** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

**(Mark One)**

 
| **ý** | **Quarterly Report Pursuant to  Section 13 or 15(d) of the Securities Exchange Act of 1934.**                                                                                                                                                                                                                                                                                                                                             |
|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** |
| ** ** | **For the  quarterly period ended December 31, 2005.**                                                                                                                                                                                                                                                                                                                                                                                    |
|       |
| **OR**     |
|       |
| **o**      | **Transition Report Pursuant to  Section 13 or 15(d) of the Securities Exchange Act of 1934.**                                                                                                                                                                                                                                                                                                                                            |
|       |
|       | **For the transition period  from                                  to                                 .** |

 

**Commission File Number:  001-13748**

 

**ZiLOG,Inc.**

(Exact name of registrant as specified in itscharter)

 

| **Delaware**                                              | ** ** | **13-3092996**         |
|-----------------------------------------------------------|------------|------------------------|
| (State or other jurisdiction of                           |       | (I.R.S. Employer       |
| incorporation or organization)                            |       | Identification Number) |
|                                                      |       |                   |
| **532 Race Street, San Jose, California,  95126**         |
| (Address  of principal executive offices)                 |
|                                                      |       |                   |
| Registrant’s telephone number, including  area code: |
| **(408) 558-8500**                                        |

 

Indicate by check mark whether the registrant (l) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

 

Yes ý    No o

 

Indicate by check mark whether the registrant is an accelerated filer (asdefined in Rule 12b-2 of the Exchange Act)

 

Yes ý    No o

 

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act)

 

Yes o    No ý

 

Indicate by check mark whether the registrant has filed all documentsand reports required to be filed by Section 12, 13 or 15(d) of the SecuritiesExchange Act of 1934 subsequent to the distribution of securities under a planconfirmed by a court.

 

Yes ý    No o

 

Asof February 8, 2005 there were 16,562,554 shares of the Company’s Common Stock,$0.01 par value outstanding.

 

 

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Some of the statements under sections entitled “Risk Factors” and “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” andelsewhere in this Form 10-Q constitute forward-looking statements within themeaning of the Private Securities Litigation Reform Act of 1995, Section 27A ofthe Securities Act of 1933 and Section 21E of the Securities Exchange Act of1934. These statements relate to future events or our future financialperformance including our projected capital expenditures and the adequacy ofour cash to satisfy our cash requirement over the next twelve months andinvolve known and may involve unknown risks, uncertainties and other factorsthat may cause our actual results, levels of activity, performance orachievements to be materially different from any future results, levels ofactivity, performance or achievements expressed or implied by forward-lookingstatements including, but not limited to, prospects for future market growth,statements relating to the general direction of our business, our expectedliquidity, capital expenditures and expense levels in future periods. Otherfactors that may cause or contribute to differences include, but are not limitedto:  continued availability ofthird-party foundry and assembly services at commercially-reasonable qualityand prices; under-absorption of manufacturing costs in our test andmanufacturing support facilities from under-utilization of capacity; our distributorsand customers significantly reducing their existing inventories before orderingnew products; the sale of any key customers or distributors; our ability tosell and/or recover the carrying value of our assets held for sale at ourNampa, Idaho facility; ongoing costs to maintain MOD III assets in a saleablestate and anticipated costs in connection with the decommissioning of our MODII wafer fabrication facility;  costsincurred in connection with the transfer of certain activities to our facility inManila, Philippines and the costs associated with the Microchip lawsuit. . Insome cases, you can identify forward-looking statements by terminology such as “may,”“will,” “should,” “expects,” “anticipates,” “believes,” “estimates,” “potential,”“continue,” or the negative terms or other comparable terminology. Inevaluating these statements, you should specifically consider various factors,including the risks outlined under “Risk Factors.”

 

Although we believe that the expectations in the forward-lookingstatements contained in this Form 10-Q are reasonable, we cannot guaranteefuture results, levels of activity, and performance achievements. Theseforward-looking statements are based on our current expectations, and wedisclaim any obligation to update these forward-looking statements forsubsequent events or to explain why actual results differ unless otherwiserequired by law. You should not place undue reliance on these forward-lookingstatements.

 

Based in San Jose, California, we were incorporated in California inOctober 1981 and reincorporated in Delaware in April 1997. In this report, “ZiLOG,”“the Company,” “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 of theU.S. bankruptcy code, they are referring only to the parent company, ZiLOG,Inc., and not to any of its subsidiaries. ZiLOG, eZ80, Z8Encore! and eZ80TM areregistered trademarks of ZiLOG, Inc. and eZ80Acclaim! is a trademark of ZiLOG,Inc.

 

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ZiLOG, INC**.**

 

**QUARTERLY REPORT ON FORM 10-Q FOR THE PERIODENDED DECEMBER 31, 2005**

 

**TABLE OF CONTENTS**

 
| **PART I.  FINANCIAL INFORMATION** | ** **                                                                                                                                                              |
|------------------------------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                               | ** **                                                                                                                                                              |
| Item 1.                            | Financial Statements                                                                                                                                                    |   |
|                               |                                                                                                                                                                    |   |
|                               | Unaudited Condensed Consolidated Statements  of Operations for the three and nine months ended December 31, 2005 and the  three and nine months ended December 31, 2004 |   |
|                               |                                                                                                                                                                    |   |
| ** **                         | Unaudited Condensed Consolidated Balance  Sheets at December 31, 2005 and March 31, 2005                                                                                |   |
| ** **                         |                                                                                                                                                                    |   |
| ** **                         | Unaudited Condensed Consolidated Statements  of Cash Flows for the nine months ended December 31, 2005 and December 31,  2004                                           |   |
| ** **                         |                                                                                                                                                                    |   |
|                               | Notes to Unaudited Condensed Consolidated  Financial Statements                                                                                                         |   |
|                               |                                                                                                                                                                    |   |
| Item 2.                            | Management’s Discussion and Analysis of Financial Condition and  Results of Operations                                                                             |   |
|                               |                                                                                                                                                                    |   |
| Item 3.                            | Quantitative and Qualitative Disclosures  About Market Risk                                                                                                             |   |
|                               |                                                                                                                                                                    |   |
| Item 4.                            | Controls and Procedures                                                                                                                                                 |   |
|                               |                                                                                                                                                                    |   |
| **PART II. OTHER INFORMATION**     | ** **                                                                                                                                                              |
| ** **                         | ** **                                                                                                                                                              |
| Item 1.                            | Legal Proceedings                                                                                                                                                       |   |
|                               |                                                                                                                                                                    |   |
| Item 2:                            | Changes in Securities, Use of Proceeds and  Issuer Proceeds of Equity Securities                                                                                        |   |
|                               |                                                                                                                                                                    |   |
| Item 3.                            | Defaults Upon Senior Securities                                                                                                                                         |   |
|                               |                                                                                                                                                                    |   |
| Item 4.                            | Submission of Matters to a Vote of Security  Holders                                                                                                                    |   |
|                               |                                                                                                                                                                    |   |
| Item 5.                            | Other Information                                                                                                                                                       |   |
|                               |                                                                                                                                                                    |   |
| Item 6.                            | Exhibits                                                                                                                                                                |   |

 

1

----

 

### **PARTI**

**FINANCIAL INFORMATION**

 

**Item 1. Financial Statements**

 

**ZiLOG, INC.**

**UNAUDITED CONDENSED CONSOLIDATED STATEMENTSOF OPERATIONS**

**(in millions, except per share data)**

 
| ** **                                                     | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|----------------------------------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                     | ** ** | **2005**                                            | ** ** | **2004**                                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net sales                                                      |       | $                                                   | 17.6       |                                               | $          | 18.9 |   | $ | 58.7 |   | $ | 69.6 |   |
| Cost of sales                                                  |       | 9.7                                                 |       | 13.0                                               |       | 34.1 |   | 39.6 |   |
| Gross margin                                                   |       | 7.9                                                 |       | 5.9                                                |       | 24.6 |   | 30.0 |   |
| Operating expenses:                                            |       |                                                |       |                                               |       |   |   |   |   |
| Research and development                                       |       | 5.2                                                 |       | 5.4                                                |       | 16.0 |   | 15.9 |   |
| Selling, general and administrative                            |       | 5.0                                                 |       | 7.8                                                |       | 17.7 |   | 22.7 |   |
| Special charges and credits                                    |       | 0.3                                                 |       | (0.4                                               | )          | 2.5 |   | 5.4 |   |
| Amortization of intangible assets                              |       | 0.6                                                 |       | 1.0                                                |       | 1.6 |   | 3.1 |   |
| Total operating expenses                                       |       | 11.1                                                |       | 13.8                                               |       | 37.8 |   | 47.1 |   |
| Operating loss                                                 |       | (3.2                                                | )          | (7.9                                               | )          | (13.2 | ) | (17.1 | ) |
|                                                           |       |                                                |       |                                               |       |   |   |   |   |
| Other income (expense):                                        |       |                                                |       |                                               |       |   |   |   |   |
| Interest income                                                |       | 0.2                                                 |       | 0.1                                                |       | 0.6 |   | 0.3 |   |
| Interest expense                                               |       | —                                              |       | —                                             |       | — |   | — |   |
| Other, net                                                     |       | (0.1                                                | )          | 0.1                                                |       | (0.1 | ) | (0.1 | ) |
| Loss before income taxes                                       |       | (3.1                                                | )          | (7.7                                               | )          | (12.7 | ) | (16.9 | ) |
| Provision (benefit) for income taxes                           |       | —                                              |       | 1.6                                                |       | 1.3 |   | 1.6 |   |
| Net loss                                                       |       | $                                                   | (3.1       | )                                                  | $          | (9.3 | ) | $ | (14.0 | ) | $ | (18.5 | ) |
| Basic and diluted net loss per share                           |       | $                                                   | (0.19      | )                                                  | $          | (0.57 | ) | $ | (0.86 | ) | $ | (1.13 | ) |
| Shares used in computing basic and diluted  net loss per share |       | 16.4                                                |       | 16.1                                               |       | 16.3 |   | 16.3 |   |

 

See accompanying notes to unaudited condensedconsolidated financial statements.

 

2

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**ZiLOG, INC.**

**UNAUDITED CONDENSED CONSOLIDATED BALANCESHEETS**

**(in millions)**

 
| ** **                                                                                                         | ** ** | **December 31,  2005** | ** ** | **March 31,  2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|--------------------------|------------|
| **ASSETS**                                                                                                         |       |                        |       |                     |       |
| Current assets:                                                                                                    |       |                        |       |                     |       |
| Cash and cash equivalents                                                                                          |       | $                           | 24.1       |                     | $          | 33.6 |   |
| Accounts receivable, less allowance for  doubtful accounts of $0.3 at December 31, 2005 and $0.2 at March 31, 2005 |       | 9.2                         |       | 12.5                     |       |
| Inventories                                                                                                        |       | 8.0                         |       | 10.6                     |       |
| Deferred income taxes                                                                                              |       | 0.5                         |       | 2.7                      |       |
| Prepaid expenses and other current assets                                                                          |       | 2.3                         |       | 2.8                      |       |
| Total current assets                                                                                               |       | 44.1                        |       | 62.2                     |       |
|                                                                                                               |       |                        |       |                     |       |
| MOD II Inc. assets held for sale                                                                                   |       | 3.4                         |       | 3.4                      |       |
| Net property, plant and equipment                                                                                  |       | 7.8                         |       | 5.9                      |       |
| Goodwill                                                                                                           |       | 8.2                         |       | 8.6                      |       |
| Intangible assets, net                                                                                             |       | 5.1                         |       | 6.7                      |       |
| Other assets                                                                                                       |       | 4.6                         |       | 5.6                      |       |
| Total Assets                                                                                                       |       | $                           | 73.2       |                     | $          | 92.4 |   |
|                                                                                                               |       |                        |       |                     |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                     |       |                        |       |                     |       |
| Current liabilities:                                                                                               |       |                        |       |                     |       |
| Accounts payable                                                                                                   |       | $                           | 10.1       |                     | $          | 11.5 |   |
| Accrued compensation and employee benefits                                                                         |       | 2.5                         |       | 3.0                      |       |
| Other accrued liabilities                                                                                          |       | 3.5                         |       | 4.7                      |       |
| Deferred income on shipments to  distributors                                                                      |       | 5.8                         |       | 6.0                      |       |
| Total current liabilities                                                                                          |       | 21.9                        |       | 25.2                     |       |
|                                                                                                               |       |                        |       |                     |       |
| Deferred income taxes                                                                                              |       | 0.5                         |       | 2.7                      |       |
| Other non-current tax liabilities                                                                                  |       | 6.3                         |       | 6.6                      |       |
| Total liabilities                                                                                                  |       | 28.7                        |       | 34.5                     |       |
|                                                                                                               |       |                        |       |                     |       |
| Stockholders’ equity:                                                                                         |       |                        |       |                     |       |
| Common stock                                                                                                       |       | 0.2                         |       | 0.2                      |       |
| Additional paid-in capital                                                                                         |       | 123.1                       |       | 122.1                    |       |
| Deferred stock compensation                                                                                        |       | (0.7                        | )          | (0.4                     | )          |
| Treasury stock                                                                                                     |       | (7.2                        | )          | (7.1                     | )          |
| Accumulated deficit                                                                                                |       | (70.9                       | )          | (56.9                    | )          |
| Total stockholders’ equity                                                                                    |       | 44.5                        |       | 57.9                     |       |
| Total liabilities and stockholders’ equity                                                                    |       | $                           | 73.2       |                     | $          | 92.4 |   |

 

Seeaccompanying notes to unaudited condensed consolidated financial statements.

 

3

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**ZiLOG, INC.**

**UNAUDITED CONDENSED CONSOLIDATED STATEMENTSOF CASH FLOWS**

**(in millions)**

 
| ** **                                                                                                         | ** ** | **Nine Months Ended  December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                                                                         | ** ** | **2005**                                           | ** ** | **2004** | ** ** |
| **Cash Flows from Operating Activities:**                                                                          |       |                                               |       |   |   |
| Net loss                                                                                                           |       | $                                                  | (14.0      | ) | $ | (18.5 | ) |
| Adjustments to reconcile net loss to net  cash provided (used) by operating activities:                            |       |                                               |       |   |   |
| Amortization of intangible assets                                                                                  |       | 1.6                                                |       | 3.1 |   |
| Goodwill adjustment                                                                                                |       | 0.4                                                |       | 8.3 |   |
| Disposition of Assets                                                                                              |       | —                                             |       | 0.2 |   |
| Deferred income tax assets and liabilities                                                                         |       | (0.2                                               | )          | (7.9 | ) |
| Depreciation and other amortization                                                                                |       | 1.9                                                |       | 1.8 |   |
| Gain on the sale of Mod II assets                                                                                  |       | —                                             |       | (1.7 | ) |
| Impairment of long-lived assets                                                                                    |       | —                                             |       | 5.4 |   |
| Stock-based compensation                                                                                           |       | 0.6                                                |       | 1.6 |   |
| Changes in operating assets and  liabilities:                                                                      |       |                                               |       |   |   |
| Accounts receivable, net                                                                                           |       | 3.2                                                |       | 6.4 |   |
| Inventories                                                                                                        |       | 2.6                                                |       | (0.4 | ) |
| Prepaid expenses and other current and  non-current assets                                                         |       | 1.5                                                |       | 0.8 |   |
| Accounts payable                                                                                                   |       | (1.4                                               | )          | 1.9 |   |
| Accrued compensation and employee benefits                                                                         |       | (0.5                                               | )          | (1.2 | ) |
| Other accrued liabilities, deferred income  on shipments to distributors, income taxes and accrued special charges |       | (1.5                                               | )          | 1.5 |   |
| Net cash provided (used) by operating  activities                                                                  |       | (5.8                                               | )          | 1.3 |   |
|                                                                                                               |       |                                               |       |   |   |
| **Cash Flows From Investing Activities:**                                                                          |       |                                               |       |   |   |
| Proceeds from the sale of Mod II assets                                                                            |       | —                                             |       | 5.9 |   |
| Capital expenditures                                                                                               |       | (3.7                                               | )          | (3.5 | ) |
| Cash provided (used) by investing  activities                                                                      |       | (3.7                                               | )          | 2.4 |   |
|                                                                                                               |       |                                               |       |   |   |
| **Cash Flows From Financing Activities:**                                                                          |       |                                               |       |   |   |
| Proceeds from public stock offering, net of  offering costs                                                        |       | —                                             |       | 2.8 |   |
| Proceeds from issuance of common stock  under stock purchase plans                                                 |       | 0.1                                                |       | 0.5 |   |
| Repayments of short-term debt                                                                                      |       | —                                             |       | (4.3 | ) |
| Payments for common stock repurchases                                                                              |       | (0.1                                               | )          | (5.0 | ) |
| Cash provided (used) by financing  activities                                                                      |       | —                                             |       | (6.0 | ) |
| ** **                                                                                                         | ** ** | ** **                                         | ** ** | ** ** | ** ** |
| Increase (decrease) in cash and cash equivalents                                                                   |       | (9.5                                               | )          | (2.3 | ) |
| Cash and cash equivalents at beginning of  period                                                                  |       | 33.6                                               |       | 40.0 |   |
| Cash and cash equivalents at end of period                                                                         |       | $                                                  | 24.1       |   | $ | 37.7 |   |

 

See accompanying notes to unaudited condensedconsolidated financial statements.

