** **

**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**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  October 1, 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                            .** |

 

**CommissionFile Number:  001-13748**

 

**ZiLOG, Inc.**

(Exact name of registrant asspecified in its charter)

 
| **Delaware**                                                     | ** ** | **13-3092996**                            |
|------------------------------------------------------------------|------------|-------------------------------------------|
| (State or  other jurisdiction of  incorporation or organization) |       | (I.R.S.  Employer  Identification Number) |

 

**532 RaceStreet, 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 reports required to be filed by Section 13 or 15(d) ofthe Securities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.

 

Yes ý   No o

 

Indicate by check mark whether the registrantis an accelerated filer (as defined in Rule 12b-2 of the Exchange Act)

 

Yes ý   No o

 

Indicate by check mark whether the registrantis a shell company (as defined in Rule 12b-2 of the Exchange Act)

 

Yes o   No ý

 

Indicate by check mark whether the registranthas filed all documents and reports required to be filed by Section 12, 13or 15(d) of the Securities Exchange Act of 1934 subsequent to thedistribution of securities under a plan confirmed by a court.

 

Yes ý   No o

 

As of November 10, 2005, there were16,309,770 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 withinthe meaning of the Private Securities Litigation Reform Act of 1995, Section 27Aof the Securities Act of 1933 and Section 21E of the Securities ExchangeAct of 1934. These statements relate to future events or our future financial performanceand involve known and may involve unknown risks, uncertainties and otherfactors that 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.  Other factors that may cause or contribute todifferences include, but are not limited to: continued availability of third-party foundry and assembly services atcommercially-reasonable quality and prices; under-absorption of manufacturingcosts in our test and manufacturing support facilities from under-utilizationof capacity; our distributors and customers significantly reducing theirexisting inventories before ordering new products; our ability to sell and/orrecover the carrying value of our assets held for sale at our Nampa, Idahofacility; ongoing costs to maintain MOD III assets in a saleable state andanticipated costs in connection with the decommissioning of our MOD II waferfabrication facility; and costs incurred in connection with the transfer ofcertain activities to our facility in Manila, Philippines [.  In some cases, you can identifyforward-looking statements by terminology such as “may,” “will,” “should,” “expects,”“anticipates,” “believes,” “estimates,” “potential,” “continue,” or thenegative terms or other comparable terminology. In evaluating these statements,you should specifically consider various factors, including the risks outlinedunder “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 in October 1981and reincorporated in Delaware in April 1997.  In this report, “ZiLOG,” “the Company,” “our,”“us,” “we,” and similar expressions refer to ZiLOG, Inc. and itssubsidiaries.  However, when theseexpressions are used throughout this report in connection with ZiLOG, Inc.’sreorganization under Chapter 11 of the U.S. bankruptcy code, they are referringonly 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 ofZiLOG, Inc.

 

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ZiLOG, INC**.**

 

**QUARTERLYREPORT ON FORM 10-Q FOR THE PERIOD ENDED OCTOBER 1, 2005**

**TABLE OFCONTENTS**

 
| **PART I. FINANCIAL INFORMATION** | ** **                                                                                                                                                                          |
|----------------------------------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **                             | ** **                                                                                                                                                                          |
| Item 1.                                | Financial Statements                                                                                                                                                                |   |
|                                   | Unaudited Condensed Consolidated Statements of Operations for the  three and nine months ended September 30, 2005 and the three and nine  months ended September 30, 2004 | 2 |
| ** **                             | Unaudited Condensed Consolidated Balance Sheets at September 30,  2005 andDecember 31, 2004                                                                               | 3 |
| ** **                             | Unaudited Condensed Consolidated Statements of Cash Flows for the  nine months ended September 30, 2005 and September 30, 2004                                            | 4 |
|                                   | Notes to Unaudited Condensed Consolidated Financial Statements                                                                                                                      | 5 |
| Item 2.                                | Management’s Discussion and Analysis of Financial Condition and  Results of Operations                                                                                         | 15 |
| Item 3.                                | Quantitative and Qualitative Disclosures  About Market Risk                                                                                                                         | 37 |
| Item 4.                                | Controls and Procedures                                                                                                                                                             | 37 |
|                                   |                                                                                                                                                                                |   |
| **PART II. OTHER INFORMATION**    | ** **                                                                                                                                                                          |
| ** **                             | ** **                                                                                                                                                                          |
| Item 1.                                | Legal Proceedings                                                                                                                                                                   | 38 |
| Item 2:                                | Changes in Securities, Use of Proceeds and  Issuer Proceeds of Equity Securities                                                                                                    | 38 |
| Item 3.                                | Defaults Upon Senior Securities                                                                                                                                                     | 38 |
| Item 4.                                | Submission of Matters to a Vote of Security  Holders                                                                                                                                | 38 |
| Item 5.                                | Other Information                                                                                                                                                                   | 38 |
| Item 6.                                | Exhibits                                                                                                                                                                            | 38 |

 

1

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**PART I**

**FINANCIALINFORMATION**

 

**Item 1.  Financial Statements**

 

**ZiLOG,INC.**

**UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

**(inmillions, except per share data)**

 
| ** **                                                     | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                     | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net sales                                                      |       | $                                          | 20.5       |                                      | $          | 22.8 |   | $ | 61.3 |   | $ | 76.7 |   |
| Cost of sales                                                  |       | 12.4                                       |       | 12.4                                      |       | 36.9 |   | 39.2 |   |
| Gross margin                                                   |       | 8.1                                        |       | 10.4                                      |       | 24.4 |   | 37.5 |   |
| Operating expenses:                                            |       |                                       |       |                                      |       |   |   |   |   |
| Research and development                                       |       | 5.6                                        |       | 5.2                                       |       | 16.1 |   | 15.6 |   |
| Selling, general and administrative                            |       | 5.6                                        |       | 7.2                                       |       | 20.2 |   | 21.8 |   |
| Special charges and credits                                    |       | 0.7                                        |       | (1.9                                      | )          | 2.6 |   | 6.3 |   |
| Amortization of intangible assets                              |       | 0.5                                        |       | 1.0                                       |       | 1.6 |   | 3.1 |   |
| Total operating expenses                                       |       | 12.4                                       |       | 11.5                                      |       | 40.5 |   | 46.8 |   |
| Operating loss                                                 |       | (4.3                                       | )          | (1.1                                      | )          | (16.1 | ) | (9.3 | ) |
|                                                           |       |                                       |       |                                      |       |   |   |   |   |
| Other income (expense):                                        |       |                                       |       |                                      |       |   |   |   |   |
| Interest income                                                |       | 0.2                                        |       | 0.1                                       |       | 0.6 |   | 0.2 |   |
| Interest expense                                               |       | —                                     |       | (0.1                                      | )          | — |   | (0.2 | ) |
| Other, net                                                     |       | —                                     |       | —                                    |       | 0.1 |   | (0.1 | ) |
| Loss before income taxes                                       |       | (4.1                                       | )          | (1.1                                      | )          | (15.4 | ) | (9.4 | ) |
| Provision (benefit) for income taxes                           |       | 0.7                                        |       | 0.9                                       |       | 2.1 |   | (0.2 | ) |
| Net loss                                                       |       | $                                          | (4.8       | )                                         | $          | (2.0 | ) | $ | (17.5 | ) | $ | (9.2 | ) |
| Basic and diluted net loss per share                           |       | $                                          | (0.29      | )                                         | $          | (0.12 | ) | $ | (1.07 | ) | $ | (0.58 | ) |
| Shares used in computing basic and diluted  net loss per share |       | 16.3                                       |       | 16.4                                      |       | 16.3 |   | 15.9 |   |

 

See accompanying notes tounaudited condensed consolidated financial statements.

