 2006, three month transitionperiod ended March 31, 2005, and the years ended December 31, 2004and 2003 are as follows (in millions):

| ** **                                             | ** ** | **Twelve  Months  Ended  Mar. 31,** | ** ** | **Twelve   Months   Ended  December 31,** | ** ** | **Three  Months  Ended  Mar. 31,** | ** ** |
|--------------------------------------------------------|------------|------------------------------------------|------------|----------------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                             | ** ** | **2006**                                 | ** ** | **2004**                                                 | ** ** | **2003**                                | ** ** | **2005** | ** ** |
| **Asset impairments:**                                 |       |                                     |       |                                                     |       |                                    |       |   |   |   |   |   |   |
| Test and probe equipment written-off                   |       |                                     | $          | —                                                   |       |                                    | $          | — |   | $ | 0.2 |   |   | $ | — |   |   |
| MOD II assets impairment(a)                            |       |                                     | 0.5        |                                                     |       | 5.4                                     |       | — |   |   | — |   |   |
| MOD II assets, gain on sale(a)                         |       |                                     | —     |                                                     |       | (1.7                                    | )          |   |   |   |   |   |   |
| Equity investment write-down                           |       |                                     | —     |                                                     |       | —                                  |       | 0.2 |   |   | — |   |   |
| **Restructuring of operations:**                       |       |                                     |       |                                                     |       |                                    |       |   |   |   |   |   |   |
| Employee severance and termination benefits, other     |       |                                     | 1.7        |                                                     |       | 0.3                                     |       | 1.5 |   |   | — |   |   |
| MOD II employee severance and termination benefits     |       |                                     | —     |                                                     |       | 1.8                                     |       | — |   |   | — |   |   |
| MOD II costs to close facility                         |       |                                     | 0.7        |                                                     |       | 3.2                                     |       | — |   |   | 0.3 |   |   |
| MOD III costs to  close facility                       |       |                                     |       |                                                     |       |                                    |       |   |   |   |   |   |   |
| MOD III sustaining costs for post-closure  maintenance |       |                                     | 0.4        |                                                     |       | 1.7                                     |       | 1.3 |   |   | 0.1 |   |   |
| MOD III reimbursement of maintenance costs(a)          |       |                                     | (0.8       | )                                                        |       | (4.9                                    | )          | — |   |   | — |   |   |
| **Professional  fees for debt restructuring**          |       |                                     | (0.1       | )                                                        |       | 0.1                                     |       | 0.6 |   |   | — |   |   |
|                                                   |       |                                     | $          | 2.4                                                      |       |                                    | $          | 5.9 |   | $ | 3.8 |   |   | $ | 0.4 |   |   |

 

a)                Asset impairmentitems and reimbursements were not included in the provision accruals in thefirst table above.

**NOTE 5.   RETIREMENTAND PENSION PLANS**

The Company has anemployee savings plan that qualifies as a deferred salary arrangement under Section 401(k) ofthe Internal Revenue Code (the “401(k) Plan”). Under the 401(k) Plan,participating U.S. employees may defer a portion of their pretax earnings, upto the Internal Revenue Service annual contribution limit. The Company may makematching contributions on behalf of each participating employee in an amountequal to 100% of the participant’s deferral contribution, up to 1.5% of theparticipant’s compensation on a quarterly basis. The Company may also makeadditional discretionary contributions to the 401(k) Plan. Matchingcontributions to the 401(k) Plan were approximately $0.2 million forthe twelve months ended March 31, 2006, $0.1 million for the three monthtransition period ended March 31, 2005, $0.3 million for the year ended December 31,2004, and $0.4 million for the year ended December 31, 2003. There were nodiscretionary contributions made in fiscal 2006, the three month transitionperiod ended March 31, 2005, or the years 2004 and 2003. The Company’sPhilippines subsidiaries maintain a defined benefit pension plan for localemployees, which is consistent with local statutes and practices. This benefitplan had no material impact on the Company’s financial statements for theperiods presented.

**NOTE 6.   STOCKHOLDERS’EQUITY**

**Common Stock**

The following descriptionsummarizes information regarding the Company’s capital stock after confirmationof the Reorganization Plan. This information is subject in all respects toapplicable provisions of ZiLOG’s amended and restated certificate ofincorporation and its amended and restated bylaws.

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***Stock Split***

On February 18, 2004,the Board of Directors approved a reverse stock split in which every two sharesof common stock was converted into one share of common stock, effective March 1,2004. All Successor Company common shares and per-share figures have beenretroactively restated to reflect this one-for-two reverse stock split. Inaddition, the Company reclassified $200,000 from “Common stock” to “Additionalpaid-in capital” in the Company’s balance sheet at December 31, 2003.

***General***

The Company’s authorizedcapital stock consists of 60,000,000 shares of Common Stock, par value $0.01per share. The holders of outstanding shares of common stock are entitled toreceive dividends or distributions as may be lawfully declared by the board ofdirectors. In the event that the corporation is dissolved, the holders ofcommon stock would be entitled to share ratably in all assets that may beavailable for distribution after the satisfaction of all liabilities. TheCommon Stock has no preemptive or conversion rights and is not subject to redemption.All outstanding shares of common stock are fully paid and non-assessable.

***Voting***

The holders of commonstock are entitled to one vote per share on all matters submitted to a vote ofstockholders. The holders of a majority of the outstanding shares of commonstock must approve all matters brought before the stockholders, except asotherwise required by the Delaware General Corporation Law and except asotherwise set forth below.

***2004 Public Stock Offering***

On March 12, 2004,the Company’s common stock was listed for trading on the NASDAQ National Marketwith a ticker symbol of ZILG. On March 18, 2004, and subsequently on April 6,2004 through exercise of an over allotment option, the Company raisedapproximately $24.4 million through the sale of 2,252,100 shares of its commonstock at a price $12.50 per share in a registered public offering of its stock.

**2004 Employee StockPurchase Plan**

The 2004 Employee Stock Purchase Plan (“2004 ESPP”)was adopted by the compensation committee of the Company’s Board of Directorson December 17, 2003 and approved by the Company’s stockholders on February 12,2004. The 2004 ESPP became effective on May 15, 2004. A total of 1,250,000shares of common stock have been reserved for issuance under the 2004 ESPP toeligible employees. These shares will be either authorized as un-issued shares,or shares that have been reacquired by the Company. The 2004 ESPP isimplemented by 12-month offering periods, each of which is composed offour 3-month purchase periods. Four overlapping offering periodsgenerally commence during each fiscal year, with an offering period commencingon the first day of each fiscal quarter. Four purchase periods also commenceduring each fiscal year, with a purchase period commencing on the first day ofeach fiscal quarter. An eligible employee is granted an option at the start ofthe offering period to purchase shares of the Company’s common stock withpayroll deductions ranging from 1% to 15% of their eligible compensation duringthe offering period. The payroll deductions are accumulated and, at the end ofeach purchase period, applied to purchase shares of common stock, unless theemployee withdraws from the 2004 ESPP prior to such date. The purchase pricewill be the lower of 85% of the fair market value of the common stock either onthe first business day of the applicable offering period or the last businessday of the purchase period within such offering period.

At March 31, 2006 atotal of 134,153 shares of the Company’s common stock have been purchased underthe 2004 ESPP, leaving a total of 1,115,847 shares available to be purchased.

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**Stock RepurchasePrograms**

As of March 31,2006, total stock repurchases for the 2003 and 2004 stock repurchase programsand other stock repurchases total 1,087,388 shares with a net aggregate cost of$7.2 million.

| ** **     | ** ** | **Treasury Shares Outstanding** | ** ** |
|----------------|------------|-------------------------------------------|------------|
| ** **     | ** ** | **3/31/06**                               | ** ** | **3/31/05** | ** ** | **12/31/04** | ** ** | **12/31/03** | ** ** |
| 2003 Plan      |       | 405,164                                   |       | 405,164 |   | 405,164 |   | 382,664 |   |
| 2004 Plan      |       | 572,100                                   |       | 572,100 |   | 572,100 |   | — |   |
| Others         |       | 110,124                                   |       | 92,735 |   | 92,735 |   | — |   |
| Ending Balance |       | 1,087,388                                 |       | 1,069,999 |   | 1,069,999 |   | 382,664 |   |

 

***2004 Stock Repurchase Program***

The Company’s Board of Directors approved the 2004stock repurchase program on July 29, 2004, pursuant to which the Companymay repurchase up to $5.0 million in market value of its outstanding shares ofcommon stock.

In August 2004, the Company purchased 415,300shares of its common stock in the market for $3.2 million. In September 2004,it purchased 136,400 shares of common stock in the market for $1.1 million.And, in October 2004, the Company purchased 20,400 shares of its commonstock in the market for $0.1 million.

As of March 31, 2006,the Company had repurchased 572,100 shares under this program at an aggregatecost of $4.4 million.

***2003 Stock Repurchase Program***

The Company’s Board of Directors approved a stockrepurchase program on April 17, 2003, under which the Company mayrepurchase up to 500,000 shares of its outstanding common stock.

Asummary of the activity under this plan is as follows ($ in millions):

| ** **                                        | ** ** | **Shares** | ** ** | **Net  Cost** | ** ** | **Loan  Repayment** | ** ** |
|---------------------------------------------------|------------|------------|------------|---------------|------------|---------------------|------------|
| 2003 repurchases  from open market                |       | 125,000    |       | $             | 0.5        |                |       | $ | — |   |   |
| 2003 repurchases  from former executive officer   |       | 50,000     |       | $             | 0.2        |                |       | $ | 0.1 |   |   |
| 2003 repurchases  from other and former employees |       | 207,664    |       | $             | 0.6        |                |       | $ | 0.5 |   |   |
| 2003 Total repurchases                            |       | 382,664    |       | $             | 1.3        |                |       | $ | 0.6 |   |   |
| 2004 repurchases  from other and former employees |       | 22,500     |       | $             | 0.1        |                |       | $ | 0.1 |   |   |
| Total repurchases  through March 31, 2006    |       | 405,164    |       | $             | 1.4        |                |       | $ | 0.7 |   |   |

 

On May 30, 2003, ZiLOG’s Board of Directorsapproved the repurchase of 50,000 shares of common stock from ZiLOG’sPresident, Michael Burger, at the closing price on that day of $6.50 per share.The net cash paid to repurchase these shares from Mr. Burger was net ofcertain loan repayments made to the Company by Mr. Burger.