 

4

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**ZILOG, INC.**

 

**NOTES TO UNAUDITED CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

**NOTE 1.****                BASIS OFPRESENTATION**

 

The accompanying interim financial information is unaudited. In theopinion of ZiLOG, Inc.’s (“ZiLOG” or the “Company”) management, all adjustments(consisting only of normal recurring adjustments) necessary for a fairpresentation of interim results have been included. The results for interimperiods are not necessarily indicative of results to be expected for the entireyear. These condensed consolidated financial statements and notes should beread in conjunction with the Company’s annual consolidated financial statementsand notes thereto contained in the Company’s 2004 Annual Report filed on Form10-K Commission File Number 001-13748 for the fiscal year ended December 31,2004, filed on March 31, 2005.

 

EffectiveDecember 29, 2005, ZiLOG changed its fiscal year end from December 31 to March31. ZiLOG’s 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 31 beginning infiscal 2006.  In accordance with the fiscal calendar in place at thattime, the fiscal 2005 year ended on March 27, 2005 and the Fiscal 2004 yearended on March 28, 2004. The additional four days and 3 days have been includedin the Company’s first quarter results for fiscal 2006 and 2005 respectively.For financial reporting purposes and convenience of reference, interim fiscalperiods are labeled as ending on calendar month-end.  The operatingresults for any interim period are not necessarily indicative of results forany subsequent period or the full fiscal year. The condensed consolidated balancesheet at March 31, 2005 has been derived from unaudited financial statements atthat date.

 

**NOTE 2.****                SUMMARY OFSIGNIFICANT ACCOUNTING POLICIES**

 

***Revenue Recognition.***Revenuefrom product sales to Original Equipment Manufacturers (“OEM”) customers isrecognized when evidence of an agreement exists, customers or their agentsreceive the product and title transfers, and collection of amounts due isreasonably assured. Appropriate allowances for returns, discounts and warrantycosts are recorded concurrent with revenue recognition.

 

The Company also licenses technology for certain of its products andreceives payment in the form of royalties. Typically, licensees provideshipment and royalty information when the payment is remitted, usually 60 dayssubsequent to the end of the quarter shipments are made. As such, the Companyrecords these royalty revenues as micrologic net sales when the cash isreceived from the licensees.

 

Revenue on shipments to distributors who have rights of return andprice protection on unsold merchandise held by them, is deferred until productsare resold by the distributors to end users. Although revenue is deferred untilresale, title of products sold to distributors transfers upon shipment.Accordingly, shipments to distributors are reflected in the consolidatedbalance sheets as accounts receivable and a reduction of inventories at thetime of shipment. Deferred revenue and the corresponding cost of sales onshipments to distributors are reflected in the consolidated balance sheets on anet basis as “Deferred income on shipments to distributors.”

 

***Assets Held for Sale.***Theremaining assets of MOD II, consisting primarily of land and buildings with acarrying value of $3.4 million at December 31, 2005, have been classified asasset held for sale on the Company’s accompanying condensed consolidatedbalance sheet.

 

5

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***Goodwill and Intangible Assets***.Effective January 1, 2002, ZiLOG adopted the provisions of FASB Statement ofFinancial Accounting Standards No. 142, “Goodwill and Other Intangible Assets”(“SFAS 142”). Under SFAS 142, goodwill and intangible assets with indefinitelives are not amortized, but are reviewed annually or more frequently ifimpairment indicators arise. In the three months ended December 31, 2005, theCompany reviewed its goodwill and intangible assets and determined that therewas no impairment indicated.

 

Separable intangible assets that are deemed to have defined lives arebeing amortized utilizing the pattern-of-use method over their estimated usefullives of six years for current technology and ten years for brand name.

 

The separable intangible assets identified in connection withfresh-start accounting and included in the condensed consolidated balance sheetare as follows (in millions):

 
| ** **                               | ** ** | **Current  Technology** | ** ** | **Brand  Name** | ** ** | **Total** | ** ** |
|------------------------------------------|------------|-------------------------|------------|-----------------|------------|-----------|------------|
| Gross carrying amount, recorded May 2002 |       | $                       | 17.0       |            | $          | 9.2       |       | $ | 26.2 |   |
| Accumulated amortization                 |       | 16.4                    |       | 4.7             |       | 21.1      |       |
| Book value at December 31, 2005          |       | $                       | 0.6        |            | $          | 4.5       |       | $ | 5.1 |   |

 

The anticipated remaining amortizationschedule for these assets is as follows (in millions):

 
| **Fiscal Year**  | ** ** | **Current  Technology** | ** ** | **Brand  Name** | ** ** | **Total to be  Amortized** | ** ** |
|-----------------------|------------|-------------------------|------------|-----------------|------------|--------------------------------------|------------|
| January -  March 2006 |       | $                       | 0.1        |            | $          | 0.2                                  |       | $ | 0.3 |   |
| 2007                  |       | 0.3                     |       | 0.9             |       | 1.2                                  |       |
| 2008                  |       | 0.1                     |       | 0.9             |       | 1.0                                  |       |
| 2009                  |       | 0.1                     |       | 0.7             |       | 0.8                                  |       |
| 2010                  |       | —                  |       | 0.7             |       | 0.7                                  |       |
| Thereafter            |       | —                  |       | 1.1             |       | 1.1                                  |       |
| Total                 |       | $                       | 0.6        |            | $          | 4.5                                  |       | $ | 5.1 |   |

 

***Use of Estimates.***The preparation of the condensed consolidated financial statements inconformity with accounting principles generally accepted in the United Statesrequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities at the date of financial statements and the reported amounts of netsales and expenses during the reporting period. Significant estimates made inpreparing these financial statements include, but are not limited to, excessand obsolete inventories, taxation valuation allowances, allowance for doubtfulaccounts and sales returns and allowances. Actual results could differ fromthose estimates.

 

***Research and Development Expenses.***TheCompany’s policy is to record all research and development expenditures with nofuture alternative use as period expenses when incurred.

 

***Fair Value of Financial Instruments andConcentration of Credit Risk.***The carrying valueof the Company’s financial instruments, including cash and cash equivalents,accounts receivable, accounts payable and current liabilities, approximatesfair value due to their relatively short maturities. Financial instruments thatsubject the Company to concentrations of credit risk consist primarily of cashand cash equivalents and accounts receivable. The Company maintains its cashand cash equivalents and investments with high quality financial institutions.The Company’s customer base is located primarily in North America, Europe andAsia. The Company performs ongoing credit evaluations of its customers andgenerally does not require collateral on accounts receivable. The Companymaintains allowances for potential credit losses. As of December 31, 2005,there were two customers with net accounts receivable each comprising 10% ormore of total net accounts receivable, ranging between $1.0 million to $1.4million each.

 

6

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***Stock-based Compensation***.The Company accounts for employee stock awards in accordance with AccountingPrinciples Board Opinion No. 25, “Accounting for Stock Issued to Employees,”and related interpretations including FASB Interpretation No. 44, “Accountingfor Certain Transactions Involving Stock Compensation—an Interpretation of APBNo. 25”, issued in March 2000, to account for its fixed plan options. Underthis method, compensation expense is recorded on the date of grant only if thecurrent market price of the underlying stock exceeds the exercise price. SFAS123, “Accounting for Stock-Based Compensation,” as amended by SFAS 148, “Accountingfor Stock-Based Compensation — Transition and Disclosure,” established accountingand disclosure requirements using a fair-value method of accounting describedbelow. The Company has adopted only the disclosure requirements of SFAS 123 and148. For purposes of both financial statement and proforma disclosure, theamortization of the stock-based compensation is allocated over the vestingperiod on a straight-line basis. The Company has applied the principles of FTB97-1, “Accounting under Statement 123 for Certain Employee Stock Purchase Planswith a Look-Back Option.” Under this technical bulletin, the fair value methodof accounting is used to account for shares issued to employees under theCompany’s employee stock purchase plan. The table below illustrates the effecton net loss if the fair-value based method had been applied to all outstandingand unvested awards in each period (in millions).

 

The amounts reflected as stock-based compensationexpense deductions in the proforma net loss for the three and nine monthsending December 31, 2004, have been revised from the historically reportedamounts. The revision reflects additional stock option grants to the Company’sChief Executive Officer previously omitted and subsequently corrected on Form10-KA, filed on August 5, 2005 and included in the Form 10-Q for the quarterended September 30, 2005.

 
| ** **                                                                                                                                     | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| **(in millions)**                                                                                                                              | ** ** | **2005**                                            | ** ** | **2004**                                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net loss - as reported                                                                                                                         |       | $                                                   | (3.1       | )                                                  | $          | (9.3 | ) | $ | (14.0 | ) | $ | (18.5 | ) |
| Add: stock-based employee Compensation  expense included in Reported net loss, net of taxes in fiscal 2004                                     |       | 0.1                                                 |       | 0.5                                                |       | 0.6 |   | 1.6 |   |
| Deduct: total stock-based employee  Compensation expense determined Under fair-value-based method for all Awards,  net of taxes in fiscal 2004 |       | (0.4                                                | )          | (0.8                                               | )          | (1.8 | ) | (2.6 | ) |
|                                                                                                                                           |       |                                                |       |                                               |       |   |   |   |   |
| Net loss – proforma                                                                                                                       |       | $                                                   | (3.4       | )                                                  | $          | (9.6 | ) | $ | (15.2 | ) | $ | (19.5 | ) |

 

The fair value of options granted in fiscal 2005 and 2004 under the2004 Omnibus Stock Incentive Plans were estimated at the date of grant usingthe Black-Scholes option-pricing model. The following weighted averageassumptions were used:

 
| ** **              | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|-------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **              | ** ** | **2005**                                            | ** ** | **2004**                                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| Risk free interest rate |       | 4.4                                                 | %          | 3.4                                                | %          | 4.4 | % | 3.4 | % |
| Estimated life in years |       | 5                                                   |       | 5                                                  |       | 5 |   | 5 |   |
| Dividend yield          |       | —                                              |       | —                                             |       | — |   | — |   |
| Volatility              |       | 51.2                                                | %          | 51.9                                               | %          | 51.2 | % | 51.9 | % |

 

7

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The fair value of shares purchased under the Employee Stock PurchasePlan, were estimated at the date of the offering period using the Black-Scholespricing model. The following assumptions were used:

 
| ** **              | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|-------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **              | ** ** | **2005**                                            | ** ** | **2004**                                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| Risk free interest rate |       | 3.90                                                | %          | 2.03                                               | %          | 3.41 | % | 1.3% to 2.2 | % |
| Estimated life in years |       | 0.5                                                 |       | 0.313                                              |       | 0.5 |   | 0.313 |   |
| Dividend yield          |       | —                                              |       | —                                             |       | — |   | — |   |
| Volatility              |       | 51.2                                                | %          | 51.9                                               | %          | 51.2 | % | 51.9 | % |

 

The weighted average fair value of options granted and weighted-averageexercise price of employee stock purchases are as follows:

 
| ** **                                                                                   | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                                                   | ** ** | **2005**                                            | ** ** | **2004**                                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| Weighted-average fair value of options  granted during the period                            |       | $                                                   | 2.61       |                                               | $          | 6.20 |   | $ | 2.67 |   | $ | 10.89 |   |
| Weighted-average exercise price of employee  stock purchase plan issuances during the period |       | $                                                   | 2.44       |                                               | $          | 7.71 |   | $ | 3.12 |   | $ | 7.42 |   |

 

***Adoption of Accounting Standards***.In January 2003, the Financial Accounting Standards Board issued FASBInterpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities.”In December 2003, the FASB issued Interpretation No. 46 (revised December2003), “Consolidation of Variable Interest Entities (“FIN 46R”),” whichaddresses how a business enterprise should evaluate whether it has acontrolling financial interest in an entity through means other than votingrights.

 

EffectiveJanuary 1, 2004, the Company adopted the provisions of FIN 46R.  Under theprovisions of FIN 46R, the Company’s investment in ZiLOG MOD III, Inc. (“MODIII”) was determined to be a variable interest entity; however, the Companydetermined it was not the primary beneficiary.  Accordingly, as prescribedby FIN 46R, the Company’s adoption of this pronouncement:

 

•      Was recordedas a cumulative effect of a change in accounting principle and not as arestatement to any previous period financial statements;

•      Effectedelimination of both the $30.0 million of MOD III assets held for sale and thecorresponding $30.0 million minority interest in MOD III on the consolidatedbalance sheet;  and

•      Resulted inno impact to results of operations.

 

Substantiallyall of the equipment of MOD III was sold on July 16, 2004 and the net cashreceived after recoupment of costs was distributed to the MOD III Series Apreferred stockholders in September 2004. The remaining assets of MOD IIIconsist primarily of land and a building. The Company expects to continueincurring period expenses for the ongoing costs of maintaining the remainingassets of MOD III, which costs are recorded as special charges in operatingexpenses. Future reimbursement for MODIII maintenance costs, if any, will berecorded as a credit to special charges in the period funds are received.

 

***Recent Accounting Pronouncements.***InNovember 2004, the FASB issued SFAS No. 151, “Inventory Costs”. SFAS 151 is anamendment to ARB 43, Chapter 4, “Inventory Pricing”. SFAS 151 clarified theaccounting for abnormal amounts of idle facility expense, freight, handlingcosts and wasted material or spoilage. The provisions of SFAS 151 becomeeffective on a prospective basis for fiscal years beginning after June 15, 2005with early

 

8

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application permitted. The Company has not yet determined the impact,if any, of adopting SFAS 151, but it does not expect the adoption to have amaterial impact on its consolidated financial position, results of operationsor cash flows.

 

InDecember 2004, the FASB issued SFAS No. 123R, “Share-Based Payment.” SFAS 123Rrequires employee stock options and rights to purchase shares under stockparticipation plans to be accounted for under the fair value method, andeliminates the ability to account for these instruments under the intrinsicvalue method prescribed by APB Opinion No. 25, and allowed under the originalprovisions of SFAS No. 123, SFAS No. 123R requires the use of an option pricingmodel for estimating fair value, which is amortized to expense over the serviceperiods. The requirements of SFAS No. 123R will become effective for fiscalperiods beginning in 2006. 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 periods inthe year of adoption. The Company is currently evaluating the impact adoptingSFAS No.123R, but expects the adoption of SFAS No. 123R will result insignificant stock compensation expense.

 

In December 2004, the FASB issued FASB Staff Position (“FSP”) No.109-1, “Application of FASB Statement No. 109,”Accounting for Income Taxes,” tothe Tax Deduction on Qualified Production Activities Provided by the AmericanJobs Creation Act of 2004 (“AJCA”).”The AJCA introduces a special 9% taxdeduction on qualified production activities. FSP 109-1 clarifies that this taxdeduction should be accounted for as a special tax deduction in accordance withStatement 109. The Company has not yet determined the impact, if any, ofadopting FSP 109-1, but it does not expect the adoption to have a materialimpact on its consolidated financial position, results of operations or cashflows.

 

In December 2004, the FASB issued FSP No.109-2, “Accounting andDisclosure Guidance for the Foreign Earnings Repatriation Provision within theAmerican Jobs Creations Act of 2004.” The AJCA introduces a limited time 85%dividends received deduction on the repatriation of certain foreign earnings toa U.S. taxpayer (repatriation provision), provided certain criteria are met. FPS109-2provides accounting and disclosure guidance for the repatriation provision. AlthoughFSP 109-2 is effective immediately, the Company does not expect to be able tocomplete its evaluation of the repatriation provision until after Congress orthe Treasury Department provides additional clarifying language on key elementsof the provision. In January 2005, the Treasury Department began to issue thefirst of a series of clarifying guidance documents related to this provision. TheCompany has not yet determined the impact of adopting FSP 109-2, if any, on itsconsolidated financial statements and related disclosures.