 

2

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**ZiLOG,INC.**

**UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS**

**(inmillions)**

 
| ** **                                                                                                                        | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                        |       |                         |       |                        |       |
| Current assets:                                                                                                                   |       |                         |       |                        |       |
| Cash and cash equivalents                                                                                                         |       | $                            | 28.0       |                        | $          | 37.7 |   |
| Accounts receivable, less allowance for  doubtful accounts of $0.2 at September 30, 2005 and $0.3 at  December 31, 2004 |       | 8.9                          |       | 10.0                        |       |
| Inventories                                                                                                                       |       | 9.2                          |       | 12.1                        |       |
| Deferred income taxes                                                                                                             |       | 2.7                          |       | 2.7                         |       |
| Prepaid expenses and other current assets                                                                                         |       | 2.9                          |       | 4.0                         |       |
| Total current assets                                                                                                              |       | 51.7                         |       | 66.5                        |       |
|                                                                                                                              |       |                         |       |                        |       |
| MOD II Inc. assets held for sale                                                                                                  |       | 3.4                          |       | 3.6                         |       |
| Net property, plant and equipment                                                                                                 |       | 6.5                          |       | 6.1                         |       |
| Goodwill                                                                                                                          |       | 8.6                          |       | 8.6                         |       |
| Intangible assets, net                                                                                                            |       | 5.7                          |       | 7.3                         |       |
| Other assets                                                                                                                      |       | 4.7                          |       | 6.0                         |       |
|                                                                                                                              |       | $                            | 80.6       |                        | $          | 98.1 |   |
|                                                                                                                              |       |                         |       |                        |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                    |       |                         |       |                        |       |
| Current liabilities:                                                                                                              |       |                         |       |                        |       |
| Accounts payable                                                                                                                  |       | $                            | 11.0       |                        | $          | 12.3 |   |
| Accrued compensation and employee benefits                                                                                        |       | 2.5                          |       | 2.6                         |       |
| Other accrued liabilities                                                                                                         |       | 4.6                          |       | 4.0                         |       |
| Deferred income on shipments to  distributors                                                                                     |       | 5.7                          |       | 6.0                         |       |
| Total current liabilities                                                                                                         |       | 23.8                         |       | 24.9                        |       |
|                                                                                                                              |       |                         |       |                        |       |
| Deferred income taxes                                                                                                             |       | 2.7                          |       | 2.7                         |       |
| Other non-current tax liabilities                                                                                                 |       | 6.5                          |       | 6.6                         |       |
| Total liabilities                                                                                                                 |       | 33.0                         |       | 34.2                        |       |
|                                                                                                                              |       |                         |       |                        |       |
| Stockholders’ equity:                                                                                                        |       |                         |       |                        |       |
| Common stock                                                                                                                      |       | 0.2                          |       | 0.2                         |       |
| Additional paid-in capital                                                                                                        |       | 122.5                        |       | 121.9                       |       |
| Deferred stock compensation                                                                                                       |       | (0.1                         | )          | (0.7                        | )          |
| Treasury stock                                                                                                                    |       | (7.2                         | )          | (7.1                        | )          |
| Accumulated deficit                                                                                                               |       | (67.8                        | )          | (50.4                       | )          |
| Total stockholders’ equity                                                                                                   |       | 47.6                         |       | 63.9                        |       |
| Total liabilities and stockholders’ equity                                                                                   |       | $                            | 80.6       |                        | $          | 98.1 |   |

 

See accompanying notes to unaudited condensed consolidated financialstatements.

 

3

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**ZiLOG,INC.**

**UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(inmillions)**

 
| ** **                                                                                                         | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                                         | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
| **Cash Flows from Operating Activities:**                                                                          |       |                                      |       |   |   |
| Net loss                                                                                                           |       | $                                         | (17.5      | ) | $ | (9.2 | ) |
| Adjustments to reconcile net loss to net  cash provided (used) by operating activities:                            |       |                                      |       |   |   |
| Amortization of “fresh start” intangible  assets                                                         |       | 1.6                                       |       | 3.2 |   |
| Deferred income tax assets and liabilities                                                                         |       | —                                    |       | (10.0 | ) |
| Depreciation and other amortization                                                                                |       | 1.8                                       |       | 2.4 |   |
| Impairment of long-lived assets                                                                                    |       | —                                    |       | 5.4 |   |
| Loss on Disposal of Equipment                                                                                      |       | —                                    |       | 0.1 |   |
| Stock-based compensation                                                                                           |       | 0.9                                       |       | 1.5 |   |
| Changes in operating assets and  liabilities:                                                                      |       |                                      |       |   |   |
| Accounts receivable, net                                                                                           |       | 1.1                                       |       | 4.6 |   |
| Inventories                                                                                                        |       | 3.0                                       |       | (2.7 | ) |
| Prepaid expenses and other current and  non-current assets                                                         |       | 2.4                                       |       | 2.3 |   |
| Goodwill adjustment                                                                                                |       | —                                    |       | 7.4 |   |
| Accounts payable                                                                                                   |       | (1.3                                      | )          | 2.3 |   |
| Accrued compensation and employee benefits                                                                         |       | 0.1                                       |       | (0.2 | ) |
| Other accrued liabilities, deferred income  on shipments to distributors, income taxes and accrued special charges |       | 0.1                                       |       | (0.7 | ) |
| Net cash provided (used) by operating  activities                                                                  |       | (7.8                                      | )          | 6.4 |   |
|                                                                                                               |       |                                      |       |   |   |
| **Cash Flows From Investing Activities:**                                                                          |       |                                      |       |   |   |
| Proceeds from Sale of MOD II Assets                                                                                |       | 0.1                                       |       | 0.0 |   |
| Capital expenditures                                                                                               |       | (2.2                                      | )          | (4.2 | ) |
| Cash used by investing activities                                                                                  |       | (2.1                                      | )          | (4.2 | ) |
|                                                                                                               |       |                                      |       |   |   |
| **Cash Flows From Financing Activities:**                                                                          |       |                                      |       |   |   |
| Proceeds from public stock offering, net of  offering costs                                                        |       | —                                    |       | 24.4 |   |
| Proceeds from issuance of common stock  under stock purchase plans                                                 |       | 0.3                                       |       | 0.4 |   |
| Repayments of short-term debt                                                                                      |       | —                                    |       | (5.0 | ) |
| Payments for treasury stock redemptions                                                                            |       | (0.1                                      | )          | (4.5 | ) |
| Cash provided by financing activities                                                                              |       | 0.2                                       |       | 15.3 |   |
|                                                                                                               |       |                                      |       |   |   |
| Increase (decrease) in cash and cash  equivalents                                                                  |       | (9.7                                      | )          | 17.5 |   |
| Cash and cash equivalents at beginning of  period                                                                  |       | 37.7                                      |       | 22.0 |   |
| Cash and cash equivalents at end of period                                                                         |       | $                                         | 28.0       |   | $ | 39.5 |   |
|                                                                                                               |       |                                      |       |   |   |
| **Supplemental disclosure of cash flow  information:**                                                             |       |                                      |       |   |   |
| Interest paid during period                                                                                        |       | $                                         | —     |   | $ | 0.2 |   |
| Income taxes paid during period                                                                                    |       | $                                         | 0.3        |   | $ | 1.5 |   |
| **Supplemental disclosure of non cash  transactions:**                                                             |       |                                      |       |   |   |
| Director Fees paid in stock                                                                                        |       | $                                         | 0.1        |   | $ | — |   |