As of  March 31, 2006, the Company hadrepurchased 405,164 shares under this program from employees and formeremployees pursuant to repurchase rights at an aggregate cost of $2.1 million.

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***Other Stock Repurchases***

On November 17, 2004, the Board of Directors, inconjunction with the resignation of a former executive, Michael Burger,approved the repurchase of 92,735 shares for the fair market purchase price of$6.20 per share in consideration for the repayment of his loans totaling $0.6 million.

During fiscal 2006, the Company repurchased 17,386shares from former employees in consideration for the repayment of loanspayable to us totaling $0.1 million.

Total stock repurchasesfor the 2003 and 2004 stock repurchases and other stock repurchases through March 31,2006 total 1,087,388 shares with a net aggregate cost of $7.2 million.

***2004 Omnibus Stock Incentive Plan***

The 2004 Omnibus Stock Incentive Plan (the “2004 Plan”)was adopted by the compensation committee of the Company’s Board of Directorson December 17, 2003 and approved by the Company’s stockholders on February 12,2004. The 2004 Plan became effective on March 10, 2004. The committee maygrant incentive stock options (ISO”), non-statutory stock options (“NSO”) orrestricted shares to certain employees, officers, directors, advisors andconsultants of the Company who may purchase up to 1,500,000 shares of theCompany’s common stock, par value $0.01 per share under the 2004 Plan.

In general, the options and shares granted pursuant tothe 2004 Plan are exercisable at such time or times, and subject to such termsand conditions (including the vesting schedule, period of exercisability andexpiration date) as the Compensation Committee determines, in the applicableoption agreement. The exercise price per share, payable upon the exercise of anoption, is established by the committee at the time of the grant. But, is notless than par value per share of common stock on the date of the grant and inthe case of an ISO generally is not less than 100% of the fair market value pershare on the date of grant.

Ingeneral, restricted stock awards granted pursuant to the 2004 Plan are subjectto the restricted stock award agreement that reflects terms, conditions andrestrictions related to the restricted stock award. The agreement includesamong other things, the period during which the restricted stock is subject toforfeiture, the imposition of any performance-based conditions or otherrestrictions on the award if any.

**2002 Omnibus StockIncentive Plan:**

***Common Stock***

The 2002 Omnibus Stock Incentive Plan (the “OmnibusPlan”) was adopted by the Board of Directors in May 2002. Subject toadjustment pursuant to the terms of the Omnibus Plan, the compensationcommittee of the Board of Directors may grant options to purchase up to anaggregate of 1,058,140 shares of common stock under the Omnibus Plan. Stockoptions granted under the Omnibus Plan were permitted to be: (1) incentivestock options or non-qualified stock options; (2) EBITDA-linked optionsand or non-EBITDA linked options. The term of a non EBITDA-linked option isdetermined by the Compensation Committee at the time of grant, but will notexceed ten years.

Each EBITDA-linked option will be immediatelyexercisable on the date of grant and cliff-vest on the sixth anniversary fromthe date of grant. Vesting can be accelerated for EBITDA-linked options basedon the “adjusted EBITDA,” as defined, reported for the immediately preceding 12-monthperiod as follows: (1) one-third if the Company reports adjusted EBITDAfor the previous 12 months in excess of $17.2 million; (2) two-thirdsif the Company reports adjusted EBITDA for the previous 12 months inexcess of $25.7 million; and (3) 100% if the Company reports adjustedEBITDA for the previous 12 months in excess of $30.0 million.

In accordance withSecurities and Exchange Commission guidelines, EBITDA figures presented in thisForm 10-K represent a non-GAAP measure of liquidity. EBITDA reflectsnet income adjusted for 

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non-cashitems, interest and income taxes. Management uses a separate “adjusted EBITDA”calculation for purposes of determining certain employees’ incentivecompensation and, subject to meeting specified adjusted EBITDA amounts, foraccelerating the vesting of EBITDA-linked stock options. This measure ofadjusted EBITDA was approved as part of the Reorganization Plan. AdjustedEBITDA excludes interest, income taxes, effects of changes in accountingprinciples and equity adjustments and non-cash charges such as depreciation,amortization, in-process research and development, and stock-based compensationexpense. It also excludes cash and non-cash charges associated withreorganization items and special charges which represent operational restructuringcharges, including asset write-offs, employee termination costs, and leasetermination costs. The differences between EBITDA and ZiLOG’s adjusted EBITDArelate to the following cash-settled reorganization and special items that areadded-back in adjusted EBITDA computations:

·       Employeeretention bonuses, severance pay and termination benefits;

·       Professionalfees for debt restructuring;

·       Leasetermination costs;

·       Terminationand exit charges; and

·       MODIII closure costs.

At March 31, 2006, 228,353 shares of common stockout of a total of 414,431 EBITDA-linked options granted, net of cancellationshave vested. In no event will any EBITDA-linked options vest later than May 15,2008, even if these adjusted EBITDA thresholds have not been satisfied. The pershare exercise price of shares purchasable under an EBITDA-linked option is$5.52 and each such option will be exercisable for ten years after the datesuch option is granted, unless earlier terminated. In general,non-EBITDA-linked options granted pursuant to the Omnibus Plan will beexercisable at such time or times, and subject to such other terms andconditions (including the vesting schedule, period of exercisability andexpiration date) as the Compensation Committee determines, in the applicable awardagreements or thereafter. The exercise price per share payable upon theexercise of an option will be established by the committee, in its solediscretion, at the time of grant.

When an optionee exercisesan option before the option is vested, then the optionee will receive shares ofrestricted stock equal to the number of shares exercised. If the optioneeterminates employment or service before the restrictions on the restrictedstock have lapsed, then the Company has the right to repurchase these shares asdescribed below.

***Restricted Stock***

The Company was permitted to grant up to 1,220,930restricted shares of common stock under the Omnibus Plan. The restricted sharesgenerally vest 25% of the shares on the date of grant and an additional 25% oneach of the first, second and third anniversaries of such grant date.

The Omnibus Plan authorizes the Compensation Committeeto make loans available to participants with respect to certain restrictedstock awards for the payment of any federal or state income tax attributable tothe restricted stock subject to the award. Subsequent to the passing of theSarbanes Oxley Act of 2002, the Company no longer will offer loans to employeesfor the payment of taxes on restricted stock. At March 31, 2006 and 2005,and December 31, 2004 and 2003, employee loans outstanding aggregated were$0.4 million, $0.5 million, $0.5 million, and $1.4 million,respectively, and these amounts are recorded as other assets in theaccompanying balance sheet.

As of December 31, 2003, there were 365,128shares of common stock that were subject to repurchase rights by the Companyupon termination of employment by the holders. Following the Company’s public 

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offering of stock in March 2004,the restrictions as to repurchase rights no longer apply. The restrictions onthese shares lapsed in May 2005.

On October 18, 2002, the Board of Directorsamended the Omnibus Plan to provide, among other things, that no furtherrestricted shares be issued under the Omnibus Plan (other than those alreadyreserved for particular plan participants) and that the shares which hadformerly been allocated for restricted shares be allocated to future grants ofstock options.

In January 2002, the Company entered into anemployment agreement with James M. Thorburn, the Company’s Chairman and ChiefExecutive Officer, pursuant to which the Company was required to make awards of88,232 shares of restricted common stock on each of May 13, 2002, 2003,2004 and 2005. The Company committed to loan Mr. Thorburn the funds to paythe income taxes due with respect to his restricted stock awards, as theCompany had done with other employees that previously received awards ofrestricted stock.

In July 2002,however, Congress enacted the Sarbanes-Oxley Act of 2002, which prohibits such loans.As a result of this change, the restricted stock award of May 13, 2003 wascancelled and replaced with options to purchase 114,709 shares of common stockat an exercise price of $2.00. The restricted stock awards of May 13, 2004and 2005 were cancelled and replaced with options to purchase 229,420 shares ofcommon stock at an exercise price of $5.20. The original vesting dates wereretained. The Company recorded additional compensation expense for thesemodifications to the restricted stock awards.

***Deferred Stock Compensation***

For the twelve monthsended March 31, 2006, the three month transition period ended March 31,2005, and for the years ended December 31, 2004 and 2003, ZiLOG recognized$0.7 million, $0.3 million, $2.0 million and $1.5 million, respectively,of stock-based compensation expense primarily in connection with the award ofrestricted stock, during May 2002 to certain employees, executives andconsultants at purchase prices below their deemed fair market value at the dateof grant. The restrictions on the shares of restricted stock lapsed 25% on theaward date which was May 15, 2002 and 25% on each of the first threeanniversaries following the award date. Compensation expense for employee stockawards was measured on the award date and is being recognized over three yearsas these restrictions lapse. Compensation expense for stock awards toconsultants is re-measured at each balance sheet date until the awards vest andis being recognized over the vesting periods.