 

**NOTE 3.****                INVENTORIES**

 

Inventories are stated at the lower of cost, determined on afirst-in-first-out basis, or market. Provisions, when required, are made toreduce excess and obsolete inventories to their estimated realizable values. Itis possible that estimates of realizable value can decline in the short-term.Inventory reserves as of December 31, 2005 and March 31, 2005 were $5.3 millionand $7.3 million, respectively. Inventories, net of provisions, consist of thefollowing (in millions):

 
| ** **       | ** ** | **December 31,  2005** | ** ** | **March 31,  2005** | ** ** |
|------------------|------------|-----------------------------|------------|--------------------------|------------|
| Raw materials    |       | $                           | 0.8        |                     | $          | 0.6 |   |
| Work-in-progress |       | 5.1                         |       | 6.6                      |       |
| Finished goods   |       | 2.1                         |       | 3.4                      |       |
|             |       | $                           | 8.0        |                     | $          | 10.6 |   |

 

9

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**NOTE 4.****                SPECIAL CHARGESAND REORGANIZATION ITEMS**

 

The components of special charges and reorganization items are asfollows (in millions):

 

| ** **                                                   | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|--------------------------------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                   | ** ** | **2005**                                            | ** ** | **2004**                                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Asset impairments:**                                       |       |                                                |       |                                               |       |   |   |   |   |
| MOD II asset impairment                                      |       | $                                                   | —     |                                               | $          | — |   | $ | — |   | $ | 5.4 |   |
| MOD II assets carrying value                                 |       | —                                              |       | 4.2                                                |       | — |   | 4.2 |   |
| MOD II assets proceeds                                       |       | —                                              |       | (5.9                                               | )          | — |   | (5.9 | ) |
| **Restructuring of operations:**                             |       |                                                |       |                                               |       |   |   |   |   |
| Employee severance, termination benefits  and transfer costs |       | 0.1                                                 |       | 0.2                                                |       | 1.6 |   | 2.0 |   |
| MOD II period maintenance costs                              |       | 0.1                                                 |       | 0.8                                                |       | 0.7 |   | 3.2 |   |
| MOD III period maintenance costs                             |       | 0.1                                                 |       | 0.3                                                |       | 0.2 |   | 1.3 |   |
| MOD III period maintenance cost  reimbursement               |       | —                                              |       | —                                             |       | — |   | (4.8 | ) |
|                                                         |       | $                                                   | 0.3        |                                               | $          | (0.4 | ) | $ | 2.5 |   | $ | 5.4 |   |

 

Duringthe nine months ended December 31, 2005, the Company has continued toconsolidate its activities in an effort to streamline operations and align itsoverall supports costs to current business levels. Additionally, following theclosure of its remaining fab in July 2004 and completion of conversion to afully fabless model, the Company continues to consolidate certain supportactivities in its Philippines facility in line with the expanding businessopportunities in Asia and China. The total severance and benefits costof this action were $1.6 million during the nine months ended December 31,2005.

 

The following table summarizes activity in accrued special chargeswhich is included within accrued liabilities on the condensed consolidatedbalance sheets (in millions):

 
| ** **                                                  | ** ** | **Severance  and  Termination  Benefits** | ** ** | **MOD II  Period  Closure  Costs** | ** ** | **Total** | ** ** |
|-------------------------------------------------------------|------------|-------------------------------------------|------------|-----------------------------------------|------------|-----------|------------|
| Balance at March 31, 2005                                   |       | $                                         | 0.1        |                                    | $          | 0.3       |       | $ | 0.4 |   |
| Provisions for employee severance and  termination benefits |       | 1.6                                       |       | —                                  |       | 1.6       |       |
| Cash paid                                                   |       | (1.2                                      | )          | (0.1                                    | )          | (1.3      | )          |
| Balance at December 31, 2005                                |       | $                                         | 0.3        |                                    | $          | 0.2       |       | $ | 0.5 |   |

 

In addition, the Company continues to incur period expenses to sustainthe remaining assets of MOD II and MOD III in a saleable state. Futurereimbursement for MOD II and MOD III maintenance costs, if any, will berecorded as a credit to special charges in the period such funds are received.

 

10

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**NOTE 5.****                GEOGRAPHIC ANDSEGMENT INFORMATION**

 

***Segment Information***.The Company’s business is comprised of one operating segment and engagesprimarily in the design, development, manufacture, marketing and sales ofsemiconductor products. The Company sells its products to distributors andoriginal equipment manufacturers (“OEM”) in a broad range of market segments,performs on-going credit evaluations of its customers and generally requires nocollateral. The Company’s operations outside the United States consist of afinal test and logistics facility in the Philippines, sales and support centersin Asia and Western Europe and design centers in China and India. Domesticoperations include product design and development, as well as the coordinationof production planning, sales, marketing, general and administrative functions.The Philippine test facility is reimbursed in relation to value added withrespect to test operations and other functions performed, and certain foreignsales offices receive a commission on export sales within their territory. Accordingly,for financial statement purposes, it is not meaningful to segregate sales oroperating profits for the test and foreign sales office operations. ZiLOG hastwo broad business lines called micrologic devices and other devices that, asaggregated, are referred to as the ‘base business’ and exclude foundry services.The Company effectively exited the foundry services business when it closed itsMOD II wafer manufacturing facility in July, 2004.

 

***Sales by Business Line***.The following table represents the net sales by business line for each of theperiods indicated (in millions):

 
| ** **                                                     | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|----------------------------------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                     | ** ** | **2005**                                            | ** ** | **2004**                                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Net sales by business line:**                                |       |                                                |       |                                               |       |   |   |   |   |
| 8-bit**Micrologic Devices**                                    |       |                                                |       |                                               |       |   |   |   |   |
| Microcontrollers – Flash based                            |       | $                                                   | 1.9        |                                               | $          | 1.0 |   | $ | 5.2 |   | $ | 2.8 |   |
|                                                           |       |                                                |       |                                               |       |   |   |   |   |
| Microcontrollers & microprocessors –  non-flash based |       | 11.4                                                |       | 13.2                                               |       | 39.2 |   | 46.0 |   |
| Total 8-bit Micrologic Devices                                 |       | $                                                   | 13.3       |                                               | $          | 14.2 |   | $ | 44.4 |   | $ | 48.8 |   |
|                                                           |       |                                                |       |                                               |       |   |   |   |   |
| **Other Devices :**                                            |       |                                                |       |                                               |       |   |   |   |   |
| Serial Communications Controllers                              |       | $                                                   | 3.1        |                                               | $          | 2.7 |   | $ | 9.4 |   | $ | 10.4 |   |
| Modems                                                         |       | 0.1                                                 |       | 0.6                                                |       | 0.9 |   | 2.2 |   |
| IrDA transceivers                                              |       | 0.3                                                 |       | 0.3                                                |       | 0.8 |   | 1.1 |   |
| Television, PC peripheral and other                            |       | 0.8                                                 |       | 0.9                                                |       | 3.2 |   | 3.7 |   |
| Total                                                          |       | $                                                   | 4.3        |                                               | $          | 4.5 |   | $ | 14.3 |   | $ | 17.4 |   |
| **Base business (excluding foundry)**                          |       | $                                                   | 17.6       |                                               | $          | 18.7 |   | $ | 58.7 |   | $ | 66.2 |   |
| **Foundry services:**                                          |       | —                                              |       | 0.2                                                |       | — |   | 3.4 |   |
| Total sales                                                    |       | $                                                   | 17.6       |                                               | $          | 18.9 |   | $ | 58.7 |   | $ | 69.6 |   |

 

11

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The following table summarizes ZiLOG’s netsales by region and by channel (in millions):

 
| ** **                | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|---------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                | ** ** | **2005**                                            | ** ** | **2004**                                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Net sales by region:**  |       |                                                |       |                                               |       |   |   |   |   |
| Americas                  |       | $                                                   | 7.5        |                                               | $          | 10.2 |   | $ | 23.8 |   | $ | 36.2 |   |
| Asia                      |       | 7.5                                                 |       | 6.2                                                |       | 26.6 |   | 23.6 |   |
| Europe                    |       | 2.6                                                 |       | 2.5                                                |       | 8.3 |   | 9.8 |   |
| Total sales               |       | $                                                   | 17.6       |                                               | $          | 18.9 |   | $ | 58.7 |   | $ | 69.6 |   |
|                      |       |                                                |       |                                               |       |   |   |   |   |
| **Net sales by channel:** |       |                                                |       |                                               |       |   |   |   |   |
| OEM                       |       | $                                                   | 7.7        |                                               | $          | 9.1 |   | $ | 26.0 |   | $ | 34.6 |   |
| Distribution              |       | 9.9                                                 |       | 9.8                                                |       | 32.7 |   | 35.0 |   |
| Total sales               |       | $                                                   | 17.6       |                                               | $          | 18.9 |   | $ | 58.7 |   | $ | 69.6 |   |

 

***Major customers:***During******the three and nine months endedDecember 31, 2005, two customers accounted for******greaterthan 10% of the total net sales, respectively. During the three and nine monthsended December 31, 2004, two customers and one customer, respectively,accounted for greater than 10% of total net sales.

 

##### **NOTE 6.**                SHORT-TERMDEBT

 

The Company entered into a senior securedfinancing facility (the “Facility”) with a commercial lender, dated May 13,2002, for a three-year $15.0 million senior secured revolving credit facility***.***Borrowings on the Facility weresecured primarily against certain North American accounts receivable and boreinterest at a rate per annum equal, at the Company’s option, to the commerciallender’s stated prime rate or LIBOR, plus 2.5%. This Facility expired onMay 13, 2005.

 

**NOTE 7.****                CONTINGENCIES**

 

OnAugust 11th, 2005 Microchip Technology Inc. (Microchip) filed a patentinfringement claim against the Company in the U.S. District Court of Arizona(case number CV05-2406-PHX-MHM). Microchip alleges that the Company has beeninfringing and currently infringes its patents numbered 5,847,450, 6,696,316and 6,483,183. Microchip claims that unspecified products of the company,including the Z8 Encore! XP 4K Series of products, infringe these patents andis seeking preliminary and permanent injunctive relief, unspecified damages andcosts including attorneys’ fees. We filed a response to the claims on September15, 2005 generally denying the claims and challenging the validity of thepatents. In January, 2006, theCompany filed a request for the re-examination of these patents with the UnitedStates Patent and Trademarks Office. The U.S. PTO usually takes up to 90 daysto determine and advise as to their decision on undergoing such re-examination.

 

TheCompany does not believe it is feasible to predict or determine the outcome orresolution of this litigation at this time. We believe we have meritoriousdefenses and will defend ourselves against these claims vigorously. We mayincur substantial expenses in our defense against these claims. In the event ofa determination adverse to us, we may incur substantial monetary liability, andbe required to change our business practices. Either of these could have amaterial adverse effect on our financial position, results of operations orcash flow.

 

Duringthe ordinary course of business, in certain limited circumstances, we haveagreed to indemnify, hold harmless and agree to reimburse the indemnified partyfor losses suffered or incurred by the indemnified party, generally partieswith which we have commercial relations, in connection with certainintellectual property infringement claims by any third party with respect toour 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 with suchindemnification arrangements; therefore, there is no accrual of such amounts atDecember 31, 2005. We disclose indemnification liabilities according to

 

12

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FASB Staff Position FIN45-1, “Accountingfor Intellectual Property Infringement Indemnifications under FASInterpretation No. 45.” Under FAS No. 5, “Loss Contingencies,” aclaim would be accrued when a loss is probable and the amount can be reasonablyestimated. At December 31, 2005, no such amounts are accrued.

 

**NOTE 8.****                INCOMETAXES**

 

During the nine months ended December 31, 2005 and December 31, 2004,our income tax provision was $1.3 and $1.6 million, respectively, whichprimarily reflects amortization of a deferred charge and provisions for taxesin profitable foreign jurisdictions. We provide for income tax expense inforeign jurisdictions where the foreign subsidiaries operations generateprofits that are taxable. On November 1, 2005, the Company entered into anAdvanced Pricing Agreement with United States Internal Revenue Service wherebyboth parties agreed to certain valuations associated with the transfer of theeconomic value of certain assets between legal entities. The tax provision forthe three and nine months ended December 31, 2005 includes a one-time credit of$0.7 million reflecting the reversal of certain provisions no longer considerednecessary based on this agreement.

 

A valuation allowance is required to be recorded if in management’sjudgment, based on available evidence, it is more likely than not that someportion or all of the deferred tax assets will not be realized.  Based onavailable evidence, management has concluded that a valuation allowance isnecessary to reduce the net deferred tax asset balance to zero.  Deferredtax assets have been recognized only to the extent of deferred tax liabilities.

 

**NOTE 9.****                NET LOSS PER SHARE**

 

The following table presents the calculation of basic and diluted netloss per share of common stock (in millions, except per share data):

 
| ** **                                                                      | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|---------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                                      | ** ** | **2005**                                            | ** ** | **2004**                                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net loss                                                                        |       | $                                                   | (3.1       | )                                                  | $          | (9.3 | ) | $ | (14.0 | ) | $ | (18.5 | ) |
|                                                                            |       |                                                |       |                                               |       |   |   |   |   |
| Weighted-average shares used in computing  basic and diluted net loss per share |       | 16.4                                                |       | 16.1                                               |       | 16.3 |   | 16.3 |   |
| Basic and diluted net loss per share                                            |       | $                                                   | (0.19      | )                                                  | $          | (0.57 | ) | $ | (0.86 | ) | $ | (1.13 | ) |

 

For the nine months endedDecember 31, 2005 and December 31, 2004, options to purchase approximately 2.1and 2.2 million shares of common stock at a weighted average exercise price of$5.80 and $7.58, respectively, were excluded from the determination of dilutednet loss per share, as the effect of such shares were anti-dilutive. AtDecember 31, 2005 and 2004, there were 16,557,684 and 16,226,860 common sharesissued and outstanding, respectively.

 

**NOTE 10.  COMPREHENSIVE INCOME**

 

The Company had no items of othercomprehensive income to report in any of the three or nine months endedDecember 31, 2005 or December 31, 2004.

 

**NOTE 11. STOCK AND STOCK REPURCHASES**

 

During the calendar year ended December 31,2005, 12,389 shares with a fair market value of approximately $0.1 million werereceived from a former employee in payment of an existing employee loan. Duringthe three months ended December 31, 2005, no shares were purchased under eitherplan.

 

13

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2004 Stock Repurchase Program: On July 29,2004 the Company’s Board of Directors approved a stock repurchase programpursuant to which the Company may repurchase up to $5.0 million in market valueof its outstanding shares of common stock. Through the calendar year endedDecember 31, 2005, 572,100 shares costing $4.4 million had been repurchased.

 

2004 Other Stock Repurchases: On November 17, 2004,the board of directors, in conjunction with Mr. Burger’s resignation, approvedthe repurchase of 92,735 shares for fair market purchase price of $6.20 pershare in consideration for the repayment of his loans totaling $0.6 million.

 

2003 Stock Repurchase Program: On April 17,2003, the Company’s Board of Directors approved a stock repurchase programauthorizing the repurchase of up to 500,000 shares of its common stock. As ofDecember 31, 2005, 405,164 shares had been repurchased at a cost of $2.1million.

 

**NOTE 12. SALES OF MOD III AND MOD II ASSETS**

 

***Sale of MOD III Equipment***

 

On July 16, 2004, the shareholders of MOD III approved the sale ofsubstantially all of the manufacturing equipment of MOD III toSTMicroelectronics (STM) for an aggregate amount of $26.0 million. The saleclosed and was funded on July 16, 2004. MOD III paid dividends on and redeemeda portion of the 28,000 Preferred Series A shares outstanding for a netconsideration of approximately $20.2 million after reimbursements totalingapproximately $4.9 million were paid to the Company and transaction costsrelated to the sale, including brokerage fees, legal fees and otherprofessional services costs were paid. Reimbursements to ZiLOG are to paycertain costs of maintaining MODIII in a saleable condition on MOD III’s behalf.Such reimbursement to ZiLOG was recognized in the three months ended September30, 2004 as a credit to special charges.