 

See accompanying notes tounaudited condensed consolidated financial statements.

 

4

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**ZILOG,INC.**

 

**NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE 1.        BASIS OF PRESENTATION**

 

The accompanying interim financial information is unaudited.  In the opinion of ZiLOG, Inc.’s (“ZiLOG”or the “Company”) management, all adjustments (consisting only of normalrecurring adjustments) necessary for a fair presentation of interim resultshave been included.  The results forinterim periods are not necessarily indicative of results to be expected forthe entire year.  These condensedconsolidated financial statements and notes should be read in conjunction withthe Company’s annual consolidated financial statements and notes theretocontained in the Company’s 2004 Annual Report filed on Form 10-KCommission File Number 001-13748 for the fiscal year ended December 31,2004, filed on March 31, 2005.

 

Historically, ZiLOG’s interimresults were based on fiscal quarters of thirteen weeks in duration ending onthe last Sunday of each calendar quarter. Starting in the third quarter of 2005, the Company’s interim fiscalcalendar was changed such that its fiscal quarters end on the Saturday nearestto the calendar quarter-end. Accordingly, the Company’s third quarter of 2005 ended on October 1,2005.  Consequently the third quarter of2005 was 6 days longer than the second quarter of 2005 and the third quarter of2004.  The Company’s second quarter endedon June 26, 2005. The Company’s new fiscal calendar was adopted because itresults in more consistency in the number of days included in each fiscalquarter.  Previous quarters have not beenrestated to conform to the new fiscal calendar format because the Companybelieves that the new fiscal calendar will not materially affect comparabilityof its financial results between periods. Generally, the first and second fiscal month of each quarter is fourweeks in duration and the third month is five weeks.  ZiLOG’s fourth fiscal quarter of each yearalways ends on December 31.  Forfinancial reporting purposes, interim fiscal periods are labeled as ending onthe 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 balance sheet at December 31,2004 was derived from audited financial statements at that date, but does notinclude all of the information and footnotes required by accounting principlesgenerally accepted in the United States for complete financial statements

 

**NOTE 2.        SUMMARY OF SIGNIFICANT ACCOUNTINGPOLICIES**

 

***Revenue Recognition.***  Revenue from product sales to OriginalEquipment Manufacturers (“OEM”) customers is recognized when evidence of anagreement exists,  customers or theiragents receive the product and title transfers, and collection of amounts dueis reasonably 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 provide shipment and royalty information when thepayment is remitted, usually 60 days subsequent to the end of the quartershipments 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 consolidated balance sheets asaccounts receivable and a reduction of inventories at the time of shipment.Deferred revenue and the corresponding cost of sales on shipments todistributors are reflected in the consolidated balance sheets on a net basis as“Deferred income on shipments to distributors.”

 

***Assets Held for Sale. ***The remainingassets of MOD II, consisting primarily of land and buildings with a carryingvalue of $3.4 million at September 30, 2005, have been classified as assetheld for sale on the Company’s accompanying condensed consolidated balancesheet.

 

5

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***Goodwill and Intangible Assets***.  Effective January 1, 2002, ZiLOG adoptedthe provisions of FASB Statement of Financial Accounting Standards No. 142,“Goodwill and Other Intangible Assets” (“SFAS 142”).  Under SFAS 142, goodwill and intangibleassets with indefinite lives are not amortized, but are reviewed annually ormore frequently if impairment indicators arise. In the third quarter of 2005, the Company reviewed its goodwill andintangible assets and determined that there was 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 sheetas follows (in millions):

 
| ** **                                     | ** ** | **Current  Technology** | ** ** | **Brand  Name** | ** ** | **Total** | ** ** |
|------------------------------------------------|------------|-------------------------|------------|-----------------|------------|-----------|------------|
| Gross carrying amount, recorded  May 2002 |       | $                       | 17.0       |            | $          | 9.2       |       | $ | 26.2 |   |
| Accumulated amortization                       |       | 16.1                    |       | 4.4             |       | 20.5      |       |
| Book value at September 30, 2005          |       | $                       | 0.9        |            | $          | 4.8       |       | $ | 5.7 |   |

 

The anticipated remainingamortization schedule for these assets is as follows (in millions):

 
| **Year**                   | ** ** | **Current  Technology** | ** ** | **Brand  Name** | ** ** | **Total to be  Amortized** | ** ** |
|----------------------------|------------|-------------------------|------------|-----------------|------------|----------------------------|------------|
| October-December 2005 |       | $                       | 0.3        |            | $          | 0.3                        |       | $ | 0.6 |   |
| 2006                       |       | 0.4                     |       | 1.0             |       | 1.4                        |       |
| 2007                       |       | 0.1                     |       | 0.8             |       | 0.9                        |       |
| 2008                       |       | 0.1                     |       | 0.8             |       | 0.9                        |       |
| 2009                       |       | —                  |       | 0.7             |       | 0.7                        |       |
| Thereafter                 |       | —                  |       | 1.2             |       | 1.2                        |       |
| Total                      |       | $                       | 0.9        |            | $          | 4.8                        |       | $ | 5.7 |   |

 

***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. ***The Company’spolicy is to record all research and development expenditures with no futurealternative use as period expenses when incurred.