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***Stock Plan Activity***

A summaryof the Company’s stock plan activity for the twelve months ended March 31,2006, twelve months ended December 31, 2004, and the three months ended March 31,2005, are as follows:

| ** **                                       | ** ** | **Shares Available  for Grant** | ** ** | **Options  Outstanding** | ** ** | **Weighted-Average  Exercise Price** | ** ** |
|--------------------------------------------------|------------|-------------------------------------------|------------|--------------------------|------------|-------------------------------------------|------------|
| **2002 and 2004 Omnibus Stock  Incentive Plans** | ** ** |                                      | ** ** | ** **               |       |                                      | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Balance as of  December 31, 2003            |       |                                      | 249,700    |                     |       |                                      | 1,222,485  |   |   |   | $ | 5.48 | ** ** |   |
| Options and shares reserved                      |       |                                      | 1,500,000  |                     |       |                                      | —     |   |   |   | — | ** ** |   |
| Restricted shares granted                        |       |                                      | (37,730    | )                        |       |                                      | —     |   |   |   | — | ** ** |   |
| Options granted                                  |       |                                      | (1,243,004 | )                        |       |                                      | 1,243,004  |   |   |   | 9.77 | ** ** |   |
| Options exercised                                |       |                                      | —     |                     |       |                                      | (25,854    | ) |   |   | 8.18 | ** ** |   |
| Options cancelled                                |       |                                      | 240,580    |                     |       |                                      | (240,580   | ) |   |   | 8.46 | ** ** |   |
| Restricted shares cancelled                      |       |                                      | 176,465    |                     |       |                                      | —     |   |   |   | 0.02 | ** ** |   |
| Restricted shares repurchased                    |       |                                      | 115,235    |                     |       |                                      | —     |   |   |   | 6.45 | ** ** |   |
| Balance as of December 31, 2004             |       |                                      | 1,001,246  |                     |       |                                      | 2,199,055  |   |   |   | $ | 7.55 | ** ** |   |
| Restricted shares granted                        |       |                                      | (3,252     | )                        |       |                                      | —     |   |   |   | — | ** ** |   |
| Options granted                                  |       |                                      | (25,250    | )                        |       |                                      | 25,250     |   |   |   | 5.06 | ** ** |   |
| Options exercised                                |       |                                      | —     |                     |       |                                      | (22,572    | ) |   |   | 5.45 | ** ** |   |
| Options cancelled                                |       |                                      | 59,123     |                     |       |                                      | (59,123    | ) |   |   | 7.51 | ** ** |   |
| Balance as of March 31, 2005                |       |                                      | 1,031,867  |                     |       |                                      | 2,142,610  |   |   |   | $ | 7.61 | ** ** |   |
| Restricted shares granted                        |       |                                      | (267,176   | )                        |       |                                      | —     |   |   |   | 0.01 | ** ** |   |
| Options granted                                  |       |                                      | (401,615   | )                        |       |                                      | 401,615    |   |   |   | 2.80 | ** ** |   |
| Options cancelled                                |       |                                      | 740,916    |                     |       |                                      | (740,916   | ) |   |   | 7.71 | ** ** |   |
| Restricted shares repurchased                    |       |                                      | 17,389     |                     |       |                                      | —     |   |   |   | 4.60 | ** ** |   |
| Balance as of  March 31, 2006               |       |                                      | 1,121,381  |                     |       |                                      | 1,803,309  |   |   |   | $ | 6.50 | ** ** |   |

 

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Asummary of the predecessor company’s stock plan activity for the four monthsended April 30, 2002 and the eight months ended December 31, 2002 andthe twelve months ended December 31, 2003 are as follows:

| ** **                                    | ** ** | **Shares Available  for Grant** | ** ** | **Options  Outstanding** | ** ** | **Weighted-Average  Exercise Price** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------|------------|--------------------------|------------|-------------------------------------------|------------|
| Pre-2002 Option  Plans                        |       |                                      |       |                     |       |                                      |       |   |   |   |   |
| Balance as of  December 31, 2001         |       |                                      | 6,506,214  |                     |       | 6,498,730                                 |       |   | $ | 3.83 |   |   |
| Options Cancelled                             |       |                                      | (6,506,214 | )                        |       | (6,498,730                                | )          |   | 3.83 |   |   |
| Balance as of April 30, 2002             |       |                                      | —     |                     |       | —                                    |       |   | — |   |   |
| 2002 and 2004 Omnibus  Incentive Plans        |       |                                      |       |                     |       |                                      |       |   |   |   |   |
| Options and shares reserved                   |       |                                      | 2,279,070  |                     |       | —                                    |       |   | $ | — |   |   |
| Restricted Shares granted                     |       |                                      | (931,233   | )                        |       | —                                    |       |   | 0.02 |   |   |
| Shares Reserved for grant of restricted stock |       |                                      | (264,697   | )                        |       | —                                    |       |   | 0.02 |   |   |
| Options granted                               |       |                                      | (1,049,333 | )                        |       | 1,049,333                                 |       |   | 5.48 |   |   |
| Restricted shares repurchased                 |       |                                      | 78,250     |                     |       | —                                    |       |   | 2.66 |   |   |
| Options cancelled                             |       |                                      | 113,508    |                     |       | (113,508                                  | )          |   | 5.52 |   |   |
| Balance as of December 31, 2002          |       |                                      | 225,565    |                     |       | 935,825                                   |       |   | $ | 5.48 |   |   |
| Options granted                               |       |                                      | (437,959   | )                        |       | 437,959                                   |       |   | — |   |   |
| Options exercised                             |       |                                      | —     |                     |       | (30,687                                   | )          |   | 0.02 |   |   |
| Options cancelled                             |       |                                      | 120,612    |                     |       | (120,612                                  | )          |   | 0.02 |   |   |
| Restricted shares cancelled                   |       |                                      | 88,232     |                     |       | —                                    |       |   | 0.02 |   |   |
| Restricted shares repurchased                 |       |                                      | 253,250    |                     |       | —                                    |       |   | 2.66 |   |   |
| Balance as of  December 31, 2003         |       |                                      | 249,700    |                     |       | 1,222,485                                 |       |   | $ | 5.48 |   |   |

 

Thefollowing table summarizes information about stock options outstanding at March 31,2006:

| ** **                                  | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|---------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| **Range of Exercise Prices** | ** ** | ** **                   | ** ** | **Number  Outstanding**      | ** ** | **Weighted-  Average  Remaining  Contractual Life** | ** ** | **Weighted-  Average  Exercise Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted-  Average  Exercise Price** | ** ** |
| $2.00-$2.28                                 |       |                         | 127,609    |                         |       |   | 7.42 |   |   |   | $ | 2.02 |   |   |   | 114,709 |   |   |   | $ | 2.00 |   |   |
| $2.70-$2.70                                 |       |                         | 305,065    |                         |       |   | 9.44 |   |   |   | 2.70 |   |   |   | — |   |   |   | 0.00 |   |   |
| $3.28-$5.19                                 |       |                         | 103,705    |                         |       |   | 8.18 |   |   |   | 4.10 |   |   |   | 40,285 |   |   |   | 4.20 |   |   |
| $5.20-$5.20                                 |       |                         | 275,304    |                         |       |   | 8.12 |   |   |   | 5.20 |   |   |   | 275,304 |   |   |   | 5.20 |   |   |
| $5.52-$5.52                                 |       |                         | 434,985    |                         |       |   | 7.09 |   |   |   | 5.52 |   |   |   | 191,489 |   |   |   | 5.52 |   |   |
| $5.80-$9.30                                 |       |                         | 124,189    |                         |       |   | 7.80 |   |   |   | 7.08 |   |   |   | 77,824 |   |   |   | 7.00 |   |   |
| $12.44-$12.44                               |       |                         | 408,852    |                         |       |   | 8.08 |   |   |   | 12.44 |   |   |   | 160,503 |   |   |   | 12.44 |   |   |
| $13.58-$13.58                               |       |                         | 16,850     |                         |       |   | 8.04 |   |   |   | 13.58 |   |   |   | 10,189 |   |   |   | 13.58 |   |   |
| $14.30-$14.30                               |       |                         | 6,750      |                         |       |   | 7.81 |   |   |   | 14.30 |   |   |   | 3,927 |   |   |   | 14.30 |   |   |
| $2.00-$14.30                                |       |                         | 1,803,309  |                         |       |   | 8.02 |   |   |   | $ | 6.50 |   |   |   | 874,230 |   |   |   | $ | 6.43 |   |   |
|                                             |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Options that were exercisable as of March 31,2006 and 2005, and December 31, 2004 and 2003 were 874,230, 739,981,689,787, and 465,217, respectively.

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Theweighted average fair value of options granted for the twelve months ended March 31,2006, the three month transition period ended March 31, 2005, and theyears ended December 31, 2004 and 2003 were $2.80, $5.06, $9.77, and $5.60per share, respectively. The fair value of options granted was estimated at thedate of grant using the Black-Scholes option pricing model applying thefollowing weighted average assumptions:

| ** **                              | ** ** | **Twelve  Months  Ended  Mar. 31** | ** ** | **Twelve  Months  Ended  Dec. 31** | ** ** | **Three  Months  Ended  Mar. 31** | ** ** |
|-----------------------------------------|------------|-----------------------------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|
| ** **                              | ** ** | **2006**                                | ** ** | **2004**                                | ** ** | **2003**                               | ** ** | **2005** | ** ** |
| Annual average  risk-free interest rate |       |                                    | 4.9        | %                                       |       |                                   | 3.4        | % |   | 3.0 | % |   | 3.4 | % |   |
| Estimated life in  years                |       |                                    | 5          |                                    |       |                                   | 5          |   |   | 5 |   |   | 5 |   |   |
| Dividend yield                          |       |                                    | 0.0        | %                                       |       |                                   | 0.0        | % |   | 0.0 | % |   | 0.0 | % |   |
| Volatility                              |       |                                    | 54.2       | %                                       |       |                                   | 5.8        | % |   | 66.5 | % |   | 52.2 | % |   |

 

**NOTE 7.   MINORITYINTEREST**

At December 31, 2003, a minority interest ofapproximately $30.0 million was recorded on the consolidated balance sheetin order to reflect the share of MOD III, Inc. held by minority investors.The minority interest share represented their entitlement to receive anaggregate liquidation preference of the first $30.0 million plus anyaccrued but unpaid dividends on the MOD III, Inc. Series A preferredstock from the net proceeds from the sale of the MOD III, Inc. assets heldfor sale at December 31, 2003.

In December 2003, the FASB issued Interpretation No. 46(revised December 2003), “Consolidation of Variable Interest Entities (“FIN46R”),” which addresses how a business enterprise should evaluate whether ithas a controlling financial interest in an entity through means other thanvoting rights. The interpretation replaces Interpretation No. 46, “Consolidationof Variable Interest Entities,” which was issued in January 2003.

Effective January 1,2004, the Company adopted the provisions of FIN 46R. Under the provisions ofFIN 46R, the Company’s investment in ZiLOG MOD III, Inc. (“MOD III”) wasdetermined to be a variable interest entity; however, the Company was notdetermined to be the primary beneficiary. Accordingly, as prescribed by FIN46R, the Company’s adoption of this pronouncement:

·       Wasrecorded as a cumulative effect of a change in accounting principle and not asa restatement to any previous period financial statements;

·       Effectedelimination of both the $30.0 million of MOD III assets held for sale andthe corresponding $30.0 million minority interest in MOD III on theconsolidated balance sheet; and

·       Resultedin no impact to results of operations.