 

***Sale of MOD II Equipment***

 

In the three months endedDecember 31, 2004, the Company sold all of its wafer manufacturing equipmentand certain other manufacturing support-related assets of its MOD II facilityin Nampa, Idaho, to STM for an aggregate cash consideration of $5.9 million netof selling costs and expenses. A net gain of $1.7 million was recorded inconnection with these sales. The remaining assets of MOD II primarily consistsof land and buildings which a carrying value of $3.4 million which have beenclassified as assets held for sale on the Company’s balance sheet as ofDecember 31, 2005.

 

14

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

 

Our actualresults may 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 quarterly report.

 

**Overview**

 

The followingis management’s discussion and analysis of financial condition and results ofoperations of the Company and its subsidiaries for the three-month andnine-months ended December 31, 2005 and December 31, 2004. This discussion andanalysis should be read in conjunction with the condensed consolidatedfinancial statements and notes thereto included elsewhere herein and theCompany’s 2004 annual report on Form 10-K. Management’s discussion and analysisprovides information concerning our business environment, consolidated resultsof operations and liquidity and capital resources.

 

We prepare and release quarterly unaudited financial statementsprepared in accordance with accounting principles generally accepted in theUnited States or GAAP. We also disclose and discuss Earnings Before Interest,Taxes, Depreciation, Asset Impairments and Amortization (“EBITDA”) as a measureof liquidity in our filings with the Securities and Exchange Commission. Webelieve the disclosure of such information helps investors more meaningfullyevaluate the results of our liquidity. However, we recommend that investorscarefully review the GAAP financial information included as part of this reportand read the associated reconciliation...

 

Effective December 29, 2005,ZiLOG changed its fiscal year end from December 31 to March 31. ZiLOG’s interimresults are based on fiscal quarters of approximately thirteen weeks induration ending on the closest Saturday to each calendar quarter end, with theexception of the last quarter, which will end on March 31 beginning in fiscal2006.  In accordance with the fiscal calendar in place at that time, thefiscal 2005 year ended on March 27, 2005 and the Fiscal 2004 year ended onMarch 28, 2004. The additional four days and 3 days have been included in theCompany’s first quarter results for fiscal 2006 and 2005 respectively. Forfinancial reporting purposes and convenience of reference, interim fiscalperiods are labeled as ending on calendar month-end.  The operatingresults for any interim period are not necessarily indicative of results forany subsequent period or the full fiscal year. The condensed consolidatedbalance sheet at March 31, 2005 has been derived from unaudited financialstatements at that date.

 

**CriticalAccounting Estimates**

 

We believe ourcritical accounting estimates are as follows:

 

•        estimatingsales returns and allowances;

 

•        estimatingallowance for doubtful accounts;

 

•        estimatingwrite-downs of excess and obsolete inventories; and

 

•        assetimpairments.

 

On an on-goingbasis, we evaluate our estimates, including those related to sales returns,allowance for doubtful accounts, inventory write-downs and asset impairments. Webase our estimates on historical trends and various other assumptions that webelieve to be reasonable at the time the estimates are made. Actual resultscould differ from those estimates. A brief description of each of thesepolicies is set forth below.

 

**Estimating sales returns and allowances.**Ournet sales to OEM customers consist of gross product sales reduced by expectedfuture sales returns and allowances. To estimate sales returns and priceallowances, we analyze historical returns and allowance activity to establish abaseline reserve level. We then evaluate whether there are any underlyingproduct quality or other customer specific issues that require additionalspecific reserves above the baseline level. Because the reserve for salesreturns and allowances is based on our judgments and estimates, our

 

15

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reserves may not be adequate to cover actual sales returns and otherallowances. If our reserves are not adequate, our net sales and accounts receivablecould be adversely affected.

 

Our net sales to distributors that have rights of return and/or priceprotection allowances on unsold merchandise held by them are deferred untilsuch products are resold by the distributors to the end customers. At the timethat we recognize distributor sales as revenue, we record a reserve forestimated price adjustments that the distributors will reclaim from us on themerchandise they have resold to end users. These reserves are recorded as areduction to our net sales and a reduction to our accounts receivable. Toestimate this distributor price adjustment reserve, we analyze our historicalprice adjustment payments and pending price adjustments that have beenauthorized by us but have not yet been claimed by our distributors. Because ourdistributor allowance reserve is based upon our judgments and estimates, suchreserves may not be adequate to cover actual distributor price allowances. Ifour reserves are not adequate, our net sales and accounts receivable could beadversely affected.

 

**Allowancefor doubtful accounts.**We maintain an allowance forlosses we may incur as a result of our customers’ inability to make requiredpayments. Any increase in the allowance results in a corresponding increase inour selling, general and administrative expenses. In establishing thisallowance, and then evaluating the adequacy of the allowance for doubtfulaccounts, we consider the aging of our accounts receivable, historical baddebts, customer concentrations, and 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 the financialcondition of one or more of our customers unexpectedly deteriorated, resultingin their inability to make payments, or if we otherwise underestimate thelosses we incur as a result of our customers’ inability to pay us, we could berequired to increase our allowance for doubtful accounts which could adverselyaffect our operating results.

 

**Estimating write-downs of excess and obsolete inventories**.Each inventory component, other thanembedded flash, is assessed for excess or obsolescence by using an algorithmthat we established. This algorithm is based on historical trends, demandforecasts and inventory age. We review the result of this algorithm andgenerally record appropriate reserves for all work-in-process inventories morethan six months old and finished goods inventory quantities in excess of ourcurrent backlog and historical shipment rates. Since embedded flash inventoriesreflect new and growing product sales, inventories have been historicallypurchased to support anticipated demand. We review these inventory levelsperiodically to ensure appropriate reserves are recorded if required. Reservesrecorded for excess and obsolete inventories are reflected as a reduction toinventory values in the accompanying consolidated balance sheets, and anincrease in cost of sales. Inventory values are reviewed and are compared tothe average selling prices. Where prices are lower than the cost of theproduct, an appropriate lower of cost or market reserve is recorded against theinventory value. If actual market conditions or customer demand patterns areless favorable than, or inconsistent with our assumptions, we may be requiredto take further write-downs of our inventory value, which could adverselyimpact our cost of sales and operating results.

 

**Asset impairments.**We apply theprovisions of Statement of Financial Accounting Standards No. 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets” and Statement of FinancialAccounting Standards No. 142, “Goodwill and Other Intangible Assets.”  We assess the impairment of long-lived assetswhenever events or changes in circumstances indicate that the carrying valuemay not be recoverable Factors we consider important which could trigger animpairment review include the following:

 

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

•      decreasein our market value below our stockholders’ equity book value;

•      significantchanges in the strategy for our overall business; and

•      significantnegative sales, industry or economic trends.

 

When we determine that the carrying value oflong-lived assets may not be recoverable based upon the existence of one ormore of the above indicators of impairment, and the undiscounted cash flowsestimated to be generated by those assets are less than the asset’s carryingvalue, the carrying value of the assets are reduced to their estimated fairvalue. The estimated fair value is determined based on an estimate of futurediscounted cash flows, independent appraisals or purchase offers received fromindependent third parties. Asset impairments are recorded as a reduction in theasset value in our consolidated balance sheets and as special charges in ourconsolidated statements of operations.

 

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The intangible assets created by the adoption offresh-start accounting on our emergence from our capital restructuring in May2002 consist of existing technology, brand name as well as excess enterprisevalue, or goodwill. The existing technology and brand name are being amortizedbased on a pattern-of-use method in proportion to estimated discounted cashflows from such assets. We evaluate the existing technology and brand name ateach reporting period to determine whether events and circumstances continue tosupport the current carrying value as well as the remaining useful life. Additionally,although goodwill is not amortized, it is tested for impairment at leastannually and more often if events and circumstances indicate that its fairvalue may be less than its carrying value. The Company performs its annualimpairment test for goodwill in the third fiscal quarter of each fiscal year,unless the existence of triggering events indicates that an earlier reviewshould be performed.

 

Followingthe April 2004 announcement of the closure of our MOD II facility, we recordedcharges reflecting the impairment of MOD II long-lived assets as well as othercharges related to the closure. The carrying value of MOD II assets held forsale at December 31, 2005 was $3.4 million. If the ultimate net value realizedupon the disposition of MOD II assets is less than the estimated fairvalue, our future results of operations would be adversely impacted.

 

Adjustments torecord additional impairment of long-lived assets or intangible assets couldhave a material adverse impact on our financial condition and results ofoperations in the period or periods in which such impairment is identified.

 

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**ReportingSegments**

 

Beginning inMay 2002, we 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.

 

**Results ofOperations**

 

Our net salesby region, by channel, and by business line are summarized for each periodindicated, as follows (in millions):

 
| ** **                                                     | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|----------------------------------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                     | ** ** | **2005**                                            | ** ** | **2004**                                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Net sales by business line:**                                |       |                                                |       |                                               |       |   |   |   |   |
| 8-bit **Micrologic Devices**                                   |       |                                                |       |                                               |       |   |   |   |   |
| Microcontrollers – Flash based                            |       | $                                                   | 1.9        |                                               | $          | 1.0 |   | $ | 5.2 |   | $ | 2.8 |   |
|                                                           |       |                                                |       |                                               |       |   |   |   |   |
| Microcontrollers & microprocessors –  non-flash based |       | 11.4                                                |       | 13.2                                               |       | 39.2 |   | 46.0 |   |
| Total 8-bit Micrologic Devices                                 |       | $                                                   | 13.3       |                                               | $          | 14.2 |   | $ | 44.4 |   | $ | 48.8 |   |
|                                                           |       |                                                |       |                                               |       |   |   |   |   |
| **Other Devices :**                                            |       |                                                |       |                                               |       |   |   |   |   |
| Serial Communications Controllers                              |       | $                                                   | 3.1        |                                               | $          | 2.7 |   | $ | 9.4 |   | $ | 10.4 |   |
| Modems                                                         |       | 0.1                                                 |       | 0.6                                                |       | 0.9 |   | 2.2 |   |
| IrDA transceivers                                              |       | 0.3                                                 |       | 0.3                                                |       | 0.8 |   | 1.1 |   |
| Television, PC peripheral and other                            |       | 0.8                                                 |       | 0.9                                                |       | 3.2 |   | 3.7 |   |
| Total                                                          |       | $                                                   | 4.3        |                                               | $          | 4.5 |   | $ | 14.3 |   | $ | 17.4 |   |
| **Base business (excluding foundry)**                          |       | $                                                   | 17.6       |                                               | $          | 18.7 |   | $ | 58.7 |   | $ | 66.2 |   |
| **Foundry services:**                                          |       | —                                              |       | 0.2                                                |       | — |   | 3.4 |   |
| Total sales                                                    |       | $                                                   | 17.6       |                                               | $          | 18.9 |   | $ | 58.7 |   | $ | 69.6 |   |

 

The following table summarizes ZiLOG’s netsales by region and by channel (in millions):

 

| ** **                | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|---------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                | ** ** | **2005**                                            | ** ** | **2004**                                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Net sales by region:**  |       |                                                |       |                                               |       |   |   |   |   |
| Americas                  |       | $                                                   | 7.5        |                                               | $          | 10.2 |   | $ | 23.8 |   | $ | 36.2 |   |
| Asia                      |       | 7.5                                                 |       | 6.2                                                |       | 26.6 |   | 23.6 |   |
| Europe                    |       | 2.6                                                 |       | 2.5                                                |       | 8.3 |   | 9.8 |   |
| Total sales               |       | $                                                   | 17.6       |                                               | $          | 18.9 |   | $ | 58.7 |   | $ | 69.6 |   |
|                      |       |                                                |       |                                               |       |   |   |   |   |
| **Net sales by channel:** |       |                                                |       |                                               |       |   |   |   |   |
| OEM                       |       | $                                                   | 7.7        |                                               | $          | 9.1 |   | $ | 26.0 |   | $ | 34.6 |   |
| Distribution              |       | 9.9                                                 |       | 9.8                                                |       | 32.7 |   | 35.0 |   |
| Total sales               |       | $                                                   | 17.6       |                                               | $          | 18.9 |   | $ | 58.7 |   | $ | 69.6 |   |

 

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Other key indices relevant in understanding our business and financialperformance include the following metrics:

 
| ** **                                | ** ** | **As of December 31, and for the  three-months ended** | ** ** |
|-------------------------------------------|------------|-------------------------------------------------------------------------------------------|------------|
| ** **                                | ** ** | **2005**                                                                                  | ** ** | **2004** | ** ** |
| Days sales outstanding                    |       | 47                                                                                        |       | 48 |   |
| Net sales to inventory ratio (annualized) |       | 8.8                                                                                       |       | 6.2 |   |
| weeks of inventory at distributors        |       | 11                                                                                        |       | 10 |   |
| Current ratio                             |       | 2.0                                                                                       |       | 2.7 |   |

 

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

 

Day’s sales outstanding, DSO, is a common metric used to analyze howquickly our customers pay us. This metric is calculated as our ending netaccounts receivable divided by our average daily net sales during the periodand it is influenced largely by the timing and mix of our customer billings andcollections. At December 31, 2005, our DSO was 47 days compared to 48 days forthe three month period ended December 31, 2004. Overall, our DSO has trended inthe range of 40 to 55 days and is impacted by billings patterns and associatedcollections and when these occur either early or late in a particular quarter. Theimprovement in DSO for the three months ended December 31, 2005 compared to thesame period in 2004 reflects lower sales levels in 2005 and less shipments madelate in the quarter versus the same period of 2004. Because our DSO isprimarily influenced by payment cycles from our OEM customers, increases in ourDSO do not generally correlate to increased credit risk. In addition, our baddebts have historically been minimal.

 

Net sales to inventory ratio is a metric we use to analyze how quicklyour investment in inventories is recovered by our sales. This metric may not becomparable to those other companies use to analyze inventory and is not thesame as a typical inventory turnover ratio. Our net sales to inventory ratioimproved in the three months ended December 31, 2005 as compared to the sameperiod in 2004 due to our reduction of inventory levels. The decline ininventories in the three months ended December 31, 2005 compared to the sameperiod in 2004 reflects the fact that in 2004 we built additional inventory inour MOD II facility prior to its closure in July 2004 in order to minimizerisks of supply of products to our customers following the MOD II closure. Themajority of these products are now being manufactured in X-FAB’s six-inch wafermanufacturing facility in Lubbock, Texas and we typically schedule productionat X-FAB to correlate with current customer backlog or historical shipmentpatterns.

 

Weeks of inventory at distributors measures how quickly ourdistributors sell the inventories that we sell to them to their end customersand as such, is relative to the level of sales we record for distribution sales.We do not recognize revenue on shipments to distributors until our distributorsresell our products to end users. Although our distributors in various regionsof the world maintain different inventory stocking levels, overall our goal isto maintain 10 to 13 weeks of inventories at our distributors to satisfy theirend demand.

 

Current ratio represents current assets divided by current liabilitiesand is commonly used to assess a company’s liquidity. The Company uses thisratio to make spending determinations on discretionary items. Our current ratiodeclined as of December 31, 2005 compared to December 31, 2004 primarily due tothe reduction in our cash and cash equivalents used to fund our operations,cost associated with consolidation of business activities and capital used in ourtest operations as we expand test capacity for the embedded products growth.

 

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**Three and Nine Months Ended December 31, 2005 and 2004**

 

**Net Sales.**Overall,our net sales of $17.6 million for the three months ended December 31, 2005,represents a decrease of 7% from $18.9 million of net sales for the same periodof 2004. For the nine months ended December 31, 2005, net sales were $58.7million, down 16% from $69.6 million of net sales during the same period of2004.

 

Net sales of our micrologic devices were $13.3 and $14.2 million forthe three months ended December 31, 2005 and 2004, respectively. For the ninemonths ended December 31, 2005, net sales of our micrologic devices were $44.4million, down 9% from $48.8 million during the same period of 2004.

 

The decrease in micrologic sales during the three and nine months endedDecember 31, 2005 compared to December 31, 2004, reflects declines in unitsales of our legacy Z8 and Z80 microcontroller products as these productsconvert to embedded flash designs. Overall, we anticipate that market demandand net sales for our general purpose microcontrollers will decline over timeas a result of customers moving from these older Z80 and Z8 products toalternative technologies, primarily microcontrollers with embedded flashtechnology and the need for further integration of peripheral functions andcapabilities. .