 

***Fair Value of FinancialInstruments and Concentration of Credit Risk.**** *The carrying value ofthe 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 September 30, 2005, there werethree customers with net accounts receivable each comprising 10% or more oftotal net accounts receivable, ranging between $1.2 million to $1.4 millioneach.

 

6

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***Stock-based Compensation***.  The Company accounts for employee stockawards in accordance with Accounting Principles Board Opinion No. 25, “Accountingfor Stock Issued to Employees,” and related interpretations including FASBInterpretation No. 44, “Accounting for Certain Transactions InvolvingStock Compensation—an Interpretation of APB No. 25”, issued in March 2000,to account for its fixed plan options. Under this method, compensation expenseis recorded on the date of grant only if the current market price of theunderlying stock exceeds the exercise price. SFAS 123, “Accounting forStock-Based Compensation,” as amended by SFAS 148, “Accounting for Stock-BasedCompensation — Transition and Disclosure,” established accounting anddisclosure 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.  TheCompany has applied the principles of FTB 97-1, “Accounting under Statement 123for Certain Employee Stock Purchase Plans with a Look-Back Option.” Under thistechnical bulletin, the fair value method of accounting is used to account forshares issued to employees under the Company’s employee stock purchaseplan.  The table below illustrates theeffect on net loss if the fair-value based method had been applied to alloutstanding and unvested awards in each period (in millions).

 

The amounts reflected as stock-based compensationexpense deductions in the proforma net loss for the three-month and nine-monthperiods ending September 30, 2004, have been revised from the historicallyreported amounts.  The revision reflectsadditional stock option grants to the Company’s Chief Executive Officerpreviously omitted

 
| ** **                                                                                                       | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                                       | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net loss - as reported                                                                                           |       | $                                          | (4.8       | )                                         | $          | (2.0 | ) | $ | (17.5 | ) | $ | (9.2 | ) |
| Add: stock-based employee Compensation  expense included in Reported net loss, net of tax in 2004                |       | 0.1                                        |       | 0.2                                       |       | 0.9 |   | 0.9 |   |
|                                                                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Deduct: total stock-based employee Compensation  expense determined Under fair-value-based method for all Awards |       | (0.4                                       | )          | (0.6                                      | )          | (2.2 | ) | (1.9 | ) |
|                                                                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Net loss – proforma                                                                                         |       | $                                          | (5.1       | )                                         | $          | (2.4 | ) | $ | (18.8 | ) | $ | (10.2 | ) |

 

The fair value of options granted in 2005 and 2004 under the 2004Omnibus Stock Incentive Plans were estimated at the date of grant using theBlack-Scholes option-pricing model.  Thefollowing weighted average assumptions were used:

 
| ** **              | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **              | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Risk free interest rate |       | 4.5                                        | %          | 3.2                                       | %          | 4.5 | % | 3.2 | % |
| Estimated life in years |       | 5                                          |       | 5                                         |       | 5 |   | 5 |   |
| Dividend yield          |       | —                                     |       | —                                    |       | — |   | — |   |
| Volatility              |       | 49.0                                       | %          | 46.9                                      | %          | 49.0 | % | 46.9 | % |

 

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 assumptionswere used:

 
| ** **              | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **              | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Risk free interest rate |       | 3.89                                       | %          | 2.20                                      | %          | 3.89 | % | 1.81% to 2.2% |   |
| Estimated life in years |       | 0.5                                        |       | 0.313                                     |       | 0.5 |   | 0.313 |   |
| Dividend yield          |       | —                                     |       | —                                    |       | — |   | — |   |
| Volatility              |       | 49.0                                       | %          | 46.9                                      | %          | 49.0 | % | 46.9% |   |

 

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

 
| ** **                                                                                   | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                   | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Weighted-average fair value of options  granted during the period                            |       | $                                          | 2.76       |                                      | $          | 9.22 |   | $ | 2.67 |   | $ | 11.41 |   |
| Weighted-average exercise price of employee  stock purchase plan issuances during the period |       | $                                          | 2.64       |                                      | $          | 4.82 |   | $ | 3.86 |   | $ | 3.91 |   |

 

***Adoption of Accounting Standards***.  In January 2003, the FinancialAccounting Standards Board issued FASB Interpretation No. 46 (“FIN 46”), “Consolidationof Variable Interest Entities.” In December 2003, the FASB issuedInterpretation No. 46 (revised December 2003), “Consolidation ofVariable Interest Entities (“FIN 46R”),” which addresses how a businessenterprise should evaluate whether it has a controlling financial interest inan entity through means other than voting rights.

 

EffectiveJanuary 1, 2004, the Company adopted the provisions of FIN 46R. Under the provisions of FIN 46R, the Company’s investment in ZiLOG MOD III, Inc.(“MOD III”) was determined to be a variable interest entity; however, theCompany was not determined to be the primary beneficiary.  Accordingly, asprescribed by 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.

 

Substantially all of the equipment of MOD IIIwas sold on July 16, 2004 and the net cash received after recoupment ofcosts was distributed to the MOD III Series A preferred stockholders in September 2004.  The remaining assets of MOD III consistprimarily of land and a building.  TheCompany expects to continue incurring period expenses for the ongoing costs ofmaintaining the remaining assets of MOD III, which costs are recorded asspecial charges.

 

***Recent Accounting Pronouncements. ***In November 2004,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

 

8

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not expect the adoption to have a material impact on its consolidatedfinancial position, results of operations or cash flows.

 

In December 2004, the FASB issued SFAS No. 123R, “Share-BasedPayment.” SFAS 123R requires employee stock options and rights to purchaseshares under stock participation plans to be accounted for under the fair valuemethod, and eliminates the ability to account for these instruments under theintrinsic value method prescribed by APB Opinion No. 25, and allowed underthe original provisions of SFAS No. 123, SFAS No. 123R requires theuse of an option pricing model for estimating fair value, which is amortized toexpense over the service periods.  Therequirements of SFAS No. 123R will become effective for fiscal periodsbeginning in 2006. SFAS No. 123R allows for either prospective recognitionof compensation expense or retrospective recognition, which may be back to theoriginal issuance of SFAS No. 123R or only to interim periods in the yearof adoption.  The Company is currentlyevaluating the alternatives under SFAS No.123R.

 

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 theimpact, if any, of adopting FSP 109-1, 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 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 aremet.  FPS109-2 provides accounting anddisclosure 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.