Subsequent to the adoption of FIN 46R which resultedin the de-consolidation of the Company’s subsidiary, ZiLOG MOD III, Inc.,  Zilog Inc. management received authorizationfrom the stockholders of ZiLOG MOD III, Inc. to sell the remaining assetswithout further stockholder approval and consequently the final results ofZiLOG MOD III, Inc. were included in the Company’s consolidated financialresults.

Substantially all of the equipment of MOD III was soldon July 16, 2004. The remaining assets of MOD III consisted primarily ofland and a building. Under the terms of the MOD III, Inc. Series Apreferred stock liquidation preference, approximately $4.9 million ofhistorical costs incurred by the Company on behalf of MOD III, Inc. tomaintain its assets in saleable condition was reimbursed to the Company fromthe net proceeds received from the sale of the MOD III’s equipment. Suchreimbursement is included within the caption special charges and reorganizationitems in the Company’s consolidated statement of operations for the year ended March 31,2006.

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On February 16, 2006,ZiLOG MOD III, Inc., a special purpose subsidiary created largely for theeconomic benefit of the Company’s former bondholders, completed the sale of itsremaining assets to Micron Technology, Inc for a total consideration of $3.8 million.These assets included the dormant 8” wafer fabrication facility andassociated land owned by ZiLOG Mod III Inc.. The cost of the transaction was$0.4 million and has been apportioned on a prorated basis to the relatedassets sold.

This transactionrepresents the sale of the remaining assets of ZiLOG Mod III Inc. and, as such,the shareholders voted to liquidate the special purpose entity and distributethe remaining net proceeds to its Series A Preferred shareholders at theconclusion of that process. The costs to liquidate ZiLOG Mod III, Inc. areestimated to be $0.2 million. It is anticipated that approximately $2.5 millionwill be distributed to holders of ZiLOG Mod III, Inc. Series APreferred Stock on the liquidation of the subsidiary and as such this estimatedamount due has been recorded in our consolidated financial statements at March 31,2006. The estimated distribution to the ZiLOG Mod III, Inc. shareholdersis net of reimbursement to ZiLOG for costs it has incurred to maintain thefacility totaling approximately $0.8 million. These costs includesustaining costs incurred by ZiLOG on behalf of ZiLOG Mod III, Inc. sincethe last sale of the equipment and distribution to Series A Preferredshareholders.

**NOTE 8.**   CREDIT FACILITY

Upon consummation of theReorganization Plan, the Company entered into a senior secured financingfacility (the “Facility”) with a commercial lender (the “Lender”), dated May13, 2002, for a three-year $15.0 million senior secured revolving creditfacility. Borrowings on the Facility bear interest at a rate per annum equal,at the Company’s option, to the commercial lender’s stated prime rate or LIBOR,plus 2.5%. At December 31, 2004, the Company had no borrowings outstandingunder this facility. At December 31, 2003, the Company had borrowingsoutstanding of $5.0 million, at a LIBOR-based rate of 3.6%. This creditfacility expired on May 13, 2005. As of March 31, 2006, March 31, 2005,December 31, 2004 and December 31, 2003, the Company had no standby credit, andhad zero, $0.1 million, $0.2 and $0.3 million of standby letters of credit,respectively, issued to vendors under the Facility.

**NOTE 9.   NET LOSS PER SHARE**

Thefollowing table presents the calculation of basic and diluted net loss pershare of common for the periods indicated (in millions, except per sharedata):

| ** **                                                                      | ** ** | **Twelve Months Ended** | ** ** | **Three  Months  Ended** | ** ** |
|---------------------------------------------------------------------------------|------------|-----------------------------------|------------|--------------------------|------------|
| ** **                                                                      | ** ** | **Mar. 31,  2006**           | ** ** | **Dec. 31,  2004**  | ** ** | **Dec. 31,  2003** | ** ** | **Mar. 31,  2005** | ** ** |
| Net loss                                                                        |       |                              | $          | (16.8                    | )          |   |   | $ | (18.5 | ) |   |   | $ | (5.9 | ) |   |   | $ | (6.6 | ) |   |
| Weighted-average  shares outstanding                                            |       |                              | 16.4       |                     |       |   | 16.1 |   |   |   | 14.7 |   |   |   | 16.3 |   |   |
| Less:  Weighted-average shares subject to repurchase                            |       |                              | —     |                     |       |   | (0.1 | ) |   |   | (0.4 | ) |   |   | (0.1 | ) |   |
| Weighted-average  shares used in computing basic and diluted net loss per share |       |                              | 16.4       |                     |       |   | 16.0 |   |   |   | 14.3 |   |   |   | 16.2 |   |   |
| Basic and diluted net  loss per share                                           |       |                              | $          | (1.02                    | )          |   |   | $ | (1.16 | ) |   |   | $ | (0.41 | ) |   |   | $ | (0.41 | ) |   |

 

At March 31, 2006, March 31, 2005, and December 31,2004, options to purchase 1.8 million, 2.1 million, and 2.2 millionshares of common stock, respectively, are excluded from the determination ofdiluted net loss per share, as the effect of such shares is anti-dilutive.

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**NOTE 10.   INCOMETAXES**

Thecomponents of loss before provision (benefit) for income taxes are as follows(in millions):

| ** **    | ** ** | **Twelve Months Ended** | ** ** | **Three  Months  Ended** | ** ** |
|---------------|------------|-----------------------------------|------------|--------------------------|------------|
| ** **    | ** ** | **Mar. 31,  2006**           | ** ** | **Dec. 31,  2004**  | ** ** | **Dec. 31,  2003** | ** ** | **Mar. 31,  2005** | ** ** |
| United States |       |                              | $          | (9.7                     | )          |   |   | $ | (7.0 | ) |   |   | $ | (4.6 | ) |   |   | $ | (2.2 | ) |   |
| Foreign       |       |                              | (5.2       | )                        |       |   | (10.1 | ) |   |   | (2.8 | ) |   |   | (3.6 | ) |   |
|          |       |                              | $          | (14.9                    | )          |   |   | $ | (17.1 | ) |   |   | $ | (7.4 | ) |   |   | $ | (5.8 | ) |   |

 

Theprovision (benefit) for income taxes is as follows (in millions):

| ** **                            | ** ** | **Twelve Months Ended** | ** ** | **Three  Months  Ended** | ** ** |
|---------------------------------------|------------|-----------------------------------|------------|--------------------------|------------|
| ** **                            | ** ** | **Mar. 31,  2006**           | ** ** | **Dec. 31,  2004**  | ** ** | **Dec. 31,  2003** | ** ** | **Mar. 31,  2005** | ** ** |
| Federal                               |       |                              |       |                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Current                               |       |                              | $          | (0.6                     | )          |   |   | $ | 0.3 |   |   |   | $ | 1.0 |   |   |   | $ | 0.2 |   |   |
| Deferred                              |       |                              | 1.9        |                     |       |   | 0.3 |   |   |   | (2.6 | ) |   |   | 0.4 |   |   |
|                                  |       |                              | 1.3        |                     |       |   | 0.6 |   |   |   | (1.6 | ) |   |   | 0.6 |   |   |
| State                                 |       |                              |       |                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Current                               |       |                              | —     |                     |       |   | — |   |   |   | 0.2 |   |   |   | — |   |   |
| Deferred                              |       |                              | —     |                     |       |   | — |   |   |   | (0.5 | ) |   |   | — |   |   |
|                                  |       |                              | —     |                     |       |   | — |   |   |   | (0.3 | ) |   |   | — |   |   |
| Foreign                               |       |                              |       |                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Current                               |       |                              | 0.6        |                     |       |   | 0.8 |   |   |   | 0.4 |   |   |   | 0.2 |   |   |
|                                  |       |                              | 0.6        |                     |       |   | 0.8 |   |   |   | 0.4 |   |   |   | 0.2 |   |   |
| Provision (benefit) for  income taxes |       |                              | $          | 1.9                      |       |   |   | $ | 1.4 |   |   |   | $ | (1.5 | ) |   |   | $ | 0.8 |   |   |

 

Theprovision (benefit) for income taxes differs from the amount computed byapplying the statutory income tax rate of 34% to income before taxes. Theprovision (benefit) and tax effects of the differences are as follows (inmillions):

| ** **                                     | ** ** | **Twelve Months Ended** | ** ** | **Three  Months  Ended** | ** ** |
|------------------------------------------------|------------|-----------------------------------|------------|--------------------------|------------|
| ** **                                     | ** ** | **Mar. 31,  2006**           | ** ** | **Dec. 31,  2004**  | ** ** | **Dec. 31,  2003** | ** ** | **Mar. 31,  2005** | ** ** |
| Computed expected  benefit                     |       |                              | $          | (5.1                     | )          |   |   | $ | (5.8 | ) |   |   | $ | (2.5 | ) |   |   | $ | (2.0 | ) |   |
| State taxes, net  of federal benefits          |       |                              | 0.0        |                     |       |   | 0.0 |   |   |   | 0.2 |   |   |   | 0.0 |   |   |
| Foreign taxes                                  |       |                              | 0.6        |                     |       |   | 0.8 |   |   |   | 0.2 |   |   |   | 0.1 |   |   |
| Foreign losses  (benefited)/not benefited      |       |                              | 0.2        |                     |       |   | 5.0 |   |   |   | (0.1 | ) |   |   | 0.0 |   |   |
| Deferred tax  assets (benefited)/not benefited |       |                              | 4.6        |                     |       |   | (1.4 | ) |   |   | (2.1 | ) |   |   | 1.2 |   |   |
| Amortization of  deferred income tax charge    |       |                              | 1.7        |                     |       |   | 1.7 |   |   |   | 1.7 |   |   |   | 0.4 |   |   |
| Stock-based  compensation not deductible       |       |                              | 0.2        |                     |       |   | 0.8 |   |   |   | 0.5 |   |   |   | 0.1 |   |   |
| Non-deductible  items                          |       |                              | 0.1        |                     |       |   | 0.2 |   |   |   | 0.3 |   |   |   | 0.0 |   |   |
| Other                                          |       |                              | (0.4       | )                        |       |   | 0.1 |   |   |   | 0.3 |   |   |   | 1.0 |   |   |
|                                           |       |                              | $          | 1.9                      |       |   |   | $ | 1.4 |   |   |   | $ | (1.5 | ) |   |   | $ | 0.8 |   |   |