 

Net sales for our embedded flash based products in the three monthsended December 31, 2005 were $1.9 million up from $1.0 million for the threemonths ended December 31, 2004. Net sales for our embedded flash based productsin the nine months ended December 31, 2005 were $5.2 million up from $2.8million in the nine months ended December 31, 2004. Since November 2002, wehave released our new Z8 Encore!, eZ80 Acclaim! Z8 Encore! XP and Z8 Encore! MCproducts that are focused on the embedded flash market, with a strategy ofrecapturing sales to these customers and entering new markets. Bookings of neworders for our embedded flash microcontroller products totaled $2.2 million forthe three months ended December 31, 2005, reflecting our design wins withcustomers moving to production and creating the need for these products.

 

Net sales of our other devices, which excludes Foundry sales, for thethree months ended December 31, 2005 decreased 4% to $4.3 million, down from$4.5 million in the same period of 2004. For the nine months ended December 31,2005, net sales of our other devices were $14.3 million or down 18% from netsales of $17.4 million during the same period of 2004. The decrease in otherdevices net sales during the three and nine months ended December 31, 2005compared to the same period of 2004 primarily reflects lower unit shipments ofmost major product types. These product categories do not have next generationproduct roadmaps and are not a focus of our research and development activitiesand we expect these sales to continue to decline as they are converted bycustomers to alternative integrated designs.

 

Net sales of Foundry Services, for the three and nine months endedDecember 31, 2004 were $0.2 million and $3.4 million while we had no such salesduring 2005. The decrease is due to the closure of our MOD II wafer fabricationfacility in July 2004 and as a result, we do not anticipate any further foundrybusiness.

 

**Gross Margin**. Our cost of sales primarilyrepresents purchased manufacturing services relating to wafer fabrication andpackage assembly operations, as well as captive product testing, productionplanning, and manufacturing support costs. Cost of sales fluctuates, dependingon materials and services prices from our vendors, manufacturing productivityand efficiency, product mix, equipment utilization and depreciation.

 

Gross profit as a percent of net sales (“gross margin”) was 45% for thethree months ended December 31, 2005, up from 31% in the same period of 2004.The 2004 results included charges and inventory reserves associated with theclosure of the Mod II wafer manufacturing facility in July, 2005 totaling $1.9million. Additionally, the increase in gross margin for the three months endedDecember 31, 2005 compared to the same period of 2004 reflects improved waferpricing and cost savings as a result of actions taken in the summer of 2005 toconsolidate certain support activities including the transfer of certain ofthese activities from our U.S. operations to our Philippines operations. Theconsolidations are in line with our focus on supporting the growingopportunities in the Asia and China regions.

 

For the nine months ended December 31, 2005, our gross margin was 42%compared to 43% in the same period of 2004. As previously stated the 2004results included charges and inventory reserves associated with the closure ofthe Mod II wafer manufacturing facility in July, 2005 totaling $1.9 million.The decrease in gross margin for the

 

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nine months ended December 31, 2005 compared to the same period of 2004reflects the reduction in sales of higher margin legacy products coupled withthe proportionate increase of flash-based microcontroller products whichcurrently generate lower gross margin than our some of the more mature productofferings. Gross margins on these flash products continue to improve as salesdemand and volume grows allowing us to leverage lower wafer pricing from oursuppliers.

 

**Research and Development Expenses.**Researchand development expenses were $5.2 million in the three months ended December31, 2005, reflecting a 4% decrease from the $5.4 million in the three monthsended December 31, 2004. For the nine months ended December 31, 2005, researchand development expenses increased 1% to $16.0 million from $15.9 million forthe same period in 2004.

 

For the three months and nine months ended December 31, 2005,fluctuation and changes in the research and development spending primarilyreflects increases or decreases in support costs such as engineering wafers,mask costs, contractors and other associated costs to support the programs andcan be merely a function of the status or stage of the various programs in itsdevelopment. Our research and development spending continues to be focused onour new embedded flash products, including our latest family of Flash-basedMicrocontrollers, the Z8Encore!XP and Z8 Encore! MC as well as new devices andsoftware features for our Crimzon line of consumer solution productsconcentrated in the Infrared remote control market segment Additionally, inFebruary 2005, we announced the release of our 32 bit ARM based family ofmicrocontroller products initially focused on the point of sale and securitybased target markets.

 

**Selling, General and Administrative Expenses.**Selling,general and administrative expenses for the three months ended December 31,2005 decreased 36% to $5.0 million, down from $7.8 million for the three monthsended December 31, 2004. Selling, general and administrative expenses decreasedby $5.0 million, or 22%, to $17.7 million for the nine months ended December 31,2005, as compared to the same period in 2004.

 

The decrease in our selling, general and administrative spending forboth the three and nine months ended December 31, 2005, compared to 2004 isprimarily due to savings from cost reduction programs to reduce headcount inour sales and marketing support functions, as well as savings from theconsolidation certain administrative functions in our Philippines operations.These savings were partially offset by increased costs to supportSarbanes-Oxley activities and incremental costs associated with the Microchiplawsuit.

 

**Special Charges**. Special charges for eachperiod indicated were as follows (in millions):

 

| ** **                                                   | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|--------------------------------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                   | ** ** | **2005**                                            | ** ** | **2004**                                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Asset impairments:**                                       |       |                                                |       |                                               |       |   |   |   |   |
| MOD II asset impairment                                      |       | $                                                   | —     |                                               | $          | — |   | $ | — |   | $ | 5.4 |   |
| MOD II assets carrying value                                 |       | —                                              |       | 4.2                                                |       | — |   | 4.2 |   |
| MOD II assets proceeds                                       |       | —                                              |       | (5.9                                               | )          | — |   | (5.9 | ) |
| **Restructuring of operations:**                             |       |                                                |       |                                               |       |   |   |   |   |
| Employee severance, termination benefits  and transfer costs |       | 0.1                                                 |       | 0.2                                                |       | 1.6 |   | 2.0 |   |
| MOD II period maintenance costs                              |       | 0.1                                                 |       | 0.8                                                |       | 0.7 |   | 3.2 |   |
| MOD III period maintenance costs                             |       | 0.1                                                 |       | 0.3                                                |       | 0.2 |   | 1.3 |   |
| MOD III period maintenance cost  reimbursement               |       | —                                              |       | —                                             |       | — |   | (4.8 | ) |
|                                                         |       | $                                                   | 0.3        |                                               | $          | (0.4 | ) | $ | 2.5 |   | $ | 5.4 |   |

 

During the three months ended June 30, 2005, the Company initiated aplan of action to consolidate certain of its support activities and transfercertain of these activities to its Philippines operations. These activitieshave resulted in lower overall support costs. The total severance and benefitscost of this action to date has been $1.6 million which has been recorded asspecial charges during the nine months ended December 31, 2005, and theremaining amount will be recorded over the required service periods of theemployees to be terminated and is expected to be completed during the periodending March 31, 2006. In addition, the Company continues to incur periodexpenses to sustain the

 

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remaining assets of MOD II and MOD III in a saleable state. During thenine months ended December 31 2004, the Company received reimbursement ofaccumulated expenses for sustaining MOD III in the amount of $4.8 millionrelated to the sale of MOD III assets as noted in the preceding table ofspecial charges.

 

The following table summarizes activity in accrued special chargeswhich is included within accrued liabilities on the condensed consolidatedbalance sheets (in millions):

 
| ** **                                                  | ** ** | **Severance  and  Termination  Benefits** | ** ** | **MOD II  Period  Closure  Costs** | ** ** | **Total** | ** ** |
|-------------------------------------------------------------|------------|-------------------------------------------|------------|-----------------------------------------|------------|-----------|------------|
| Balance at March 31, 2005                                   |       | $                                         | 0.1        |                                    | $          | 0.3       |       | $ | 0. 4 |   |
| Provisions for employee severance and  termination benefits |       | 1.6                                       |       | ——                            |       | 1.6       |       |
| Cash paid                                                   |       | (1.2                                      | )          | (0.1                                    | )          | (1.3      | )          |
| Balance at December 31, 2005                                |       | $                                         | 0.3        |                                    | $          | 0.2       |       | $ | 0.5 |   |

 

***Three and Nine Months EndedDecember 31, 2005***. Restructuring of operationsduring the three and nine months ended December 31, 2005, included severanceand termination benefits of approximately $0.1 million and $1.6 million,respectively, related to a reduction-in-force and support activityconsolidation implemented during the quarter ended June 30, 2005, and $0.1million and $0.7 million, respectively, to maintain MOD II, and $0.1 millionand $0.3 million respectively to maintain MOD III.

 

***Three and Nine Months Ended December 31, 2004***.Restructuring of operations during the nine months ended December 31, 2004,included severance and termination benefits of approximately $2.0 millionprimarily related to the Company’s reduction-in-force due to the closure of itsMOD II five-inch wafer fabrication facility in Nampa, Idaho on July 11, 2004,and $5.4 million of asset impairments, primarily related to the write-down ofMOD II assets to fair value during the period. During the three and nine monthsended December 31, 2004, other special charges included $0.8 million and $3.2million, respectively, related to the closure and maintenance of MOD II, $0.3million and $1.3 million, respectively to maintain MOD III, and thereimbursement of $4.8 million of accumulated maintenance expenses of MOD III.Post-closure maintenance costs of the MOD III eight-inch and MOD II five-inchwafer fabrication facilities consist of utilities, taxes, insurance, and othermaintenance costs required to maintain the facilities in a condition requiredfor the sale of the respective properties and are expensed to special chargesas incurred. Recoupment of these charges from the sale of assets is recorded asa credit to special charges when funds are received. Completion of the migrationof the MOD II production to outside foundries, has finalized our strategy ofbecoming fully fabless and our legacy products are primarily sourced from X-FABand our newer products are sourced from foundries in Taiwan.

 

***Stock-Based Compensation.***Our****stock-based compensation primarily represents primarilyamortization of deferred compensation associated with stock options andrestricted stock awarded to employees and contractors at prices below fairvalue. During the three months ended December 31, 2005 and 2004, we recognized$0.1 million and $0.5 million of stock-based compensation, respectively. Duringthe nine months ended December 31, 2005 and 2004, we recognized $0.6 millionand $1.6 million of stock-based compensation, respectively. These charges wererecorded to reflect the intrinsic value of awards of restricted stock and stockoptions to certain executives, employees and consultants. These non-cashcharges are primarily included in our selling, general and administrativeexpenses. During the nine month period ended September 30, 2004, we canceled arestricted stock award to our CEO and replaced it with stock options thatresulted in a non-cash compensation charge of approximately $0.2 million. Ourright to repurchase shares of restricted stock for $0.01 per share generallylapsed 25% on the award date and 25% on

 

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each of the first three anniversaries following the award date. Compensationexpense for employee stock awards was measured on the award date and wasrecognized ratably over the three years vesting period as these restrictionslapsed. All restricted shares issued prior to May 2005 became fully vested inMay 2005. During the three month period ended December 31, 2005 the Board ofDirectors approved restricted shares grants to its executive officers. Thegrants approved were to Mr. Thorburn CEO 100,000, to Mr. Sheridan 60,000 and toMr. Grace 60,000. These restricted shares were issued at a price of $0.01 pershare and vest at the earlier of a change in control or a 3 year cliff vesting.Compensation expense was recorded in association with these grants and is beingamortized ratably over three years, ending on the third anniversary of the dateof the grants.

 

**Goodwill and Intangible Assets**. EffectiveJanuary 1, 2002, we adopted the provisions of FASB Statement of FinancialAccounting Standards No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”).Under SFAS 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 (but with nomaximum life). In connection with the Company’s fresh-start reporting,separable intangible assets based on independent valuations were created withdeemed defined lives. These intangible assets are being amortized utilizing thepattern-of-use method over their estimated useful lives of six years for currenttechnology and ten years for brand name.

 

The separable intangible assets identified inconnection with fresh- start accounting and included in the consolidatedbalance sheet are as follows (in millions):

 
| ** **                                | ** ** | **Current  Technology** | ** ** | **Brand  Name** | ** ** | **Total** | ** ** |
|-------------------------------------------|------------|-------------------------|------------|-----------------|------------|-----------|------------|
| Gross carrying amount, recorded May, 2002 |       | $                       | 17.0       |            | $          | 9.2       |       | $ | 26.2 |   |
| Accumulated amortization                  |       | 16.4                    |       | 4.7             |       | 21.1      |       |
| Book value at December 31, 2005           |       | $                       | 0.6        |            | $          | 4.5       |       | $ | 5.1 |   |

 

The anticipated remaining amortizationschedule for these assets is as follows (in millions):

 
| **Fiscal Year**           | ** ** | **Current  Technology** | ** ** | **Brand  Name** | ** ** | **Total  Amortization** | ** ** |
|--------------------------------|------------|-------------------------|------------|-----------------|------------|-------------------------|------------|
| January –  March 31, 2006 |       | $                       | 0.1        |            | $          | 0.2                     |       | $ | 0.3 |   |
| 2007                           |       | 0.3                     |       | 0.9             |       | 1.2                     |       |
| 2008                           |       | 0.1                     |       | 0.9             |       | 1.0                     |       |
| 2009                           |       | 0.1                     |       | 0.7             |       | 0.8                     |       |
| 2010                           |       | —                  |       | 0.7             |       | 0.7                     |       |
| Thereafter                     |       | —                  |       | 1.1             |       | 1.1                     |       |
| Total                          |       | $                       | 0.6        |            | $          | 4.5                     |       | $ | 5.1 |   |

 

**Interest Income/Expense.**Interest incomerelates to interest earned on our cash and cash equivalents. Cash equivalentsare primarily invested in money market funds and high-grade commercial paperwith maturities of 90 days or less. Interest income for the nine months endedDecember 31, 2005 was $0.6 million as compared to $0.3 million for the ninemonths ended December 31, 2004. The higher interest income reflects interestearned on cash raised by the Company in its March 19, 2004 offering of commonstock. There was no interest expense in the nine months ended December 31, 2005as outstanding debt was extinguished in 2004.

 

**Income Taxes.**During the nine months endedDecember 31, 2005, our income tax provision was $1.3 million, which primarilyreflects amortization of a deferred charge and provisions for taxes inprofitable foreign jurisdiction. We provide for income tax expense in foreignjurisdictions where the foreign subsidiaries operations generate profits thatare taxable. On November 1, 2005, the Company entered into an Advanced PricingAgreement with United States Internal Revenue Service whereby both partiesagreed to certain valuations associated with the transfer of the economic valueof certain assets between legal entities. The tax provision for the three andnine months ended December 31, 2005 includes a one-time credit of $0.7 millionreflecting the reversal of certain provisions no longer considered necessarybased on this agreement.

 

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A valuation allowance is required to be recorded if in management’sjudgment, based on available evidence, it is more likely than not that someportion or all of the deferred tax assets will not be realized.  Based onavailable evidence, management has concluded that a valuation allowance isnecessary to reduce the net deferred tax asset balance to zero.  Deferredtax assets have been recognized only to the extent of deferred tax liabilities.

 

**Liquidity and Capital Resources**

** **

AtDecember 31, 2005, we had cash and cash equivalents of $24.1 million, comparedto $33.6 million at March 31, 2004. Cash used by operating activities was $5.8 million for the nine monthsended December 31, 2005, compared to $1.3 million of cash provided by operatingactivities in the nine months ended December 31, 2004.

 

#### **During the nine months ended December 31, 2005, cash usedby operating activities of $5.8 million primarily reflects our $14.0 millionnet loss, offset partially by: (i) non-cash charges for depreciation andamortization, including**amortizationof fresh start intangible assets of $3.5 million; (ii) cash provided foroperations from reductions in accounts receivable, inventories and prepaidexpenses and other current and non-current assets of $3.2 million, $2.6 millionand $1.5 million, respectively.

#### ** **

During the nine months endedDecember 31, 2004, cash provided by operating activities of $1.3 millionprimarily reflects our $18.5 million net loss, offset by : (i) non cash chargesfor depreciation and amortization including amortization of fresh startintangible assets, net change in assets held for sale related to sale ofequipment and stock based compensation expense of $4.9 million, $4.0 millionand $1.6 million, respectively;  (ii)changes in operating assets and liabilities from decreases in accountsreceivable, prepaid expense and other current and non-current assets andaccrued charges and other liabilities of $6.4 million, $0.8 million, and $2.3million respectively; and, (iii) goodwill adjustment net of change in deferredtax assets and liabilities of $0.4 million.