 

**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 to reduce excess and obsoleteinventories to their estimated realizable values. It is possible that estimatesof realizable value can decline in the short-term. Inventories, net ofprovisions, consist of the following (in millions):

 
| ** **       | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|------------------|------------|------------------------------|------------|-----------------------------|------------|
| Raw  materials   |       | $                            | 0.8        |                        | $          | 0.6 |   |
| Work-in-progress |       | 6.2                          |       | 8.3                         |       |
| Finished  goods  |       | 2.2                          |       | 3.2                         |       |
|             |       | $                            | 9.2        |                        | $          | 12.1 |   |

 

9

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**NOTE 4.        SPECIAL CHARGES AND REORGANIZATION ITEMS**

 

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

 
| ** **                                                   | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                   | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Asset impairments:**                                       |       |                                       |       |                                      |       |   |   |   |   |
| MOD II assets                                                |       | $                                          | —     |                                      | $          | — |   | $ | — |   | $ | 5.4 |   |
|                                                         |       |                                       |       |                                      |       |   |   |   |   |
| **Restructuring of operations:**                             |       |                                       |       |                                      |       |   |   |   |   |
| Employee severance, termination benefits  and transfer costs |       | 0.5                                        |       | —                                    |       | 1.6 |   | 1.9 |   |
| MOD II period maintenance costs                              |       | 0.1                                        |       | 2.3                                       |       | 0.7 |   | 2.4 |   |
| MOD III period maintenance costs                             |       | 0.1                                        |       | (4.2                                      | )          | 0.3 |   | (3.5 | ) |
| **Professional fees for debt restructuring**                 |       | —                                     |       | —                                    |       | — |   | 0.1 |   |
|                                                         |       | $                                          | 0.7        |                                      | $          | (1.9 | ) | $ | 2.6 |   | $ | 6.3 |   |

 

During2005, the Company has continued to consolidate its activities in an effort tostreamline operations and align its overall supports costs to current businesslevels.  Additionally, following theclosure of its remaining fab in 2004 and completion of conversion to a fullyfabless model, the Company continues to consolidate certain support activitiesin its Philippines facility in line with the expanding business opportunities inAsia and China.  The totalseverance and benefits cost of this action are expected to be approximately$1.5 million, of which $1.4 million was recorded as special charges during thenine months ended September 30, 2005, and the remaining amount will be recordedover the required service periods of the employees to be terminated.

 

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 December 31, 2004                           |       | $                                         | 0.3        |                               | $          | 0.7       |       | $ | 1.0 |   |
| Provisions for employee severance and  termination benefits |       | 1.5                                       |       | —                             |       | 1.5       |       |
| Cash paid                                                   |       | (1.4                                      | )          | (0.5                               | )          | (1.9      | )          |
| Balance at September 30, 2005                          |       | $                                         | 0.4        |                               | $          | 0.2       |       | $ | 0.6 |   |

 

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 be recordedas a credit to special charges in the period such funds are received.

 

**NOTE 5.        GEOGRAPHIC AND SEGMENT 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 operationsoutside the

 

10

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United States consist of a final test and logistics facility in thePhilippines, sales and support centers in Asia and Western Europe and design centersin China and India.  Domestic operationsinclude product design and development, as well as the coordination ofproduction planning, sales, marketing, general and administrative functions.  The Philippine test facility is reimbursed inrelation to value added with respect to test operations and other functionsperformed, and certain foreign sales offices receive a commission on exportsales within their territory. Accordingly, for financial statement purposes, it is not meaningful tosegregate sales or operating profits for the test and foreign sales officeoperations. ZiLOG has two broad business lines called micrologic devices andother devices that as aggregated are referred to as the ‘base business’ andexclude foundry services.  The Companyeffectively exited the foundry services business when it closed it MOD II wafermanufacturing facility in July, 2004.

 

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

 
| ** **                                         | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                         | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Net sales by business line:**                    |       |                                       |       |                                      |       |   |   |   |   |
| **Micrologic Devices**  (including embedded flash) |       |                                       |       |                                      |       |   |   |   |   |
| 8-bit Microcontrollers and Microprocessors         |       | $                                          | 15.7       |                                      | $          | 15.7 |   | $ | 45.9 |   | $ | 54.1 |   |
|                                               |       |                                       |       |                                      |       |   |   |   |   |
| **Other Devices :**                                |       |                                       |       |                                      |       |   |   |   |   |
| Serial Communications Controllers                  |       | $                                          | 2.9        |                                      | $          | 3.6 |   | $ | 9.1 |   | $ | 11.7 |   |
| Modems                                             |       | 0.2                                        |       | 1.0                                       |       | 2.5 |   | 2.3 |   |
| IrDA transceivers                                  |       | 0.3                                        |       | 0.5                                       |       | 0.8 |   | 1.7 |   |
| Television, PC peripheral and other                |       | 1.4                                        |       | 1.6                                       |       | 3.0 |   | 3.5 |   |
| Total                                              |       | $                                          | 4.8        |                                      | $          | 6.7 |   | $ | 15.4 |   | $ | 19.2 |   |
| **Base business (excluding foundry)**              |       | $                                          | 20.5       |                                      | $          | 22.4 |   | $ | 61.3 |   | $ | 73.3 |   |
| **Foundry services:**                              |       | —                                     |       | 0.4                                       |       | — |   | 3.4 |   |
| Total sales                                        |       | $                                          | 20.5       |                                      | $          | 22.8 |   | $ | 61.3 |   | $ | 76.7 |   |

 

The following table summarizesZiLOG’s net sales by region and by channel (in millions):

 
| ** **                | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Net sales by region:**  |       |                                       |       |                                      |       |   |   |   |   |
| Americas                  |       | $                                          | 8.0        |                                      | $          | 11.0 |   | $ | 25.7 |   | $ | 37.9 |   |
| Asia                      |       | 10.0                                       |       | 8.8                                       |       | 27.8 |   | 28.3 |   |
| Europe                    |       | 2.5                                        |       | 3.0                                       |       | 7.8 |   | 10.5 |   |
| Total sales               |       | $                                          | 20.5       |                                      | $          | 22.8 |   | $ | 61.3 |   | $ | 76.7 |   |
|                      |       |                                       |       |                                      |       |   |   |   |   |
| **Net sales by channel:** |       |                                       |       |                                      |       |   |   |   |   |
| OEM                       |       | $                                          | 9.0        |                                      | $          | 10.6 |   | $ | 28.4 |   | $ | 39.1 |   |
| Distribution              |       | 11.5                                       |       | 12.2                                      |       | 32.9 |   | 37.6 |   |
| Total sales               |       | $                                          | 20.5       |                                      | $          | 22.8 |   | $ | 61.3 |   | $ | 76.7 |   |

 

***Major customers:***During******the three and nine month periodsended September 30, 2005, one customer and two customers accounted for******greater than 10% of the total netsales, respectively.  During thethree-month period ended

 

11

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September 30, 2005, one customer accounted for approximately 25%of net sales. During the nine-month period ended September 30, 2005, twocustomers accounted for approximately 22% and 10% of net sales, respectively.

 

**NOTE 6.        SHORT-TERM DEBT**

 

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

 

**NOTE 7.        CONTINGENCIES**

 

On August 11, 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 unspecified productsof 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. The Company fileda response to the claims on September 15, 2005 generally denying theclaims and challenging the validity of the patents. A hearing has beenscheduled for November 17, 2005.