 

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Deferredincome taxes reflect the net tax effects of temporary differences between thecarrying amounts of assets and liabilities for financial reporting purposes andthe amounts used for income tax purposes. Significant components of the Company’sdeferred tax liabilities and assets are as follows (in millions):

| ** **                                       | ** ** | **Mar. 31,** | ** ** | **Mar. 31,** | ** ** | **Dec. 31,** | ** ** |
|--------------------------------------------------|------------|-------------------|------------|-------------------|------------|-------------------|------------|
| ** **                                       | ** ** | **2006**          | ** ** | **2005**          | ** ** | **2004**          | ** ** |
| Deferred tax  liabilities:                       |       |              |       |              |       |              |       |   |   |   |   |   |   |
| Intangible assets                                |       |              | $          | (3.2              | )          |              |       | $ | (4.1 | ) |   |   | $ | (5.0 | ) |   |
| Total deferred tax liabilities                   |       |              | (3.2       | )                 |       |              | (4.1       | ) |   |   | (5.0 | ) |   |
| Deferred tax assets:                             |       |              |       |              |       |              |       |   |   |   |   |   |   |
| Net operating loss carryforwards                 |       |              | 12.1       |              |       |              | 5.2        |   |   |   | 1.5 |   |   |
| Accruals and allowances not currently deductible |       |              | 1.6        |              |       |              | 2.8        |   |   |   | 2.8 |   |   |
| Deferred revenue                                 |       |              | 1.4        |              |       |              | 1.2        |   |   |   | 1.1 |   |   |
| Inventory valuation adjustments                  |       |              | 0.0        |              |       |              | 0.0        |   |   |   | 0.1 |   |   |
| Tax credit carryforwards                         |       |              | 3.4        |              |       |              | 1.2        |   |   |   | 1.2 |   |   |
| Property, plant and equipment                    |       |              | 4.4        |              |       |              | 0.7        |   |   |   | 0.7 |   |   |
| Other                                            |       |              | 0.0        |              |       |              | 0.1        |   |   |   | 0.1 |   |   |
| Total deferred tax assets                        |       |              | $          | 22.9              |       |              |       | $ | 11.2 |   |   |   | $ | 7.5 |   |   |
| Net deferred tax  assets                         |       |              | 19.7       |              |       |              | 7.1        |   |   |   | 2.5 |   |   |
| Valuation allowance                              |       |              | (19.7      | )                 |       |              | (7.1       | ) |   |   | (2.5 | ) |   |
| Deferred income taxes                            |       |              | $          | 0.0               |       |              |       | $ | (0.0 | ) |   |   | $ | 0.0 |   |   |

 

Balance SheetPresentation—Deferred Tax Assets & Liabilities 

| ** **                                         | ** ** | **Mar. 31,** | ** ** | **Mar. 31,** | ** ** | **Dec. 31,** | ** ** |
|----------------------------------------------------|------------|-------------------|------------|-------------------|------------|-------------------|------------|
| ** **                                         | ** ** | **2006**          | ** ** | **2005**          | ** ** | **2004**          | ** ** |
| Total deferred  tax assets                         |       |              | $          | 3.2               |       |              |       | $ | 5.0 |   |   |   | $ | 5.0 |   |   |
| Less: non current  portion—deferred tax asset |       |              | (2.8       | )                 |       |              | (2.3       | ) |   |   | (2.3 | ) |   |
| Net current  deferred tax assets                   |       |              | $          | 0.4               |       |              |       | $ | 2.7 |   |   |   | $ | 2.7 |   |   |
| Total non-current  deferred tax liabilities:       |       |              | $          | (3.2              | )          |              |       | $ | (5.0 | ) |   |   | $ | (5.0 | ) |   |
| Less: non-current  portion—deferred tax asset |       |              | 2.8        |              |       |              | 2.3        |   |   |   | 2.3 |   |   |
| Net non-current deferred  tax liability            |       |              | $          | (0.4              | )          |              |       | $ | (2.7 | ) |   |   | $ | (2.7 | ) |   |

 

Realization of the net deferred tax assets isdependent on future earnings, which are uncertain. Accordingly, a valuationallowance, in an amount equal to the net deferred tax assets as of March 31,2006, has been established to reflect this uncertainty. The valuation allowanceincreased by approximately $17.2 million for the fifteen months ended March 31,2006 as compared to the year ended December 31, 2004. This net increasewas primarily attributable to increases in the net operating losscarry-forwards, increases in the tax credit carryforwards, and an increase inthe property, plant and equipment.

The Company has federal and state net operating losscarryforwards (“NOLs”) of $29.8 million and $32.9 million, respectively. Thefederal NOLs will expire in 2024, if not utilized, and the state NOLcarryforwards will begin to expire in 2013, if not utilized.

The Company has federal and state research anddevelopment credit carryforwards of approximately $1.4 million and $1.2million, respectively. If not utilized, the federal carryforward will begin toexpire in 2024. The California credit can be carried forward indefinitely.

The reversal of $1.9 million in certain long term taxreserves in the fiscal year ended March 31, 2006, related to the releaseof certain tax reserves accrued in fresh start accounting items which are nolonger 

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required and resulted in areduction in goodwill from $8.6 million at March 31, 2005 to $6.7 millionas of March 31, 2006.

In connection with its reorganization in 2002, theCompany recorded income tax contingencies in accordance with Statement ofFinancial Accounting Standards No. 5, “Accounting for Contingencies.”These contingencies were primarily attributable to the Company’s reorganizationof MOD III. During fiscal year ended March 31, 2006 and the years ended December 31,2003 and 2004, the Company reassessed its deferred income tax liabilities andincome tax contingencies and reduced the associated liabilities as anadjustment to goodwill. As of March 31, 2006, the remaining reserves associatedwith these fresh start accounting items were $4.5 million and are included inthe accompanying balance sheet as other long-term liabilities.

The Company provides forU.S. income taxes on the earnings of foreign subsidiaries unless they areconsidered permanently reinvested outside of the U.S. At March 31, 2006,the cumulative amount of earnings upon which U.S. income tax has not beenprovided is approximately $0.7 million.

**NOTE 11.   COMMITMENTSAND CONTINGENCIES**

Some of the Company’s leases for facilities andequipment are under non-cancelable operating leases, which expire in FY 2007through FY 2011. The facility lease agreements generally provide for baserental rates which increase at various times during the terms of the leases andalso provide for renewal options at fair market rental value.

Minimumfuture lease payments under these non-cancelable operating leases at March 31,2006 are as follows (in millions):

| ** **                    | ** ** | **Operating  Leases** | ** ** |
|-------------------------------|------------|-----------------------|------------|
| FY 2007                       |       |                  | $          | 2.0 |   |   |
| FY 2008                       |       |                  | 1.7        |   |   |
| FY 2009                       |       |                  | 1.1        |   |   |
| FY 2010                       |       |                  | 0.4        |   |   |
| FY 2011                       |       |                  | 0.1        |   |   |
| Total minimum lease  payments |       |                  | $          | 5.3 |   |   |

 

***Commitments***

The Company is also responsible for common areamaintenance charges on certain office leases, which are not included in theabove table. These charges are generally less than 10% of base rents. Totaloperating lease expense, including month-to-month rentals, were approximately$2.4 million, $2.6 million, and $2.7 million, respectively, for the twelvemonths ended March 31 2006, December 31, 2004, and December 31,2003 and $0.6 million for the three month transition period ended March 31,2005.

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TheCompany generally makes purchases under cancelable purchase orders and does notenter into long-term supply agreements. Certain of its wafer foundry, assembly,materials suppliers, software vendors and support tool manufacturers requirenon-cancelable purchase orders since they often provide products and servicestailored to the Company’s specifications. Summarized in the table below areminimum future commitments under operating leases and non-cancelable purchaseobligations as of March 31, 2006 (in millions):

| ** **                   | ** ** | **Total** | ** ** | **Within  1 year** | ** ** | **1-3  years** | ** ** | **3-5  years** | ** ** |
|------------------------------|------------|-----------|------------|-------------------------|------------|----------------|------------|----------------|------------|
| Operating lease  obligations |       | $         | 5.30       |                    |       | $              | 2.00       |           |       | $ | 2.80 |   | $ | 0.50 |   |
| Purchase  obligations        |       | 7.1       |       |                    | 6.9        |           |       | 0.2            |       | — |   |
| Total                        |       | $         | 12.40      |                    |       | $              | 8.90       |           |       | $ | 3.00 |   | $ | 0.50 |   |

 

***Contingencies***

On August 11, 2005 Microchip Technology Inc.(Microchip) filed a patent infringement claim against the Company in the U.S.District Court of Arizona (case number CV05-2406-PHX-MHM).Microchip alleges that the Company has been infringing and currently infringesits patents numbered 5,847,450, 6,696,316 and 6,483,183. Microchip claims thatunspecified products of the Company, including the Z8 Encore! XP 4K Series ofproducts, infringe these patents and is seeking preliminary and permanentinjunctive relief, unspecified damages and costs including attorneys’ fees. Wefiled a response to the claims on September 15, 2005 generally denying theclaims and challenging the validity of the patents. On January 10, 2006the Company filed a request for patent reexamination with the U.S. PTO whichwas granted in February and March for all 3 patents. On March 132006, the Company was informed that its motion to stay with the Federal courtof Arizona was granted until such time as Microchip is informed of the outcomeof the re-examinations.

The Company does not believe it is feasible to predictor determine the outcome or resolution of this litigation at this time. TheCompany believes it has meritorious defenses and will defend ourselves againstthese claims vigorously. The Company may incur substantial expenses in itsdefense against these claims. In the event of a determination adverse to theCompany, it may incur substantial monetary liability, and be required to changeits business practices. Either of these could have a material adverse effect onits financial position, results of operations or cash flow.