 

Cashused by investing activities was $3.7 million in the nine months ended December31, 2005, primarily reflecting capital expenditures for new test equipment andsoftware upgrades. For the nine months ended December 31, 2004, net cashgenerated by investing activities was $2.4 million, comprised of $3.5 millionof capital expenditures related primarily to purchase and implementation ofinternal-use software and building improvements, offset by the proceeds of $5.9million related to the sale of equipment from our MOD II wafer fabricationfacility.

 

Cashprovided by financing activities was $0.1 million for the nine months endedDecember 31, 2005 and consisted of proceeds for issuances of stock to employeesunder our employee stock purchase plan offset by $0.1 million for therepurchase of restricted common stock from a former employee. Cash used forfinancing activities for the nine months ended December 31, 2004 of $6.0million primarily reflects liquidation of short term debt, and re-purchases ofcommon stock on the open market of $4.3 million and $5.0 million, respectively,offset by net proceeds from the balance of our 2004 stock offering and theissuance of common stock under stock purchase plans of $2.8 million and $0.5million, respectively.

 

EBITDAas presented below reflect a non-GAAP measure of our liquidity.  EBITDA reflects our net income adjusted fornon-cash items, interest and income taxes. Our management uses separate “adjusted EBITDA” calculations for purposesof determining certain employees’ incentive compensation and, subject tomeeting specified adjusted EBITDA amounts, for accelerating the vesting ofEBITDA-linked stock options. This measure of adjusted EBITDA was approved aspart of our plan of reorganization. Adjusted EBITDA, as we define it, excludes interest, income taxes,effects of changes in accounting principles and non-cash charges such asdepreciation, amortization, in-process research and development, andstock-based compensation expense.  Italso excludes cash and non-cash charges associated with reorganization itemsand special charges, which represent operational restructuring charges,including asset write-offs, employee termination costs, and lease terminationcosts.  EBITDA is presented becausemanagement uses EBITDA as a measure of cash earnings for budgeting andfinancial performance measurement.

 

Thedifferences between the EBITDA amounts below and our adjusted EBITDA relate tothe following cash-settled reorganization and special items that are added-backin our adjusted EBITDA computations:

 

•      Employee retention bonuses, severance pay andtermination benefits;

 

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•      Professional fees for debt restructuring;

•      Lease termination costs;

•      Termination and exit charges, and

•      MOD III and MOD II closure costs.

 

Our EBITDA, reconciled to cash provided (used) by operations (the mostdirectly comparable measure of liquidity under accounting principles generallyaccepted in the United States) for each period presented, is as follows (inmillions):

 

| ** **                                                               | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|--------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                               | ** ** | **2005**                                            | ** ** | **2004**                                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| Reconciliation of net loss to EBITDA:                                    |       |                                                |       |                                               |       |   |   |   |   |
| Net loss                                                                 |       | $                                                   | (3.1       | )                                                  | $          | (9.3 | ) | $ | (14.0 | ) | $ | (18.5 | ) |
| Depreciation and amortization                                            |       | 1.2                                                 |       | 1.6                                                |       | 3.5 |   | 4.9 |   |
| Interest expense, net                                                    |       | (0.2                                                | )          | (0.1                                               | )          | (0.6 | ) | (0.3 | ) |
| Income tax expense (benefit)                                             |       | —                                              |       | 1.6                                                |       | 1.3 |   | 1.6 |   |
| EBITDA                                                                   |       | $                                                   | (2.1       | )                                                  | $          | (6.2 | ) | $ | (9.8 | ) | $ | (12.3 | ) |
|                                                                     |       |                                                |       |                                               |       |   |   |   |   |
| Reconciliation of EBITDA to net cash by  operating activities cash flow: |       |                                                |       |                                               |       |   |   |   |   |
| EBITDA                                                                   |       | $                                                   | (2.1       | )                                                  | $          | (6.2 | ) | $ | (9.8 | ) | $ | (12.3 | ) |
| Interest expense, net                                                    |       | 0.2                                                 |       | 0.1                                                |       | 0.6 |   | 0.3 |   |
| Benefit (provision) for income taxes and  liabilities                    |       | —                                              |       | (1.6                                               | )          | (1.3 | ) | (1.6 | ) |
| Goodwill adjustment and liabilities                                      |       | 0.4                                                 |       | 0.9                                                |       | 0.4 |   | 8.3 |   |
| Deferred income tax assets and liabilities                               |       | (0.2                                                | )          | 1.4                                                |       | (0.2 | ) | (7.9 | ) |
| Gain on sale of MOD II assets                                            |       | —                                              |       | (1.7                                               | )          | — |   | (1.7 | ) |
| Asset impairments                                                        |       | —                                              |       | —                                             |       | — |   | 5.4 |   |
| Loss on asset disposal                                                   |       | —                                              |       | 0.1                                                |       | — |   | 0.2 |   |
| Stock-based compensation                                                 |       | 0.1                                                 |       | 0.5                                                |       | 0.6 |   | 1.6 |   |
| Changes in operating assets and liabilities  and liabilities             |       | (0.3                                                | )          | (0.6                                               | )          | 3.9 |   | 9.0 |   |
| Net cash provided (used) by operating  activities                        |       | $                                                   | (1.9       | )                                                  | $          | (7.1 | ) | $ | (5.8 | ) | $ | 1.3 |   |

 

Our cash needsduring the nine months ended December 31, 2005 primarily includes fundingoperating losses, working capital, special charges and capitalexpenditures.  In April 2004, weannounced the closure of our MOD II wafer fabrication facility which resultedin the elimination of approximately 150 positions.  In May 2005, we commenced a consolidation ofour support activities.  We anticipatethe remaining cash costs of this action will be approximately $0.3 million ofstay-on entitlements, severance benefits and other cash costs to be paidprimarily during the three months ending March 31, 2006.  We currently anticipate that available cashwill be adequate to satisfy our cash requirements for at least the next twelvemonths.

 

We expectfiscal 2006 capital expenditures will total approximately $3.7 million to $4.2million, primarily for new semiconductor test equipment to support our embeddedflash production and sales, building improvements and internal usesoftware.  Decisions related to cash requirementsfor investing activities are influenced by our expected cash provided by orused in operations, our existing cash reserves and the investment needs of thebusiness as we continue to expand our development activities.

 

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**ContractualObligations.**

 

We leasecertain of our facilities and equipment under non-cancelable operating leases,which expire in fiscal 2006 through fiscal 2010. These facility leaseagreements generally provide for base rental rates which increase at varioustimes during the terms of the leases and also provide for renewal options atfair market rental value. We are also responsible for common area maintenancecharges on certain office leases.

 

We generally make purchases under cancelable purchase orders and do notenter into long-term supply agreements. Certain of our wafer foundry, assembly,materials suppliers, software vendors and support tool manufacturers requirenon-cancelable purchase orders since they often provide products and servicestailored to our specifications. We have not entered into any material newvendor supply agreements or lease commitments or indemnifications during thenine months ended December 31, 2005.

 

**Effects of Inflation and Changing Prices**

 

We believe that inflation and/or deflation had a minimal impact on ouroverall operations during the periods included in these financial statements.

 

**Seasonality**

 

Sales typically increase in the quarter ending June 30 and peak in thequarter ending September 30 driven by increased holiday demand from ourcustomers in the home entertainment and consumer products markets.  Our revenues are generally lower in thequarters ending March 31 and December 31compared to the remainder of the year.  We believe that this historical seasonaltrend could be impacted in the current year by general economic conditions andreduction in sales of our legacy and other product portfolios. Additionally,general world-wide economic, political and regional instabilities may impactour results of operations in any given period.

 

***Recent Accounting Pronouncements. ***In November2004, the FASB issued SFAS No. 151, “Inventory Costs”. SFAS 151 is an amendmentto ARB 43, Chapter 4, “Inventory Pricing”. SFAS 151 clarified the accountingfor abnormal amounts of idle facility expense, freight, handling costs andwasted material or spoilage.  Theprovisions of SFAS 151 become effective on a prospective basis for fiscal yearsbeginning after June 15, 2005 with early application permitted.  The Company has not yet determined theimpact, if any, of adopting SFAS 151, but it does not expect the adoption tohave a material impact on its consolidated financial position, results ofoperations or cash flows.

 

In December 2004, the FASB issued SFAS No. 123R, “Share-Based Payment.”SFAS 123R requires employee stock options and rights to purchase shares understock participation plans to be accounted for under the fair value method, andeliminates the ability to account for these instruments under the intrinsicvalue method prescribed by APB Opinion No. 25, and allowed under the originalprovisions of SFAS No. 123, SFAS No. 123R requires the use of an option pricingmodel for estimating fair value, which is amortized to expense over the serviceperiods.  The requirements of SFAS No.123R will become effective for fiscal periods beginning in 2006. SFAS No. 123Rallows for either prospective recognition of compensation expense orretrospective recognition, which may be back to the original issuance of SFASNo. 123R or only to interim periods in the year of adoption.  The Company is currently evaluatingthe impact adopting SFAS No.123R, but expects the adoption of SFAS No. 123Rwill result in significant stock compensation expense.

** **

In December 2004, the FASB issued FASB Staff Position (“FSP”) No.109-1, “Application of FASB Statement No. 109,”Accounting for Income Taxes,” tothe Tax Deduction on Qualified Production Activities Provided by the AmericanJobs Creation Act of 2004 (“AJCA”).”The AJCA introduces a special 9% taxdeduction on qualified production activities. FSP 109-1 clarifies that this tax deduction should be accounted for as aspecial tax deduction in accordance with Statement 109.  The Company has not yet determined the impact,if any, of adopting FSP 109-1, but it does not expect the adoption to have amaterial impact on its consolidated financial position, results of operationsor cash flows

 

In December 2004, the FASB issued FSP No.109-2, “Accounting andDisclosure Guidance for the Foreign Earnings Repatriation Provision within theAmerican Jobs Creations Act of 2004.” The AJCA introduces a limited time 85%

 

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dividends received deduction on the repatriation of certain foreignearnings to a U.S. taxpayer (repatriation provision), provided certain criteriaare met.  FPS109-2 provides accountingand disclosure guidance for the repatriation provision.  Although FSP 109-2 is effective immediately,the Company does not expect to be able to complete its evaluation of therepatriation provision until after Congress or the Treasury Department providesadditional clarifying language on key elements of the provision.  In January 2005, the Treasury Departmentbegan to issue the first of a series of clarifying guidance documents relatedto this provision.  The Company has notyet determined the impact of adopting FSP 109-2, if any, on its consolidatedfinancial statements and related disclosures.

 

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**RISK FACTORS**

 

**RisksRelated to Our Business and Industry**

 

*The followingrisk factors should be considered carefully in addition to the otherinformation in the Form 10-Q.  The risksdescribed below are the ones we deem to be material to our business, but arenot the only ones we face.  Additionalrisks we are not presently aware of or that we currently believe are immaterialmay also impair our business operations. If any of these risks actually occurs,our business could be harmed materially.*

* *

***We have experienced declines in net sales, and, if we fail to implementour new product strategy, we may continue to experience declines in sales andgross margins.***

*** ***

In each of thepast three years our net sales have declined significantly and our futurefinancial results are anticipated to be subject to substantial fluctuations. Ourtotal net sales were $95.6 million for the calendar year ended December 31,2004, compared to $103.6 million in the calendar year ended December31,2003.  In addition, our net sales forthe nine months ended December 31, 2005 were $58.7 million, compared to netsales of $69.6 million for the same period in 2004. We anticipate that sales ofour legacy products will continue to decline over time. Our future financialperformance and success are largely dependent on our ability to implement ournew product strategy, which consists partly of refocusing our business on thenext generation of micrologic products built around our core 8-bit micrologicarchitecture, beginning with the Z8 Encore! and eZ80 Acclaim! flashproducts.  In November 2002 we launchedour new 8-bit Z8 Encore! micrologic product, in February 2003 we launched ournew eZ80 Acclaim! micrologic product and in March 2004 our enhanced Z8 Encore!XP flash product family. These products typically have a long lead time fromdesign to production, which can range from twelve months to thirty-six months.These new products now represent approximately 11% of our net sales and wecurrently expect the contribution of these products to continue to grow.  If we are unable to develop new products in amanner that timely meets changing market requirements, or if we are not able toachieve significant 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 we introduce new products,including our flash and IR products, we experience additional start up costsand unfavorable manufacturing prices due to low volume. In addition, we do notexpect margins on our flash products to be as strong as those on our legacyproducts for the foreseeable future. Consequently, the introduction of newproducts could have a negative impact on our gross margin even if sales fromsuch new products offset declining revenues of our legacy products.

 

***If we are unable to obtain adequate production capacity or quality, ourbusiness will be harmed****.*

* *

We rely onindependent third-party foundry manufacturers including X-FAB, TSMC, and UMC tofabricate wafers for all of our product needs. Industry-wide shortages in foundry capacity could harm our financialresults.  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, we maynot be able to meet our customers’ demand for our products.  Any delay in initiating production atthird-party foundries, any inability to have new products manufactured at suchfoundries or any failure to meet our customers’ demands could damage our relationshipswith our customers and may decrease our sales.

 

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

 

•   reduced control over the cost of ourproducts, delivery schedules, capacity constraints and product quality;

 

•    limited warranties on wafers or productssupplied to us;

 

•    increased exposure to potentialmisappropriation of our technology;

 

•    yield or quality issues with the supplierwhich could result in us being unable to supply product to customers orproviding product that doe not meet their quality or performance standards;

 

•    vulnerability to third-party foundries’financial, operations or production difficulties; and

 

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•    the time and cost associated with switchingor sourcing alternate foundries.

 

***If we are unable to prevail in a patent litigation lawsuit we may incursubstantial monetary liability and may be required to change our businesspractices.***

 

On August 11th, 2005 Microchip Technology Inc. (Microchip) filed apatent infringement claim against the Company in the U.S. District Court ofArizona (case number CV05-2406-PHX-MHM). Microchip alleges that the Company hasbeen infringing and currently infringes its patents numbered 5,847,450,6,696,316 and 6,483,183. Microchip claims that unspecified products of thecompany, including the 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 the validityof the patents. In January, 2006, the Company filed a request for there-examination of these patents with the United States Patent and TrademarksOffice. The U.S. PTO usually takes up to 90 days to determine and advise as totheir decision on undergoing such re-examination.

 

We do not believe it is feasible to predict or determine the outcome orresolution of this litigation at this time. We believe we have meritoriousdefenses and will defend ourselves against these claims vigorously. We mayincur substantial expenses in our defense against these claims. In the event ofa determination adverse to us, we may incur substantial monetary liability, andbe required to change our business practices. Either of these could have amaterial adverse effect on our financial position, results of operations orcash flow.

 

***We depend on third-party assemblers throughout Asia, including Indonesia,Thailand and the Philippines, and the failure of these third parties tocontinue to provide services to us on sufficiently favorable terms could harmour business****.*

* *

We use outsidecontract assemblers in Indonesia, Thailand and the Philippines for packagingour products.  These countries have beensubject to political instability and terrorist activities. The packaging ofsemiconductors is a complex process requiring, among other things, a highdegree of technical skill and advanced equipment.  If we are unable to obtain additionalassembly capacity on sufficiently favorable terms, our ability to maintain orgrow our net sales could be impaired. Shortages in contract assembly capacity could cause shortages in ourproducts and could also result in the loss of customers as a result ofdelays.  Because we rely on these thirdparties, we also have less control over our costs, delivery schedules andquality of our products and our technology is at greater risk of misappropriation.

 

***Our success depends on our ability to introduce new products on atimely basis.***

 

Our operatingresults depend on our ability to introduce and sell new products on a timelybasis that can compete effectively based on price and performance and thataddress 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:

 

•      development ofsupport tools and technical documentation that make complex products easy forengineers to understand and use;

 

•      proper newproduct selection;

 

•      timelycompletion and introduction of new product designs;

 

•      support from ourfoundry service providers;

 

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•      complexity ofthe new products to be designed and manufactured; and

 

•      marketacceptance of our products and our customers’ products.

 

The emphasisof our new product development is on the next generation of products built onour 8-bit micrologic architecture. If market demand for these products does notdevelop as we anticipate, our product development strategy could fail. Becauseour products are complex, we may not meet the design and introduction schedulesfor any new products or any additions or modifications to our existingproducts, and these products may not achieve market acceptance. In addition, wemay not be able to sell these products at prices that are favorable to us.