 

The Company does not believe it is feasible to predict or determine theoutcome or resolution of this litigation at this time. The Company believes ithas meritorious defenses and will defend itself against these claims it vigorously.The Company may incur substantial expenses in our defense against these claims.In the event of a determination adverse to it, we may incur substantialmonetary liability, and be required to change its business practices. Either ofthese could have a material adverse effect on the Company’s financial position,results of operations or cash flow.

 

The Company isparticipating in other litigation and responding to claims arising in theordinary course of business.  The Companyintends to defend itself vigorously in these other matters.  The Company’s management believes that it isunlikely that the outcome of these other matters will have a material adverseeffect on the Company’s financial statements, although there can be noassurance in this regard.

 

From time totime the Company has agreed to indemnify certain customers for potentialallegations of infringement of intellectual property rights and patents arisingfrom the use of the Company’s products. Currently, there is an indemnificationagreement with a customer that limits the Company’s net contingent obligationto pay for the customer’s defense costs, if any, up to a maximum of $500,000

 

**NOTE 8.        INCOME TAXES**

 

During the nine-month period ended September 30, 2005, our incometax provision was $2.1 million, which primarily reflects amortization of adeferred charge and provisions for taxes in profitable foreignjurisdiction.  We provide for income taxexpense in foreign jurisdictions where the foreign subsidiaries operationsgenerate profits that are taxable.  Ourincome tax benefit for the nine-month period ended September 30, 2004reflects the estimated annual effective tax rate of 2% at that time based onprojections of operations.

 

 The net tax benefits recorded inthe period ended September 30, 2004, includes the reduction of deferredtax liabilities associated with the book-tax carrying value difference of MODII assets which were reduced when we recorded the impairment associated withthe announcement of the closure of the operations in Nampa, Idaho on April 16,2004.

 

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

 

12

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**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  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                      | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net loss                                                                        |       | $                                          | (4.8       | )                                         | $          | (2.0 | ) | $ | (17.5 | ) | $ | (9.2 | ) |
|                                                                            |       |                                       |       |                                      |       |   |   |   |   |
| Weighted-average shares outstanding                                             |       | 16.3                                       |       | 16.5                                      |       | 16.3 |   | 16.1 |   |
| Less: Weighted-average shares subject to  repurchase                            |       | —                                     |       | (0.1                                      | )          | — |   | (0.2 | ) |
| Weighted-average shares used in computing basic  and diluted net loss per share |       | 16.3                                       |       | 16.4                                      |       | 16.3 |   | 15.9 |   |
| Basic and diluted net loss per share                                            |       | $                                          | (0.29      | )                                         | $          | (0.12 | ) | $ | (1.07 | ) | $ | (0.58 | ) |

 

For the nine months ended September 30, 2005 and September 30,2004, options to purchase approximately 2.1 and 1.6 million shares of commonstock at a weighted average exercise price of $6.56 and $7.40, respectively,were excluded from the determination of diluted net loss per share, as theeffect of such shares were anti-dilutive. At September 30, 2005 and 2004, there were 16,303,519 and16,315,575 common shares issued and outstanding, respectively.

 

**NOTE 10.      COMPREHENSIVE INCOME**

 

The Company had noitems of other comprehensive income to report in any of the three-month ornine-month periods ended September 30, 2005 or September 30, 2004.

 

**NOTE 11.      STOCK AND STOCK REPURCHASES**

 

2003 StockRepurchase Program: On April 17, 2003, the Company’s Board of Directorsapproved a stock repurchase program authorizing the repurchase of up to 500,000shares of its common stock.  As of September 30,2005, 405,164 shares had been repurchased at a cost of $2.1 million.

 

2004 StockRepurchase Program: On July 29, 2004 the Company’s Board of Directorsapproved a stock repurchase program pursuant to which the Company mayrepurchase up to $5.0 million in market value of its outstanding shares ofcommon stock.  As of September 30,2005, 572,100 shares costing $4.4 million had been repurchased.

 

During thenine-month period ended September 30, 2005, 12,389 shares with a fairmarket value of approximately $0.1 million, were received from a formeremployee in payment of an existing employee loan.  During the three-month period ended, September 30,2005, no shares were purchased under either plan.

 

**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 sale closed and was funded on July 16,2004. MOD III paid dividends on and redeemed a portion of the 28,000 Preferred Series Ashares outstanding for a net consideration of approximately $20.2 million afterreimbursements totaling approximately $4.9 million were paid to the Company andtransaction costs related to the sale, including brokerage fees, legal fees andother professional services costs were paid. Reimbursements to ZiLOG are to pay certain costs of maintaining MODIIIin a saleable condition on MOD III’s behalf. Such reimbursement to ZiLOG was recognized in the third quarter of 2004as a credit to special charges.

 

13

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***Sale of MOD II Equipment***

 

In the fourth quarter of 2004,the Company sold all of its wafer manufacturing equipment and certain othermanufacturing support-related assets of its MOD II facility in Nampa, Idaho, toSTM for an aggregate cash consideration of $5.9 million net of selling costsand expenses. A net gain of $1.7 million was recorded in connection with thesesales.  The remaining assets of MOD IIprimarily consists of land and buildings which a carrying value of $3.4 millionwhich have been classified as assets held for sale on the Company’s balancesheet.

 

14

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**ITEM 2.****                                                     Management’sDiscussion and Analysis 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 the section 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-month periods ended September 30, 2005 and September 30,2004.  This discussion and analysisshould be read in conjunction with the condensed consolidated financialstatements and notes thereto included elsewhere herein and the Company’s 2004 annualreport on Form 10-K. Management’s discussion and analysis providesinformation concerning our business environment, consolidated results ofoperations 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 investors carefully review the GAAP financialinformation included as part of this report and read the associatedreconciliation..

 

Historically,our interim results are based on fiscal quarters of thirteen weeks in durationending on the last Sunday of each calendar quarter.  The second quarter ended on June 26,2005.  Starting in the third quarter of2005, our interim fiscal calendar was changed such that fiscal quarters willnow end on the Saturday nearest to the calendar quarter-end.  Accordingly, our fiscal third quarter of 2005ended on October 1, 2005 and was 6 days longer than the same quarter inthe prior year. This new fiscal calendar was adopted as it results in moreconsistency and comparability in the number of days included within each fiscalquarter.  Our previous quarters have notbeen restated to conform to the new fiscal calendar format because we believethat the new fiscal calendar will not materially affect comparability of ourfinancial results between periods for the three and nine months ended September 30,2005.  Generally, the first and secondfiscal months of each quarter are four weeks in duration and the third month isfive weeks.  Our fourth fiscal quarter ofeach year always ends on December 31. For financial reporting purposes, interim fiscal periods are labeled asending on the calendar month-end.  Theoperating results for any interim period are not necessarily indicative ofresults for any subsequent period or the full fiscal year.