The Company is participating in litigation andresponding to claims arising in the ordinary course of business. The Companyintends to defend itself vigorously in these matters. The Company’s managementbelieves that it is unlikely that the outcome of these matters will have amaterial adverse effect on the Company’s financial statements, although therecan be no assurance in this regard.

From time to time theCompany has agreed to indemnify and hold harmless certain customers forpotential allegations of infringement of intellectual property rights andpatents arising from the use of its products. During the ordinary course ofbusiness, in certain limited circumstances, the Company has agreed to reimbursethe indemnified party for losses suffered or incurred by the indemnified party,generally parties with which the Company has commercial relations, inconnection with certain intellectual property infringement claims by any thirdparty with respect to its products and services. The Company hasindemnification arrangements that limit its net contingent obligation to pay fordefense costs, if any, up to a maximum of $500,000. To date, there have notbeen any costs incurred in connection with such indemnification arrangements;therefore, there is no accrual of such amounts at March 31, 2006. TheCompany discloses indemnification liabilities according to FASB Staff PositionFIN45-1, “Accounting for Intellectual Property InfringementIndemnifications under FAS Interpretation No. 45.” Under FAS No. 5, “LossContingencies,” a claim would be accrued when a loss is probable and the amountcan be reasonably estimated. At March 31, 2006, no such amounts areaccrued.

99

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**NOTE 12.   RELATEDPARTY TRANSACTIONS**

In 2002, the Company entered into employmentagreements with each of its then named executive officers. In June 2002,prior to the issuance of the Sarbanes Oxley Act, loans were made to executiveofficers and certain other employees and consultants to pay the income taxesdue on the restricted shares of common stock that were granted to them. AtMarch 31, 2006, March 31, 2005, December 31, 2004 andDecember 31, 2003, total loans outstanding were $0.4 million, $0.5 million,$0.5 million and $1.4 million, respectively. Each loan recipient pledged theshares of restricted stock as collateral for these loans pursuant to stockpledge agreements. All such loans come due five years from the date of issuanceand they bear interest at 5.5% per annum.

On May 30, 2003, the Company repurchased 50,000shares of common stock from a former executive officer for a purchase price of$6.50 per share, which was the closing price on the Over-the-Counter BulletinBoard on the date of repurchase net of the repayment of certain loans to theofficer that were secured against the restricted stock. The amount of debtrepaid was $161,245 with interest accruing at a rate of 5.5% per year. Inconjunction with the resignation of a former officer, Michael Burger in 2004,the Company repurchased 92,735 shares for a fair market purchase price of $6.20per share in consideration for the repayment of his loans totaling $574,956.

In June 2004, theCompany’s CEO, James M. Thorburn paid $247,582 in cash to satisfy all of hisoutstanding loans and interest.

**NOTE 13.   GEOGRAPHICAND SEGMENT INFORMATION**

Beginning in May 2002, ZiLOG consolidated itsbusiness segments into one reportable segment to reflect the change in themanner in which its chief operating decision maker allocates resources andassesses the performance of the Company’s business. The Company engagesprimarily in the design, development, manufacture and marketing ofsemiconductor products. The Company sells its products to distributors andoriginal equipment manufacturers (OEMs) in a broad range of market segments.The Company’s operations outside the United States consist of a final testfacility in the Philippines, sales and support centers and design centers incertain foreign countries. Domestic operations are responsible for the design,development and the coordination of production planning and shipping to meetworldwide customer commitments. The Philippine test facility is reimbursed inrelation to value added with respect to test operations and other functionsperformed, and certain foreign sales offices receive a commission on exportsales within their territory. Accordingly, for financial statement purposes, itis not meaningful to segregate sales or operating profits for the test andforeign sales office operations.

The Company has two broad business lines calledmicrologic devices and other devices and foundry services within the Company’sone reportable segment.

The Company’s twobroad business lines are based on product technologies and can be summarized asfollows:

| Products                                         | ** ** | **Sample Uses**                                                                                                                                                    |
|--------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **Micrologic Devices include:**                  |       |                                                                                                                                                               |
| Core 8-bit  Microcontrollers and Microprocessors |       | Security systems, battery chargers, Universal  Infrared remote controls, industrial controllers, POS terminal, motor  control, communications products, treadmills |
| **Other Devices include:**                       |       |                                                                                                                                                               |
| Serial  Communications Controllers               |       | Telephone switches/PBX                                                                                                                                             |
| Modems                                           |       | Satellite TV set-top box, POS card validation                                                                                                                      |
| IrDA transceivers                                |       | PDAs, cell phones                                                                                                                                                  |
| Television, PC  peripheral and other products    |       | TV, keyboard, pointing device                                                                                                                                      |
| **Foundry Services**                             |       | Broadband access products                                                                                                                                          |

 

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Thefollowing table, which summarizes the Company’s net sales by region, bychannel, and by business line (in millions):

| ** **                           | ** ** | **Twelve Months Ended** | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------|------------|-----------------------------------|------------|----------------------------------|------------|
| ** **                           | ** ** | **Mar. 31,  2006**           | ** ** | **Dec. 31,  2004**          | ** ** | **Dec. 31,  2003** | ** ** | **Mar. 31,  2005** | ** ** | **Mar. 31,  2004** | ** ** |
| ** **                           | ** ** | ** **                        | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** | **(unaudited)** | ** ** |
| **Net  sales by region:**            | ** ** |                              | ** ** | ** **                       |       |   | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Americas                             |       |                              | $          | 31.9                             | ** ** |   |   | $ | 49.4 | ** ** |   | $ | 59.7 |   |   | $ | 9.4 | ** ** |   |   | $ | 14.0 | ** ** |   |
| Asia (including Japan)               |       |                              | 36.4       | ** **                       |       |   | 33.5 | ** ** |   | 30.9 |   |   | 8.2 | ** ** |   |   | 8.0 | ** ** |   |
| Europe                               |       |                              | 10.5       | ** **                       |       |   | 12.7 | ** ** |   | 13.0 |   |   | 2.6 | ** ** |   |   | 4.0 | ** ** |   |
| **Net  sales**                       |       |                              | $          | 78.8                             | ** ** |   |   | $ | 95.6 | ** ** |   | $ | 103.6 |   |   | $ | 20.2 | ** ** |   |   | $ | 26.0 | ** ** |   |
| **Net  sales by channel:**           | ** ** |                              | ** ** | ** **                       |       |   | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| OEM                                  |       |                              | $          | 34.8                             | ** ** |   |   | $ | 44.7 | ** ** |   | $ | 44.0 |   |   | $ | 10.1 | ** ** |   |   | $ | 13.5 | ** ** |   |
| Distribution                         |       |                              | 44.0       | ** **                       |       |   | 47.3 | ** ** |   | 48.5 |   |   | 10.1 | ** ** |   |   | 12.3 | ** ** |   |
| Foundry services                     |       |                              | —     | ** **                       |       |   | 3.6 | ** ** |   | 11.1 |   |   | — | ** ** |   |   | 0.2 | ** ** |   |
| **Net  sales**                       |       |                              | $          | 78.8                             | ** ** |   |   | $ | 95.6 | ** ** |   | $ | 103.6 |   |   | $ | 20.2 | ** ** |   |   | $ | 26.0 | ** ** |   |
| **Net  sales by business line:**     | ** ** |                              | ** ** | ** **                       |       |   | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Micrologic                           |       |                              |       | ** **                       |       |   |   | ** ** |   |   |   |   |   | ** ** |   |   |   | ** ** |   |
| Flash                                |       |                              | $          | 6.8                              | ** ** |   |   | $ | 3.2 | ** ** |   | $ | 1.0 |   |   | $ | 1.1 | ** ** |   |   | $ | 0.4 | ** ** |   |
| Non-Flash                            |       |                              | 53.4       | ** **                       |       |   | 65.1 | ** ** |   | 67.0 |   |   | 13.7 | ** ** |   |   | 19.1 | ** ** |   |
| Micrologic                           |       |                              | 60.2       | ** **                       |       |   | 68.3 | ** ** |   | 68.0 |   |   | 14.8 | ** ** |   |   | 19.5 | ** ** |   |
| Other Devices                        |       |                              |       | ** **                       |       |   |   | ** ** |   |   |   |   |   | ** ** |   |   |   | ** ** |   |
| Serial Communications Controllers    |       |                              | 12.8       | ** **                       |       |   | 14.4 | ** ** |   | 13.7 |   |   | 2.8 | ** ** |   |   | 4.0 | ** ** |   |
| Modems                               |       |                              | 1.0        | ** **                       |       |   | 2.8 | ** ** |   | 3.1 |   |   | 1.6 | ** ** |   |   | 0.6 | ** ** |   |
| IrDA Transceivers                    |       |                              | 1.1        | ** **                       |       |   | 2.1 | ** ** |   | 2.4 |   |   | 0.3 | ** ** |   |   | 1.0 | ** ** |   |
| Television, PC Peripherals and Other |       |                              | 3.7        | ** **                       |       |   | 4.4 | ** ** |   | 5.3 |   |   | 0.7 | ** ** |   |   | 0.7 | ** ** |   |
| Other Devices                        |       |                              | 18.6       | ** **                       |       |   | 23.7 | ** ** |   | 24.5 |   |   | 5.4 | ** ** |   |   | 6.3 | ** ** |   |
| Subtotal—Base business          |       |                              | 78.8       | ** **                       |       |   | 92.0 | ** ** |   | 92.5 |   |   | 20.2 | ** ** |   |   | 25.8 | ** ** |   |
| Foundry services                     |       |                              | —     | ** **                       |       |   | 3.6 | ** ** |   | 11.1 |   |   | — | ** ** |   |   | 0.2 | ** ** |   |
| **Net sales**                        |       |                              | $          | 78.8                             | ** ** |   |   | $ | 95.6 | ** ** |   | $ | 103.6 |   |   | $ | 20.2 | ** ** |   |   | $ | 26.0 | ** ** |   |

 