 

***Our industry is highly competitive, and we may not be able to competeeffectively.***

 

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 ourprincipal products such as the Z80 microprocessor are licensed by ourcompetitors, or are in the public domain, and can be manufactured and sold toour customers by our competitors, possibly with added features or at lowerprices than we charge. Our ability to compete successfully in our marketsdepends on factors both within and outside of our control, including:

 

•      our ability todesign and manufacture new products that implement new technologies, includingour eZ80 Acclaim! and Z8 Encore! product families;

 

•      our ability toprotect our products by effectively utilizing intellectual property laws;

 

•      our productquality, reliability, ease of use and price;

 

•      the diversityof our product line and feature sets within our products;

 

•      our efficiencyof production;

 

•      our ability toobtain adequate supplies of raw materials and other supplies at acceptableprices;

 

•      the pace atwhich customers incorporate our devices into their products; and

 

•      the success ofour competitors’ products and general economic conditions.

 

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

 

Our quarterlyoperating results have fluctuated in the past and will likely continue tofluctuate in the future. If our quarterly operating results fail to meetexpectations, 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;

 

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•      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 orders that are received and shipped in the same quarter,and therefore our results of operations may be subject to significantvariability from quarter to quarter.***

*** ***

Our net salesin any given quarter depend upon a combination of orders received in thatquarter for shipment in that quarter and shipments from backlog. Our backlog atthe beginning of each quarter does not include all sales needed to achieveexpected revenues for that quarter. Consequently, we are dependent on obtainingorders to be shipped in the same quarter that the order is received for asignificant portion of net sales in that quarter. Moreover, customers mayreschedule shipments, and production difficulties could delay shipments.Accordingly, we have limited visibility into future product shipments, and ourresults of operations may be subject to significant variability from quarter toquarter.

 

***We operate in the highly cyclical semiconductor industry, and haveexperienced a downturn in the business cycle, which has adversely affected ourrevenues and cash generation.***

*** ***

Thesemiconductor industry is highly cyclical and has experienced significant economicdownturns, often in connection with, or in anticipation of, maturing productcycles (for semiconductors and for the end-user products in which they areused) and declines 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 downturn in ourbusiness cycle and are currently experiencing another downturn. We believethat, in light of these events, some of our customers curtailed and may in thefuture delay or further curtail spending on technology, which could negativelyaffect our quarterly results or financial condition in the future.  Similar economic downturn in thesemiconductor industry could increase pressure on us to reduce our prices,which could impair our revenues, gross margins and operating cash flow. Fromtime to time, the semiconductor industry also has experienced periods ofincreased demand and production capacity constraints. We have in the pastexperienced substantial period-to-period declines in operating results, andwill likely in the future experience substantial period-to-period fluctuationsin operating results that are attributable to semiconductor industry conditionsor events occurring in the general economy.

 

***Average selling prices in the semiconductor industry typically declineover time, which directly affects our revenue and margins.***

*** ***

Historically,average selling prices in the semiconductor industry have decreased over thelife of any 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 tooffset any reductions in the selling prices of our products by introducing newproducts at higher prices or by reducing our costs, our revenues, gross marginsand operating results could be impaired. In

 

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addition, ifthe price at which we can sell products in our inventory declines below thecost of such products we may be required to write down the value of suchinventory.

 

***A significant amount of our revenues comes from relatively few of ourcustomers and distributors, and any decrease of revenues from these customersand distributors, or the loss of their business, could significantly harm ourfinancial results.***

 

***We depend on relatively few distributors for a substantial portion ofour sales.***

 

Historicallywe have been, and we expect to continue to be, dependent on a relatively smallnumber of distributors 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 57% of our net sales for the threemonths ended December 31, 2005, 56% of our net sales for the nine months endedDecember 31, 2005, and 50% of our net sales for 2004. In addition, our fivelargest distributors accounted for approximately 43% of our net sales for thethree months ended December 31, 2005, 44% of our net sales for the nine monthsended December 31, 2005 and 41% of net sales for 2004. One distribution customeraccounted for approximately 24% of our net sales for the nine months endedDecember 31, 2005, and 21% in 2004 and was our number one customer for both2005 and 2004. Our distributors decide whether to include our products amongthose that they sell, and they may carry and sell product lines that arecompetitive with ours. Because our distributors are not required to make aspecified minimum level of purchases from us, we cannot be sure that they willprioritize selling our products. We also rely on our distributors to accuratelyreport to us on a timely basis their sales of our products and provide certainsupport services to our customers.  Ourinability to obtain accurate and timely reports and to successfully managethese relationships could adversely affect our business and financial reports.Our distributors may not continue to effectively market, sell or support ourproducts. During the quarter ended December 31, 2005, our European distributorsmerged with another company. As a result of this transition, personnel assignedto the ZiLOG account may be reallocated or the level of service or amount ofour product that is carried could change. Any such changes or futureconsolidation activity by our distributors could harm our results of operations.

 

***We depend on relatively few major customers for a substantial portionof our sales.***

 

Our tenlargest customers, excluding our distributors, accounted for approximately 34%and 32% of our net sales for the three and nine months ending December 31,2005, respectively, 37% of our net sales for 2004, and approximately 38% of ournet sales for 2003.  For the three monthsended December 31, 2005, we had one distribution customer that accounted forapproximately 24% of our net sales and one OEM customer that accounted forapproximately 12% of our net sales.  Forthe nine months ended December 31, 2005 we had one distribution customer thataccounted for 23% of our net sales and one OEM customer that accounted for 10%of our net sales.  Concentration of netsales to particular customers may change from period to period, but we expectthat sales 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 to purchase our products at all, topurchase fewer products than they did in the past, or to alter their purchasingpatterns on short notice, particularly because substantially all of our salesare made on a purchase order or sales order acknowledgment basis, which permitsour customers to cancel, change or delay product purchase commitments upon 30days notice for standard products and 60 days notice for custom productswithout paying a cancellation or rescheduling charge. Customers may still cancelor reschedule within these time periods, however they routinely incur acancellation or rescheduling charge. This cancellation risk is increasedbecause our customers can purchase some similar products from our competitors.If any of our large customers choose to exit the business we supply or partnerwith or acquire any of our competitors 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 international operations subject us to risks inherent in doingbusiness in foreign countries that could impair our results of operations.***

 

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Approximately59% of our net sales for the nine months ended December 31, 2005, approximately48% of our net sales for 2004, and approximately 42% of our net sales for 2003,calculated consistent with revenue recognition of distribution revenue on adeferred (re-sale) basis were made to foreign countries. These sales to foreigncustomers will continue to represent a significant portion of our net sales inthe future. We maintain significant operations or rely on a number of contractmanufacturers in the Philippines, Indonesia, Taiwan, Thailand, India and otherlocations in Asia. We cannot assure you that we will be successful in overcomingthe risks that relate to or arise from operating in international markets.Risks inherent in doing business on an international level include:

 

•      economic andpolitical instability;

 

•      changes inregulatory requirements, tariffs, customs, duties and other trade barriers;

 

•      transportationdelays;

 

•      power supplyshortages and shutdowns;

 

•      difficulties instaffing and managing foreign operations and other labor problems;

 

•      existence oflanguage barriers and cultural distinctions;

 

•      acts of God,including floods, typhoons and earthquakes;

 

•      Taxation of ourearnings 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 activities outside the United States are subject to risks associated withfluctuating currency values and exchange rates, hard currency shortages andcontrols on currency exchange. While our sales are primarily denominated inU.S. dollars, worldwide semiconductor pricing is influenced by currency ratefluctuations, and such fluctuations could harm our operating resultsmaterially.

 

The risksinherent in our international operations have been increased by the threat ofterrorist attacks.  These attacks,coupled with an international military response, have created an uncertaineconomic environment, and we cannot predict the impact of these politicalthreats or any related military action, on our customers or our business.

 

***We have had a history of losses, and we may not be profitable in thefuture.***

*** ***

We have had ahistory of losses for each of the years in the five-year period ended December31, 2004, excluding the one-time gain on extinguishment of debt and fresh-startadjustments in 2002. We were not profitable in the nine-months ended December31, 2005. We may not be profitable in the future.

 

***We depend on key personnel, and the loss of our current personnel orour failure to hire and retain additional personnel could harm our business.***

*** ***

We depend onour ability to attract and retain highly skilled technical and managerialpersonnel. We believe that our future success in developing marketable productsand achieving a competitive position will depend in large part on our abilityto identify, recruit, hire, train, retain and motivate highly skilledtechnical, executive, managerial, marketing and customer service personnel.Competition for these personnel is intense, especially in Northern California,where our headquarters are located, and we may not be able to successfullyrecruit, assimilate or retain sufficiently qualified personnel. Our failure torecruit and retain necessary technical, executive, managerial, marketing andcustomer service personnel could harm our business and our ability to obtainnew customers and develop new products. In addition, our history of losses andour bankruptcy filing could impair our ability to recruit and retainemployees.  We do not have employmentcontracts with any of our executive officers other than Mr. Grace and Mr.Sheridan.

 

33

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If we areunable to retain our executive officers, including Mr. Thorburn as our ChiefExecutive Officer, our business may be harmed.

 

***We may fail to protect our proprietary rights, and the cost ofprotecting those rights, whether we are successful or not, may harm our abilityto compete.***

*** ***

The extent andvalue of our intellectual property is necessarily uncertain, and our efforts toprotect our 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 pending and future patent applications should not be relied upon as theymay not issue as patents, and even if they do issue, such future patents maynot be of sufficient scope or strength to provide meaningful economic orcompetitive value.

 

Litigation maybe necessary 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 could require us to incursubstantial costs and divert significant valuable resources, including theefforts of our technical and management personnel, which may harm our businessmaterially.

 

***The semiconductor industry is characterized by frequent litigationregarding patent and other intellectual property rights, both defensive andoffensive.***

*** ***

In addition tothe Microchip lawsuit described elsewhere, from time to time we have received,and may in the future receive, communications from other third partiesasserting that a product offered by us, or an aspect of our business, infringesa patent held by the other third party and/or requires a license thereto. Withrespect to those other third party communications that are currently pending,we believe, after having consulted with counsel, that either (i) we havemeritorious defenses, (ii) based on license terms previously offered to us ortypically available in the industry, we can obtain any necessary licenses oncommercially reasonable terms, or (iii) we can modify our products to avoidsuch rights, but if this is not the case, we may be sued and assessed damagesfor past infringement. Indeed, licenses may not be available on commerciallyreasonable terms, or at all. In addition, we have certain indemnificationobligations to customers with respect to the infringement of third partyintellectual property rights by our devices.

 

We havereceived in the past a letter from an electronic equipment manufacturer thatmakes products that are competitive to certain of our key products, assertingthat the sale of certain of our key products may be infringing certain patentsowned by them. After having consulted with counsel, we believe that we havemeritorious defenses to the assertions set forth in the letter. However, shouldit become necessary to engage in litigation to defend against such assertions,such litigation could be expensive and time consuming. There can be noassurance that the ultimate resolution of this matter would not have a materialadverse affect on our business.

 

Intellectualproperty lawsuits are subject to inherent uncertainties due to the complexityof the technical issues involved, and we may not be successful in defendingourselves against intellectual property claims. The cost of defending againstpatent infringement or other intellectual property litigation, in terms ofmanagement time and attention, legal fees and product delays, could besubstantial, whatever the outcome. If any patent or other intellectual propertyclaims against us are successful, we may be prohibited from using thetechnologies subject to these claims, and if we are unable to obtain a licenseon acceptable terms, license a substitute technology, or design new technologyto avoid infringement, we could be prohibited from using or selling theinfringing products or technologies and be required to pay substantial damages.Such a result could have a material adverse effect on our business.

 

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

 

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Because thedesign 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 adversely affected in one ormore of the following ways:

 

•      replacements orrecalls could impose substantial costs on us;

 

•      rumors, falseor otherwise, may be circulated by the press and other media, which could causea decrease in sales of our products; and

 

•      customers orend 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 could reduce the demandfor 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 our customerschanged the designs of computer mouse pointing devices that they manufactured,and as a result, these devices no longer contain our products. Because we donot have long-term supply contracts with most of our customers, changes in thedesigns of their products can have sudden and significant impacts on our sales.For example, net sales of our computer mouse pointing devices and othercomputer peripheral products decreased substantially from approximately $15.4million in 2000 to approximately $4.9 million in 2001, approximately $2.4million in 2002, and approximately $0.7 million for 2003 and approximately $0.1million for 2004. These reduced sales due to design changes have harmed us inthe past, and additional design changes could result in lower revenues in thefuture.

 

***We have implemented significant cost cutting measures, and we may berequired to implement additional cost cutting measures depending upon ourfuture revenues and operating results.***

*** ***

We haveimplemented significant cost cutting measures in the past, including during thenine months ended December 31,2005. These cost cutting efforts have included:

 

•      restructuringour manufacturing 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 ourstrategic priorities;

 

•      reallocatingpersonnel and responsibilities to better utilize human resources;

 

•      reducing ourworkforce; and

 

•      institutingtemporary office and facility shutdowns.

 

Cost cuttingmeasures may not increase our efficiency or lead to profitability.  In the past we have reduced our spending onresearch and development.  Reducingresearch and development spending could harm our ability to introduce newproducts in the future. If our revenue or operating results significantlydecline in the future, we may be required to institute further cost reductionmeasures.

 

From time totime, we evaluate our strategic alternatives with respect to our facilities andwe may take actions, such as our pending sale of certain assets of MOD II andthe remaining assets of our MOD III subsidiary, which may result in theoccurrence of accounting charges. Some or all of these charges may be non-cash.Such charges would have a negative impact on our GAAP profitability and mayhave a negative impact on our cash balance.

 

35

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***We are subject to various environmental laws and regulations that couldhave a material adverse effect on us.***

*** ***

Under certainof these laws and regulations, current or previous owners or operators ofproperty may be liable for clean-up costs and other damages without regard towhether they knew of, or caused, the contamination. The presence of, or failureto remediate, contamination could adversely affect the value of, and theability to transfer or encumber, our property. In addition, we may be requiredto incur significant expense in connection with governmental investigations ofenvironmental or employee health and safety matters.

 

***We may engage in acquisitions that could adversely affect our operatingresults, dilute our stockholders’ equity, or cause us to incur additional debtor assume contingent liabilities.***

*** ***

To increaseour business and maintain our competitive position, we have made acquisitionsin the past and may do so in the future.  Acquisitions involve a number ofrisks that could harm our business and result in the acquired business notperforming as expected, including:

 

•      insufficientexperience with technologies and markets in which the acquired business isinvolved, which may be necessary to successfully operate and integrate thebusiness;

 

•      problemsintegrating the acquired operations, personnel, technologies or products withthe existing business and products;

 

•      diversion ofmanagement time and attention from our core business to the acquired business;

 

•      potentialfailure to retain key technical, management, sales and other personnel of theacquired business;

 

•      difficulties inretaining relationships with suppliers and customers of the acquired business;and

 

•      subsequentimpairment of the acquired assets, including intangible assets.

 

In addition,acquisitions could require investment of significant financial resources andmay require us to obtain additional equity financing, which may dilute ourstockholders’ equity, or to incur additional indebtedness.

 

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

*** ***

The long-termeffects of potential terrorist attacks on the world economy and our businessare unknown, but could be material to our business. Terrorist acts or acts ofwar, whether in the United States or abroad, also could cause damage ordisruption to our business, our suppliers, our freight carriers, or ourcustomers, or could create political or economic instability, any of whichcould have a material adverse effect on our business.

 

***Failure to achieve and maintain effectiveinternal control 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 the Securities and Exchange Commission promulgated underSection 404 of the Sarbanes-Oxley Act of 2002, beginning with our Annual Reporton Form 10-K for the fiscal year ended December 31, 2004, we were required tofurnish a report by our management on our internal control over financialreporting.

 

**December 31, 2004 Sarbanes-Oxley Section 404 Report:**

 

In the course of our assessment of the effectiveness of our internalcontrol financial reporting as of December 31, 2004, which assessment wasconducted during the three months ended December 31 2004 and March 31, 2005 inconnection with the preparation of 2004 audited financial statements and ourannual report on Form 10-K for 2004, we identified two material weaknesses inour internal control over financial reporting which are more fully describedunder Item 9A, Controls and Procedures in our Form 10-K for the year endedDecember 31, 2004.