 

**CriticalAccounting Estimates**

 

We believe ourcritical accounting estimates are as follows:

 

•                       estimating sales returns andallowances;

 

•                       estimating allowance fordoubtful accounts;

 

•                       estimating write-downs of excessand obsolete inventories; and

 

•                       asset impairments.

 

On an on-goingbasis, we evaluate our estimates, including those related to sales returns,allowance for doubtful accounts, inventory write-downs and assetimpairments.  We base our estimates onhistorical trends and various other assumptions that we believe to bereasonable at the time the estimates are made. Actual results could differ from those estimates.  A brief description of each of these policiesis set forth below.

 

**Estimating sales returns and allowances.**  Our net sales to OEM customers consist ofgross product sales reduced by expected future sales returns and allowances. Toestimate sales returns and price allowances, we analyze historical returns andallowance activity to establish a baseline reserve level. We then evaluatewhether there are any underlying product quality or other customer specificissues that require additional specific reserves above the

 

15

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baseline level. Because the reserve for sales returns and allowances isbased on our judgments and estimates, our reserves may not be adequate to coveractual sales returns and other allowances. If our reserves are not adequate,our net sales and accounts receivable could 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.  To estimate this distributor price adjustmentreserve, we analyze our historical price adjustment payments and pending priceadjustments that have been authorized by us but have not yet been claimed byour distributors. Because our distributor allowance reserve is based upon our judgmentsand estimates, such reserves may not be adequate to cover actual distributorprice allowances. If our reserves are not adequate, our net sales and accountsreceivable could be adversely affected.

 

**Allowancefor doubtful accounts.** We maintain an allowance for losses we may incur as a result of ourcustomers’ inability to make required payments. Any increase in the allowance results in a corresponding increase in ourselling, general and administrative expenses. In establishing this allowance, and then evaluating the adequacy of theallowance for doubtful accounts, we consider the aging of our accountsreceivable, historical bad debts, customer concentrations, and customercredit-worthiness and, to a lesser extent, current economic trends and changesin our customer payment terms. Historically, we have not experienced material bad debt write-offs.  If the financial condition of one or more ofour customers unexpectedly deteriorated, resulting in their inability to makepayments, or if we otherwise underestimate the losses we incur as a result ofour customers’ inability to pay us, we could be required to increase ourallowance for doubtful accounts which could adversely affect our operatingresults.

 

**Estimatingwrite-downs of excess and obsolete inventories**.  Each inventory component is assessed forexcess or obsolescence by using an algorithm that we established.  This algorithm is based on historical trends,demand forecasts and inventory age.  Wereview the result of this algorithm and generally record inventory reserves onwork-in-process inventories more than one year old and finished goodsinventories in excess of historical demand requirements.  In addition, we analyze historical andexpected selling prices of our products compared to their historical cost andrecord reserves as considered appropriate. Write-downs of inventories are reflected as a reduction to inventoryvalues in the accompanying consolidated balance sheets, and an increase in costof sales.  Consistent with the Company’spolicies and procedures, management may adjust the reserves computed by thealgorithm to reflect specific facts and circumstances such as transitionalinventory requirements when production moves from one location or supplier toanother.  If actual market conditions,selling prices or customer demand patterns are less favorable than, orinconsistent with our assumptions, we may be required to take furtherwrite-downs of our inventory value, which could adversely impact our cost ofsales and operating results.

 

**Asset impairments.**  We apply the provisions of Statement ofFinancial Accounting Standards No. 144, “Accounting for the Impairment orDisposal of Long-Lived Assets” and Statement of Financial Accounting Standards No. 142,“Goodwill and Other Intangible Assets.” We assess the impairment of long-lived assets whenever events or changesin circumstances indicate that the carrying value may not be recoverableFactors we consider important which could trigger an impairment review includethe following:

 

•                  significant changes in the manner ofour use of the acquired assets;

•                  decrease in our market value belowour stockholders’ equity book value;

•                  significant changes in the strategyfor our overall business; and

•                  significant negative sales, industryor 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 isdetermined based on an estimate of future discounted cash flows, independentappraisals or purchase offers received from independent third parties.  Asset impairments are recorded as a reductionin the asset value in our consolidated balance sheets and as special charges inour consolidated statements of operations.

 

16

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The intangible assets created by the adoption offresh-start accounting on our emergence from our capital restructuring in May 2002consist of existing technology, brand name as well as excess enterprise value,or goodwill.  The existing technology andbrand name are being amortized based on a pattern-of-use method in proportionto estimated discounted cash flows from such assets.  We evaluate the existing technology and brandname at each reporting period to determine whether events and circumstancescontinue to support the current carrying value as well as the remaining usefullife.  Additionally, although goodwill isnot amortized, it is tested for impairment at least annually and more often ifevents and circumstances indicate that its fair value may be less than itscarrying value.  The Company performs itsannual impairment test for goodwill in the third quarter of each year, unlessthe existence of triggering events indicates that an earlier review should beperformed.  As of September 30,2005, there was no indication of impairment of the Company’s intangible assetscarrying value.

 

Followingthe April 2004 announcement of the closure of our MOD II facility, werecorded asset impairment charges to reflect the excess of book value over thecurrent estimated fair value of our MOD II fixed assets as prescribed underSFAS No. 144.   The estimates weused to determine fair value of MOD II land and buildings were based upon anindependent appraisal and the fair value of MOD II equipment was determinedbased upon offers to purchase these assets that had been received fromindependent third parties.  There can beno assurance that the ultimate value that we will realize from the ultimatesale or disposition of these assets will be equal to the appraised fairvalue.  As of September 30, 2004,the carrying value of MOD II assets held for sale was $7.8 million, of which$4.2 million was subsequently sold to STM (see Note 12).  The carrying value of MOD II assets held forsale at September 30, 2005 was $3.4 million. If the ultimate net valuerealized upon the disposition of MOD II assets is less than the estimatedfair value, our future results of operations could be adversely impacted.

 

Adjustments torecord additional impairment of our MOD II or other long-lived assets orintangible assets could have a material adverse impact on our financialcondition and results of operations in the period or periods in which suchimpairment is identified.

 

**ReportingSegments**

 

Beginning in May 2002,we consolidated our business segments into one reportable segment to reflectthe manner in which our chief operating decision-maker allocates resources andassesses the performance of our business.