Netsales are attributable to the ship-to location of the Company’s customers aspresented in the following table (In millions):

| ** **                 | ** ** | **Twelve Months  Ended** | ** ** | **Twelve Months  Ended** | ** ** | **Three Months  Ended** | ** ** |
|----------------------------|------------|-------------------------------|------------|-------------------------------|------------|------------------------------|------------|
| ** **                 | ** ** | **Mar. 31,**             | ** ** | **Dec. 31,**             | ** ** | **Mar. 31,**            | ** ** |
| ** **                 | ** ** | **2006**                      | ** ** | **2004**                      | ** ** | **2003**                     | ** ** | **2005** | ** ** |
| United States              |       |                          | $          | 25.0                          |       |                         | $          | 32.9 |   | $ | 34.8 |   |   | $ | 7.2 |   |   |
| Hong Kong  (including PRC) |       |                          | 15.0       |                          |       | 15.7                         |       | 14.4 |   |   | 3.1 |   |   |
| Singapore                  |       |                          | 6.4        |                          |       | 9.3                          |       | 12.3 |   |   | 0.9 |   |   |
| Germany                    |       |                          | 5.5        |                          |       | 6.2                          |       | 5.6 |   |   | 1.4 |   |   |
| Taiwan                     |       |                          | 3.8        |                          |       | 4.8                          |       | 11.4 |   |   | 1.0 |   |   |
| Korea                      |       |                          | 2.5        |                          |       | 4.5                          |       | 3.8 |   |   | 0.6 |   |   |
| Other Foreign  Countries   |       |                          | 20.6       |                          |       | 22.2                         |       | 21.3 |   |   | 6.0 |   |   |
| Total                      |       |                          | $          | 78.8                          |       |                         | $          | 95.6 |   | $ | 103.6 |   |   | $ | 20.2 |   |   |

 

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Thefollowing table shows the location of long-lived assets (in millions): 

| ** **    | ** ** | **March 31,** | ** ** | **December 31,** | ** ** | **March 31,** | ** ** |
|---------------|------------|--------------------|------------|-----------------------|------------|--------------------|------------|
| ** **    | ** ** | **2006**           | ** ** | **2004**              | ** ** | **2003**           | ** ** | **2005** | ** ** |
| United States |       |               | $          | 20.5                  |       |               | $29.4      |   | $ | 84.5 |   |   | $ | 27.9 |   |   |
| Philippines   |       |               | 1.0        |                  |       | 1.4                |       | 0.6 |   |   | 1.3 |   |   |
| Other         |       |               | 3.3        |                  |       | 0.8                |       | 0.4 |   |   | 1.0 |   |   |
| Total         |       |               | $          | 24.8                  |       |               | $          | 31.6 |   | $ | 85.5 |   |   | $ | 30.2 |   |   |
|               |            |                    |            |                       |            |                    |            |  |  |  |  |  |  |  |  |  |  |

 

***Major Customers***

For the twelve monthsended March 31, 2006, two customers, including one distribution customerand one OEM customer, accounted for approximately 24% and 10% of net sales,respectively. For the year ended December 31, 2004, two customers,including one distribution customer and one OEM customer accounted for 20% and12% of net sales, respectively. For the year ended December 31, 2003, twocustomers, including one distribution customer and one OEM customer, accountedfor 18% and 11% of net sales, respectively. For the three month transitionperiod ended March 31, 2005 two customers, including one distributioncustomer and one OEM customer accounted for 20% and 12% of net sales,respectively.

**ITEM 9.**                CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANT ON ACCOUNTING AND FINANCIAL DISCLOSURES

On September 22,2005, the Company engaged Armanino McKenna LLP as its principal independentregistered public accounting firm, and dismissed KPMG LLP. The decision toengage Armanino McKenna LLP and dismiss KPMG LLP was approved by the AuditCommittee of the Board of Directors, which subsequently advised the Board ofDirectors of its decision. There have been no disagreements with our currentand predecessor independent registered public accounting firms.

**ITEM 9A.**        CONTROLSAND PROCEDURES

(a)   DisclosureControls and Procedures. The Company’s management, with the participation ofthe Company’s Chief Executive Officer and Chief Financial Officer, hasevaluated the effectiveness of the Company’s disclosure controls and procedures(as such term is defined in Rules 13a-15(e) and 15d-15(e) underthe Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of March 31,2006. Based on such evaluation, the Company’s Chief Executive Officer and ChiefFinancial Officer have concluded that, as of March 31, 2006, the Company’sdisclosure controls and procedures are effective in recording, processing,summarizing and reporting, on a timely basis, information required to bedisclosed by the Company in the reports that it files or submits under theExchange Act and are effective in ensuring that information required to bedisclosed by the Company in the reports that it files or submits under theExchange Act is accumulated and communicated to the Company’s management,including the Company’s Chief Executive Officer and Chief Financial Officer, asappropriate to allow timely decisions regarding required disclosure.

(b)   Internal Control Over Financial Reporting. There have not been anychanges in the Company’s internal control over financial reporting (as suchterm is defined in Rules 13a-15(f) and 15d-15(f) underthe Exchange Act) during the quarter ended March 31, 2006 that havematerially affected, or are reasonably likely to materially affect, the Company’sinternal control over financial reporting.

**ITEM 9B.**       OtherInformation

In December 2005, the Securities and ExchangeCommission issued a release permitting an accelerated filer with an aggregateworldwide market value of voting and non-voting common equity held 

102

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by non-affiliates of lessthan $50 million to exit accelerated filer status at the end of the fiscal yearin which it fails to meet that threshold as of the last business day of itssecond quarter. The aggregate worldwide market value of all equity held bynon-affiliates of ZiLOG, Inc. was less than $50 million as of September 30,2005, the last business day of our second fiscal quarter. Accordingly, weexited accelerated filer status as of March 31, 2006, and is therefore nolonger subject to the rules and regulations applicable to acceleratedfilers, including those relating to internal controls over financial reportingand the filing of annual and periodic reports on an accelerated basis.

103

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**PART III**

**MANAGEMENT**

**ITEM 10.**         DIRECTORSAND EXECUTIVE OFFICERS OF THE REGISTRANT

**Executive Officersand Directors**

The information requiredby this item relating to the Company’s directors and nominees, and compliancewith Section 16(a) of the Securities Exchange Act of 1934 isincorporated by reference from ZiLOG’s Proxy Statement for its 2006 AnnualMeeting of Stockholders to be filed with the SEC within 120 days after theend of the fiscal year ended March 31, 2006.

**Code of Ethics**

We have adopted a code ofethics that applies to our Chief Executive Officer, Chief Financial Officer andController. You may request a copy of this code of ethics free of charge bysending a written request to ZiLOG, Inc. c/o Investor Relations at 532Race Street, San Jose, California 95126.

**ITEM 11.**         EXECUTIVECOMPENSATION

Incorporated by referencefrom ZiLOG’s Proxy Statement for its July, 2006 Annual Meeting of Stockholdersto be filed with the SEC within 120 days after the end of the fiscal year endedMarch 31, 2006.

**ITEM 12.**         SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

Incorporated by referencefrom ZiLOG’s Proxy Statement for its July, 2006 Annual Meeting of Stockholdersto be filed with the SEC within 120 days after the end of the fiscal year endedMarch 31, 2006.

**ITEM 13.**         CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS

Incorporated by referencefrom ZiLOG’s Proxy Statement for its July, 2006 Annual Meeting of Stockholdersto be filed with the SEC within 120 days after the end of the fiscal year endedMarch 31, 2006.

**ITEM 14.**         PRINCIPALACCOUNTING FEES AND SERVICES

Incorporated by reference from ZiLOG’s Proxy Statementfor its July, 2006 Annual Meeting of Stockholders to be filed with the SECwithin 120 days after the end of the fiscal year ended March 31, 2006

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**PART IV**

**ITEM 15.**         EXHIBITS,FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

(a)          The following documentsare filed as part of this report:

1.                 ConsolidatedFinancial Statements and Supplementary Data:

|                                                                                                                                                                                         | ** ** | **Page** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|
| Report of Armanino McKenna LLP, Independent Registered  Public Accounting Firm                                                                                                          |       | 69       |
| Report of KPMG LLP, Independent Registered Public  Accounting Firm                                                                                                                      |       | 70       |
| Consolidated  Balance Sheets as of March 31, 2006 and 2005 and December 31, 2004                                                                                              |       | 71       |
| Consolidated Statements of Operations for the Twelve  Months Ended March 31, 2006, December 31, 2004, December 31,  2003 and the Three Months Ended March 31, 2005. |       | 72       |
| Consolidated Statements of Cash Flows for the Twelve  Months Ended March 31, 2006, December 31, 2004, December 31,  2003 and the Three Months Ended March 31, 2005  |       | 73       |
| Consolidated Statements of Stockholders’ Equity  (Deficiency) as of March 31, 2006, December 31, 2004 and 2003 and  the Three Months Ended March 31, 2005.          |       | 74       |
| Notes to Consolidated Financial Statements                                                                                                                                              |       | 75       |

 

2.                 FinancialStatement Schedule

| Schedule II—Valuation and  Qualifying Accounts |   | 106 |
|-----------------------------------------------------|--------|-----|

 

All other schedules are omitted because theinformation required to be set forth therein is not applicable or is containedin the financial statements or notes to the financial statements.

(b)         NotRequired

(c)          Exhibits

The exhibits listed in the accompanying index toexhibits are filed or incorporated by reference (as stated therein) as part ofthis annual report.

(d)         Financial StatementsSchedule

See Item 15 (a)(2) above.