 

In addition, in the course of our ongoing 2005 evaluation of theeffectiveness of the design and operation of our disclosure controls andprocedures, we identified a failure to record and thereby disclose in our 2004Form 10-K

 

36

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certain grants of options to purchase: (1) 160,000 shares of our commonstock at an exercise price of $12.44 and; (2) 45,884 shares of our common stockat an exercise price of $5.20.  These grantswere issued 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.  Afootnote to the beneficial ownership table explaining the beneficial ownershipof certain stock options held by our CEO was also incorrect.  This reporting deficiency and the abovematerial weaknesses 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 financial reports,which in turn could have a material adverse effect on our stock price, and, ifsuch weaknesses are not properly remediated, could adversely affect our abilityto report our financial results on a timely and accurate basis.

 

Moreover, we continue to operate with a relatively small accountingstaffing level and use supplemental resources such as contractors andconsultants to provide additional accounting and finance support.  The loss of accounting personnel, particularlyour chief financial officer, would adversely impact the effectiveness of ourcontrol environment and our internal controls, including our internal controlsover financial reporting.  Additionally,we are migrating certain accounting functions from the U.S. to our Philippinesoperations.  Failure to properly hire,train and supervise the work of our accounting staff, including those in thePhilippines, could adversely impact our control environment and our internalcontrols, including internal controls over financial reporting.

 

Although we believe that we have remediated these weaknesses anddeficiencies and our disclosure control failure, we cannot assure you that thisremediation has been successful or that additional deficiencies or weaknessesin our controls and procedures will not be identified.  In addition, we cannot assure you that ourindependent registered public accounting firm will agree with our assessmentthat our material weaknesses have been remediated.

 

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

 

OnDecember 29, 2005, the Company’s Board of Directors unanimously adoptedresolutions to change its fiscal year end from December 31 to March 31. TheCompany revised its fiscal year so that its audit work can be performed duringnon-peak periods with its independent accountants which the Company believeswill result in cost savings over the long-term. The Company has also identifieddeficiencies in its information technology controls, including the need tobetter segregate duties as it relates to the use of its Oracle InformationSystems modules and to improve its General Computing Controls compliance anddocumentation. The Company has not determined whether these deficiencies in itsinternal controls over financial reporting would constitute material weaknesses,as defined in Public Company Accounting Oversight Board Auditing Standard No.2, as of December 31, 2005. The change in fiscal year will provide the Companywith additional time to review, improve and remediate activities and operationsaround these controls although no assurance can be made that such deficiencieswill be successfully remediated by March 31, 2006.  The Company is currently evaluating theimpacting of adopting SFAS No.123R, but expects the adoption of SFAS No. 123Rwill result in significant stock compensation expense.

 

InDecember, 2005 the Securities and Exchange Commission adopted a change in itsaccelerated filer rules such that a company with a market capitalization, thatis the number of shares outstanding multiplied by its trading value per share,of less than $50 million may be considered a non-accelerated filer and as suchis exempt from the management confirmation and independent auditor attestationrequirements under the Sarbanes-Oxley 404. At September 30, 2005, the Company wasbelow this measure and as such will not be an accelerated filer for fiscal 2006and will not include the management certification and independent auditorattestation over internal controls over financial reporting in its Form 10-Kfor the year ending March 31, 2006

 

***Recently enacted and proposed changes insecurities laws and regulations may increase our costs.***

 

The Sarbanes-Oxley Act of 2002 that became law in July 2002 requiredchanges in some of our corporate governance practices.  The Act also requires the SEC to promulgatenew rules on a variety of subjects. These new rules and regulations have increased our legal and financialcompliance costs, and made some activities more difficult, time consumingand/or more costly.  We also expect thatthese new 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 and regulations could alsomake it

 

37

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more difficult for us to attract and retain qualified members of ourboard of directors, particularly to serve on our audit committee, and qualifiedexecutive officers.

 

***Changes in accounting principles generallyaccepted in the United States may adversely affect our reported financialresults or otherwise harm our business.***

*** ***

We prepare ourfinancial statements in conformity with accounting principles generallyaccepted in the United States. These accounting principles are subject tointerpretation by the Financial Accounting Standards Board, the AmericanInstitute of Certified Public Accountants, the Securities and ExchangeCommission and various bodies formed to interpret and create appropriate accountingpolicies. A change in these policies or interpretations could have asignificant effect on our reported financial results, and could affect thereporting of transactions completed before the announcement of a change. Forexample, while current accounting rules allow us to exclude some expense ofstock options from our financial statements, effective for fiscal yearsbeginning in 2006, the Company will be required to include the expenses ofthese options and the 15% discount employees receive on purchase under theemployee stock purchase plan in the income statement in accordance with FAS123R.  Technology companies generally,and our company, specifically, rely heavily on stock options as a majorcomponent of our 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 adversely effect our reported financial results.

 

***Changes in our business conditions could result in impairment of ourgoodwill.***

*** ***

In accordancewith SFAS No.142 *Accounting for Goodwill and Other IntangibleAssets* the Company must perform at least an annual testing of theCompany’s stated value of its net assets including goodwill and otherintangible assets in relation to the implied fair market value of theCompany.  If the Company’s marketcapitalization or fair market value declines, we may be required to recordfinancial adjustments to the stated values of our goodwill and other intangibleassets resulting in a material adverse effect on our financial condition andresults of operations.

 

***Our North American distributor could emphasize competing products, andwe may lose some of our customers as a result.***

*** ***

In October2002, we engaged Future Electronics as our exclusive full-service distributorin North America.  Additionally, FutureElectronics provides distributor support to us in Europe and Asia on anon-exclusive basis.  For the nine monthsended December 31, 2005 and 2004, Future purchased approximately $16.0 millionand $13.5 million, respectively, contributing approximately 23% to our netsales.  Future Electronics distributesproducts of our competition that may directly compete with our productofferings. If Future Electronics chooses to promote those products over ourproducts, our operating results could be harmed significantly. In addition, ifFuture Electronics were to terminate our distribution agreement, we couldexperience a period of significant interruption of our business while weobtained other distribution channels.

 

***Provisions in our organizational documents and Delaware law coulddiscourage acquisition proposals or delay a change in control that would bebeneficial to our stockholders.***

*** ***

Our amendedand restated certificate of incorporation and bylaws contain anti-takeoverprovisions that could make it more difficult for a third party to acquirecontrol of us even if that change in control would be beneficial to ourstockholders. These provisions include:

 

•      providing for aclassified board of directors with staggered terms;

 

•      limiting thepersons who may call special meetings of stockholders; and

 

•      prohibitingstockholders from taking action by written consent.

 

In addition,provisions of Delaware law may discourage, delay or prevent someone fromacquiring or merging with us.

 

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***Our directors, named executive officers and our two largeststockholders, who beneficially own approximately 32% of our common stock in theaggregate, may have interests that conflict with the interests of our otherstockholders.***

 

Our directorsand named executive officers, together with two large stockholders, UBS WillowManagement, L.L.C., funds managed by Capital Research and Management Companybeneficially owned approximately 32% of our outstanding common stock, in theaggregate, as of December 31, 2005.  As aresult of their ownership and positions, our directors and named executiveofficers, together with UBS Willow Management and Capital Research andManagement Company, collectively are able to significantly influence allmatters requiring stockholder approval, including the election of directors andapproval of significant corporate transactions. Such concentration of ownershipmay also have the effect of delaying or preventing a change in control. If theownership of our common stock continues to be highly concentrated, it mayprevent you and other stockholders from influencing significant corporatedecisions. The investment objectives of these stockholders may differ fromthose of our other stockholders, including our future public stockholders.

 

**Item 3.  Quantitative andQualitative Disclosure About Market Risk**

 

**Interest Rate Risk**

 

Our exposure tomarket risk for changes in interest rates relates primarily to our short-terminvestment portfolio.  We do not usederivative financial investments in our investment portfolio.  Our primary investment objectives are topreserve capital and maintain liquidity. These objectives are met by investing in high-quality credit issuancesand limiting the amount of credit exposure to any one company.  Our policy is to mitigate default risk byinvesting in only the highest quality securities and monitoring the creditratings of such investments.  As ofDecember 31, 2005, our cash and cash equivalents of $24.1 million were investedin bank time deposits and money market funds. We have no significant cash flow exposure due to rate changes for ourcash equivalents as these instruments have very short maturities.  The annualized average fixed interest ratefor the three months ended December 31, 2005 was approximately 3.0 to 4.0%.

 

**Foreign Currency Exchange Risk.**  We transact business in various foreigncountries, but the vast majority of our consolidated net sales and purchasesare denominated 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 4. Controls and Procedures**

 

**Evaluationof Controls and Procedures**

 

As of December 31, 2005, the Company’s management carried out anevaluation, under the supervision and with the participation of the Company’sChief Executive Officer, James Thorburn, and the Company’s Chief FinancialOfficer, Perry J. Grace, of the effectiveness of the design and operation ofthe Company’s disclosure controls and procedures. Based upon that evaluation,except as disclosed below, Mr. Thorburn and Mr. Grace concluded that theCompany’s disclosure controls and procedures operated effectively as ofDecember 31, 2005 to ensure that information was properly compiled,communicated and analyzed by management of the Company on a timely basis sothat quality and timeliness of the Company’s public disclosures comply with itsSEC disclosure obligations**.**

** **

**Changes in Internal Controls**

** **

As disclosed in the Company’s8-K filed on December 29, 2005, the Company identified deficiencies in itsinformation technology controls, including the need to better segregate dutiesas it relates to the Company’s Oracle modules and to improve access compliance.The Company has not as yet determined whether these deficiencies in its internalcontrols over financial reporting would constitute material weaknesses, asdefined in Public Company Accounting Oversight Board Auditing Standard No. 2,as of December 31, 2005. Recently, the Company engaged independent consultantsto assist in the review of the Company’s internal controls surrounding itsinformation systems including a review with recommendations for change and theimplementation of such changes to; 1) eliminate identified conflicts associatedwith Segregation of Duties in the use of its information systems, and 2)improve the documentation and compliance surrounding its General ComputerControls.

** **

Otherthan these corrective measures, there have not been any changes in the Company’sinternal control over financial reporting (as such term is defined in Rules13a-15(f) and 15d-15(f) under the Exchange Act) during the most recent fiscalquarter that have materially affected, or are reasonably likely to materiallyaffect, the Company’s internal control over financial reporting.

 

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### **PARTII**

### ** **

### **OTHER INFORMATION**

### ** **

**Item1.  Legal Proceedings**

** **

On August 11th, 2005 Microchip Technology Inc. (Microchip) filed apatent infringement claim against the Company in the U.S. District Court ofArizona (case number CV05-2406-PHX-MHM). Microchip alleges that the Company hasbeen infringing and currently infringes its patents numbered5,847,450, 6,696,316 and 6,483,183. Microchip claims that unspecifiedproducts of the company, including the Z8 Encore! XP 4K Series of products,infringe these patents and is seeking preliminary and permanent injunctiverelief, unspecified damages and costs including attorneys’ fees. We filed aresponse to the claims on September 15, 2005 generally denying the claims and challengingthe validity of the patents. . In January, 2006, the Company filed a requestfor the re-examination of these patents with the United States Patent andTrademarks Office. The U.S. PTO usually takes up to 90 days to determine andadvise as to their decision on undergoing such re-examination

 

We do not believe it is feasible to predict or determine the outcome orresolution of this litigation at this time. We believe we have meritoriousdefenses and will defend ourselves against these claims vigorously. We may incursubstantial expenses in our defense against these claims. In the event of adetermination adverse to us, we may incur substantial monetary liability, andbe required to change our business practices. Either of these could have amaterial adverse effect on our financial position, results of operations orcash flow.

 

The Company is participating in other litigation and responding toclaims arising in the ordinary course of business.  The Company intends to defend itselfvigorously in these other matters.  TheCompany’s management believes that it is unlikely that the outcome of theseother matters will have a material adverse effect on the Company’s financialstatements, although there can be no assurance in this regard

 

**Item 2.  Unregistered Sales ofEquity Securities and Use of Proceeds**

** **

On July 29, 2004, ZiLOG announced that itsboard of directors has authorized a stock repurchase program pursuant to whichZiLOG may repurchase up to $5,000,000 in market value of its outstanding sharesof common stock. ZiLOG’s common stock trades on the NASDAQ National Market andpurchases under the program are made, from time-to-time, in the open market,through block trades or otherwise. Depending upon market conditions and otherfactors, these purchases may be commenced or suspended at any time or fromtime-to-time without prior notice.  As ofDecember 31, 2005, the Company had repurchased a total of 572,100 sharescosting $4.4 million, however, no shares were repurchased during the threemonths ended December 31, 2005.

 

**Item 3.  Defaults Upon SeniorSecurities**

** **

None.

 

**Item 4.  Submission of Matters toa Vote of Security Holders**

** **

None.

 

**Item5.  Other Information**

 

None.

 

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**Item6.  Exhibits**

 

a)             Exhibits are filed orincorporated herein by reference as indicated below:

 
| **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 (b)     |       | Amended and Restated Certificate of Incorporation of ZiLOG, Inc., as  amended and corrected.                                                                                                                      |
|        |       |                                                                                                                                                                                                              |
| 3.2 (c)     |       | Amended and Restated Bylaws of ZiLOG, Inc.                                                                                                                                                                        |
|        |       |                                                                                                                                                                                                              |
| 4.1 (d)     |       | Form of Restricted Stock Purchase Agreement.                                                                                                                                                                      |
|        |       |                                                                                                                                                                                                              |
| 4.2 (d)     |       | Form of Non-Qualified EBITDA-Linked Option Grant Agreement.                                                                                                                                                       |
|        |       |                                                                                                                                                                                                              |
| 4.3 (d)     |       | Form of Non-Qualified Non-EBITDA-Linked Option Grant Agreement.                                                                                                                                                   |
|        |       |                                                                                                                                                                                                              |
| 4.4 (e)     |       | Form of 2004 Non-Qualified Option Grant Agreement, Date of Grant.                                                                                                                                                 |
|        |       |                                                                                                                                                                                                              |
| 4.5 (e)     |       | Form of 2004 Non-Qualified Option Grant Agreement, Date of Hire.                                                                                                                                                  |
|        |       |                                                                                                                                                                                                              |
| 4.6 (e)     |       | Form of 2004 Non-Qualified Option Grant Agreement, Fully Vest Date of  Grant.                                                                                                                                     |
|        |       |                                                                                                                                                                                                              |
| 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 February 9, 2006.              |
|        |       |                                                                                                                                                                                                              |
| 31.2        |       | Certifications of Chief Financial 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 February 9, 2006.             |
|        |       |                                                                                                                                                                                                              |
| 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 February 9, 2006. |

 

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| (a)    |   | Incorporated herein by reference to Exhibit 99.1 to the Company’s  current report on Form 8-K filed with the Commission on May 15, 2002.                                           |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                    |
| (b)    |   | Incorporated herein by reference to the item of the same name filed  as an exhibit to the Company’s Annual Report on Form 10-K for the fiscal year  ended December 31, 2003.       |
|   |   |                                                                                                                                                                                    |
| (c)    |   | Incorporated herein by reference to Exhibit 99.1 to the Company’s  current report on Form 8-K filed with the Commission on November 17, 2005.                                      |
|   |   |                                                                                                                                                                                    |
| (d)    |   | Incorporated herein by reference to the item of the same name filed  as an exhibit to the Company’s Quarterly Report on Form 10-Q filed with the  Commission on August 16, 2002    |
|   |   |                                                                                                                                                                                    |
| (e)    |   | Incorporated herein by reference to the item of the same name filed  as an exhibit to the Company’s Quarterly Report on Form 10-Q filed with the  Commission on November 10, 2004. |

 

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ZiLOG, Inc.

 

**SIGNATURES**

 

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

 

 
|                         | ZiLOG, Inc.                                    |
|------------------------------|------------------------------------------------|
|                         | (Registrant)                                   |
|                         |                                           |
|                         |                                           |
|                         | /s/ Perry Grace                                |   |
|                         | Perry Grace                                    |
|                         | Vice President and Chief Financial Officer     |
|                         | (Duly Authorized Officer)                      |
|                         |                                           |
|                         |                                           |
|                         | /s/ James M. Thorburn                          |   |
|                         | James M. Thorburn                              |
|                         | Chairman, Chief Executive Officer and Director |
|                         | (Duly Authorized Officer)                      |
|                         |                                           |
|                         |                                           |
| Date:  February 9, 2006 |                                           |

 

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