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**SCHEDULE II**

**ZiLOG, INC.VALUATION AND QUALIFYING ACCOUNTS(In millions)**

| **Description**                          | ** ** | ** ** | ** ** | **Balance at  Beginning  of Period** | ** ** | **Additions  (Reductions)  Charged to  Costs and Expenses** | ** ** | **Deductions** | ** ** | **Balance at  Ending  of Period** | ** ** |
|------------------------------------------|------------|------------|------------|------------------------------------------------|------------|----------------------------------------------------------------------------|------------|----------------|------------|---------------------------------------------|------------|
| Year ended  March 31, 2006:         |       |       |       |                                           |       |                                                                       |       |           |       |                                        |       |   |   |   |   |   |   |
| Allowance for  doubtful accounts         |       |       | $          | 0.2                                            |       |                                                                       |       | $              | 0.1        |                                        |       |   | $ | (0.1 | ) |   |   | $ | 0.2 |   |   |
| Three months  ended March 31, 2005: |       |       |       |                                           |       |                                                                       |       |           |       |                                        |       |   |   |   |   |   |   |
| Allowance for  doubtful accounts         |       |       | $          | 0.3                                            |       |                                                                       |       | $              | (0.1       | )                                           |       |   | $ | — |   |   |   | $ | 0.2 |   |   |
| Year ended  December 31, 2004:      |       |       |       |                                           |       |                                                                       |       |           |       |                                        |       |   |   |   |   |   |   |
| Allowance for  doubtful accounts         |       |       | $          | 0.3                                            |       |                                                                       |       | $              | —     |                                        |       |   | $ | — |   |   |   | $ | 0.3 |   |   |
| Year ended  December 31, 2003:      |       |       |       |                                           |       |                                                                       |       |           |       |                                        |       |   |   |   |   |   |   |
| Allowance for doubtful  accounts         |       |       | $          | 0.5                                            |       |                                                                       |       | $              | (0.2       | )                                           |       |   | $ | — |   |   |   | $ | 0.3 |   |   |

 

 

106

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**Signatures**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the Registrant has duly caused the report to be signed on itsbehalf by the undersigned, thereunto duly authorized, on the 26th day of June,2006.

|        | **ZiLOG, INC.** |
|--------|-----------------|
|   | By:             | /s/ JAMES M. THORBURN |
|   | ** **      | **James  M. Thorburn*Chairman and Chief Executive Officer*** |

 

**Power of Attorney**

KNOW ALL PERSONS BY THESE PRESENTS, that each personwhose signature appears below constitutes and appoints James M. Thorburn andPerry J. Grace, his/her attorneys-in-fact, each with the power of substitution,for him/her in any and all capacities, to sign any amendments to this Report onForm 10-K, and to file the same, with Exhibits thereto and otherdocuments in connection therewith with the Securities and Exchange Commission,hereby ratifying and confirming all that each of said attorneys-in-fact, orsubstitute or substitutes may do or cause to be done by virtue hereof.

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the Registrant and inthe capacities and on the dates indicated:

|                               | **Signature** | ** **                               | ** ** |                    | **Title** | ** ** | ** ** |  | **Date** | ** ** |
|-------------------------------|---------------|------------------------------------------|------------|--------------------|-----------|------------|------------|--|----------|------------|
| /s/ JAMES  M. THORBURN   |          | Chairman, Chief  Executive Officer and   |       | June 26, 2006 |
| James M. Thorburn             |          | Director                                 |       |               |
| /s/ PERRY  J. GRACE      |          | Vice President,  Chief Financial Officer |       | June 26, 2006 |
| Perry J. Grace                |          |                                     |       |               |
| /s/ FEDERICO  FAGGIN     |          | Director                                 |       | June 26, 2006 |
| Federico Faggin               |          |                                     |       |               |
| /s/ RICHARD  L. SANQUINI |          | Director                                 |       | June 26, 2006 |
| Richard L. Sanquini           |          |                                     |       |               |
| /s/ ROBIN  A. ABRAMS     |          | Director                                 |       | June 26, 2006 |
| Robin A. Abrams               |          |                                     |       |               |
| /s/ DAVID  G. ELKINS     |          | Director                                 |       | June 26, 2006 |
| David G. Elkins               |          |                                     |       |               |

 

 

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**EXHIBIT INDEX**

| **Exhibit Number** | ** ** | **Description**                                                                                                                                                                                   |
|--------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1(a)             |       | Joint Reorganization Plan, as confirmed by order of  the U.S. Bankruptcy Court for the Northern District of California, dated  April 30, 2002.                                                    |
| 3.1(j)             |       | Amended and Restated Certificate of Incorporation of  ZiLOG, Inc., as amended and corrected.                                                                                                      |
| 3.2(k)             |       | Amended and Restated Bylaws of ZiLOG, Inc                                                                                                                                                         |
| 4.1(h)             |       | Form of common stock certificate.                                                                                                                                                                 |
| 4. 2(c)            |       | Form of Restricted Stock Purchase Agreement.                                                                                                                                                      |
| 4.3(c)             |       | Form of Non-Qualified EBITDA-Linked Option Grant  Agreement.                                                                                                                                      |
| 10.1(d)            |       | Contract of Lease, dated October 16, 2003, by and  between ZiLOG Electronics Philippines, Inc. and Fruehauf Electronics Phils.  Corporation.                                                      |
| 10.1(g)            |       | Lease, dated as of December 21, 2001, between ZiLOG,  Inc. and the Sobrato Group.                                                                                                                 |
| 10.2(c)            |       | Employment Agreement, dated May 14, 2002, between  ZiLOG, Inc. and Perry Grace.                                                                                                                   |
| 10.3(c)            |       | Financing Agreement, dated May 13, 2002, between CIT  Financing and ZiLOG, Inc.                                                                                                                   |
| 10.4(c)            |       | Contribution Agreement, dated May 13, 2002, between  ZiLOG, Inc. and ZiLOG-MOD III, Inc.                                                                                                          |
| 10.5(e)            |       | Services Agreement, dated May 13, 2002, between  ZiLOG Inc. and ZiLOG-MOD III, Inc.                                                                                                               |
| 10.6(c)            |       | Employment Agreement, dated May 14, 2002, between  ZiLOG, Inc. and Norman G. Sheridan.                                                                                                            |
| 10.7(f)            |       | Distributor Agreement, dated October 23, 2002,  between ZiLOG, Inc. and Future Electronics, Inc.                                                                                                  |
| 10.8(f)            |       | Form of Full-Recourse Promissory Note.                                                                                                                                                            |
| 10.9(f)            |       | Form of Stock Pledge Agreement.                                                                                                                                                                   |
| 10.10(i)           |       | Summary of 2004 ZiLOG Incentive Plan.                                                                                                                                                             |
| 10.11(b)           |       | ZiLOG, Inc. 2002 Omnibus Stock Incentive Plan.                                                                                                                                                    |
| 10.12(i)           |       | ZiLOG, Inc. 2004 Omnibus Stock Incentive Plan.                                                                                                                                                    |
| 10.13(i)           |       | ZiLOG, Inc. 2004 Employee Stock Purchase Plan.                                                                                                                                                    |
| 10.14(m)           |       | Amendment No. 1 to the ZiLOG, Inc. 2004 Employee  Stock Purchase Plan                                                                                                                             |
| 10.15(m)           |       | Form of Indemnification Agreement between ZiLOG,  Inc. and its Directors and Officers                                                                                                             |
| 10.16(m)           |       | Employment Offer Letter dated as of December 17,  2004 between ZiLOG, Inc and Ramesh G. Ramchandani.                                                                                         |
| 10.17              |       | Employment Offer Letter dated as of April 4, 2006  between ZiLOG, Inc and Nick Antonopolous                                                                                                       |
| 10.18(l)           |       | Form of Change of Control Agreement                                                                                                                                                               |
| 21.1               |       | Subsidiaries of ZiLOG, Inc.                                                                                                                                                                       |
| 23.1               |       | Consent of Armanino McKenna LLP, independent  registered public accounting firm.                                                                                                                  |
| 23.2               |       | Consent of KPMG LLP, independent registered public  accounting firm.                                                                                                                              |
| 24.1               |       | Power of Attorney (see the signature pages of this  Annual Report)                                                                                                                                |
| 31.1               |       | Certification of Chief Executive Officer pursuant to  Securities Exchange Act Rules 13a-14 and 15d-14 as Adopted Pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002, dated June 26, 2006. |
| 31.2               |       | Certification of Chief Financial Officer pursuant to  Securities Exchange Act Rules13a-14 and 15d-14 as Adopted Pursuant to Section  302 of the Sarbanes-Oxley Act of 2002, dated June 26, 2006.  |

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| 32.1 |   | Certifications of Chief Executive Officer and Chief  Financial Officer pursuant to Section 18 U.S.C Section 1350, as Adopted  Pursuant to Section 906 of the Sarbanes-Oxley act of 2002, dated  June 26, 2006. |
|------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

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(a)    Incorporatedherein by reference to Exhibit 99.1 to the Company’s current report on Form 8-Kfiled with the Commission on May 15, 2002.

(b)   Incorporatedherein by reference to the item of the same name filed as an exhibit to theCompany’s registration statement on Form S-8 (File No. 333-88416) filed withthe Commission on May 15, 2002.

(c)    Incorporatedherein by reference to the item of the same name filed as an exhibit to theCompany’s quarterly report on Form 10-Q filed with the Commission on August 16,2002.

(d)   Incorporatedherein by reference to the item of the same name filed as an exhibit to theCompany’s quarterly report on Form 10-Q filed with the Commission on November12, 2003.

(e)    Incorporatedherein by reference to the item of the same name filed as an exhibit to theCompany’s annual report on Form 10-K for the fiscal year ended December 31,2000.

(f)    Incorporatedherein by reference to the item of the same name filed as an exhibit to theCompany’s registration statement on Form S-1/A (File No. 333-98529) filed withthe Commission on June 9, 2003.

(g)    Incorporatedherein by reference to the item of the same name filed as an exhibit to theCompany’s annual report on Form 10-K for the fiscal year ended December 31,2002.

(h)   Incorporatedherein by reference to the item of the same name filed as an exhibit to theCompany’s registration statement on Form S-1/A (File No. 333-111471) filed withthe Commission on February 24, 2004.

(i)    Incorporatedherein by reference to the item of the same name filed as an exhibit to theForm 3 filed by Michael D. Burger on July 7, 2003.

(j)     Incorporatedherein by reference to the item of the same name filed as an exhibit to theCompany’s annual report on Form 10K for the fiscal year ended December 31,2003.

(k)   Incorporatedherein by reference to Exhibit 99.1 to the Company’s current report on Form 8-Kfiled with the Commission on November 17, 2005.

(l)    Incorporatedherein by reference to Exhibit 99.1 to the Company’s current report on Form 8-Kfiled with the Commission on December 20, 2005.

(m)  Incorporatedherein by reference to the item of the same name filed as an exhibit to theCompany’s annual report on Form 10-K for the fiscal year ended December 31,2004.

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