 

**Results ofOperations**

 

Our net sales by region, bychannel, and by business line are summarized for each period indicated, asfollows (in millions):

 
| ** **                                          | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                          | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Net sales by region:**                            |       |                                       |       |                                      |       |   |   |   |   |
| Americas                                            |       | $                                          | 8.0        |                                      | $          | 11.0 |   | $ | 25.7 |   | $ | 37.9 |   |
| Asia                                                |       | 10.0                                       |       | 8.8                                       |       | 27.8 |   | 28.3 |   |
| Europe                                              |       | 2.5                                        |       | 3.0                                       |       | 7.8 |   | 10.5 |   |
| Total                                               |       | $                                          | 20.5       |                                      | $          | 22.8 |   | $ | 61.3 |   | $ | 76.7 |   |
|                                                |       |                                       |       |                                      |       |   |   |   |   |
| **Net sales by channel:**                           |       |                                       |       |                                      |       |   |   |   |   |
| OEM                                                 |       | $                                          | 9.0        |                                      | $          | 10.6 |   | $ | 28.4 |   | $ | 39.1 |   |
| Distribution                                        |       | 11.5                                       |       | 12.2                                      |       | 32.9 |   | 37.6 |   |
| Total                                               |       | $                                          | 20.5       |                                      | $          | 22.8 |   | $ | 61.3 |   | $ | 76.7 |   |
|                                                |       |                                       |       |                                      |       |   |   |   |   |   |   |   |   |
| **Net sales by business line:**                     |       |                                       |       |                                      |       |   |   |   |   |
| **Micrologic Devices (including embedded  flash):** | ** ** | ** **                                 | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| 8-bit Microcontrollers and  Microprocessors         |       | $                                          | 15.7       |                                      | $          | 15.7 |   | $ | 45.9 |   | $ | 54.1 |   |
|                                                |       |                                       |       |                                      |       |   |   |   |   |   |   |   |   |
| **Other devices:**                                  |       |                                       |       |                                      |       |   |   |   |   |
| Serial Communications Controllers                   |       | $                                          | 2.9        |                                      | $          | 3.6 |   | $ | 9.1 |   | $ | 11.7 |   |
| Modems                                              |       | 0.2                                        |       | 1.0                                       |       | 2.5 |   | 2.3 |   |
| IrDA transceivers                                   |       | 0.3                                        |       | 0.5                                       |       | 0.8 |   | 1.7 |   |
| Television, PC peripherals and other                |       | 1.4                                        |       | 1.6                                       |       | 3.0 |   | 3.5 |   |
| Total                                               |       | $                                          | 4.8        |                                      | $          | 6.7 |   | $ | 15.4 |   | $ | 19.2 |   |
| **Base business (excluding foundry)**               |       | $                                          | 20.5       |                                      | $          | 22.4 |   | $ | 61.3 |   | $ | 73.3 |   |
| **Foundry services**                                |       | 0.0                                        |       | 0.4                                       |       | 0.0 |   | 3.4 |   |
| Net sales                                           |       | $                                          | 20.5       |                                      | $          | 22.8 |   | $ | 61.3 |   | $ | 76.7 |   |

 

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

 
| ** **                                 | ** ** | **As of September 30, and for the  three-month periods then ended** | ** ** |
|--------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| ** **                                 | ** ** | **2005**                                                                 | ** ** | **2004** | ** ** |
| Days sales  outstanding                    |       | 42                                                                       |       | 34 |   |
| Net sales to  inventory ratio (annualized) |       | 8.9                                                                      |       | 7.4 |   |
| Weeks of  inventory at distributors        |       | 10                                                                       |       | 10 |   |
| Current  ratio                             |       | 2.2                                                                      |       | 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 September 30, 2005, our DSO was 42 days which is 8 daysmore than our 2004 levels.  Overall, ourDSO has trended in the range of 40 to 55 days and is impacted by billingspatterns and associated collections and when these occur either early or latein a particular quarter.  The increase inDSO during the current year compared to the third quarter of 2004 reflectslower sales levels in 2005 and more shipments late in the third quarter of 2005versus the same period of 2004 and for certain OEM customers, shorter paymentcycles in the prior year.  Because ourDSO is primarily influenced by payment cycles from our OEM customers, increasesin our DSO do not generally correlate to increased credit risk.  In addition, our bad debts have historicallybeen minimal.Net sales to inventory ratio is a metric we use to analyze howquickly our investment in inventories is recovered by our sales. This metricmay not be comparable to those other companies use to analyze inventory and isnot the same as a typical inventory turnover ratio. Our net sales to inventoryratio improved in quarter of 2005 compared to the same period in 2004 due toour reduction of inventory levels.  Thedecline in inventories in September 2005 compared September 2004reflects the fact that in 2004 we built additional inventory in our MOD IIfacility prior to its closure in July 2004 in order to minimize risks ofsupply of products to our customers following the MOD II closure.  The majority of these products are now beingmanufactured in X-FAB’s six-inch wafer manufacturing facility in Lubbock, Texasand we typically schedule production at X-FAB to correlate with currentcustomer backlog or historical shipment patterns.

 

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 distributionsales.  We do not recognize revenue onshipments to distributors until our distributors resell our products to endusers.  Although our distributors invarious regions of the world maintain different inventory stocking levels,overall our goal is to maintain 10 to 13 weeks of inventories at ourdistributors to satisfy their end demand.

 

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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 ratio declined as of September 30,2005 compared to September 30, 2004 primarily due to the reduction in ourcash and cash equivalents used to fund our operations, cost associated withconsolidation of business activities and capital used in our test operations aswe expand test capacity for the embedded products growth.

 

**Three and Nine-Month Periods Ended September 30,2005 and 2004**

 

**Net Sales.** Overall, our net sales of $20.5 million forthe three-months ended September 30, 2005, represents a decrease of 10%from net sales of $22.8 million of net sales during the same period of2004.  For the nine months ended September 30,2005, net sales were $61.3 million, which were down 20% compared to net salesof $76.7 million during the same period of 2004.

 

Net sales of our micrologic devices wereconsistent at $15.7 million for each of the three month-periods ended September 30,2005 and 2004.  For the nine months endedSeptember 30, 2005, net sales of our micrologic devices were $45.9million, reflecting a 15% decline from $54.1 million of micrologic net salesduring the same period of 2004

 

The decrease in micrologic sales during thenine-month period of 2005 compared to 2004, reflects declines in unit sales ofour legacy Z8 and Z80 microcontroller products as these products covert toembedded flash designs. Sales declined in our Infra-red remote control productscaused by some seasonality in our OEM customer business.  These decreases in micrologic net sales werepartially offset by a $0.9million and $2.1 million increase in flash-basedmicrologic sales for the three-month and nine-month period ended September 30,2005 and 2004, respectively.  Overall, weanticipate that market demand and net sales for our general purposemicrocontrollers will decline over time as a result of customers moving fromthese older Z80 and Z8 products to alternative technologies, primarilymicrocontrollers with embedded flash technology and the need for furtherintegration of peripheral functions and capabilities.  Since November 2002, we have releasedour new Z8 Encore!, eZ80 Acclaim! and Z8 Encore! XP products that are focusedon the embedded flash market, with a strategy of recapturing sales to thesecustomers and entering new markets. Orders for our embedded flash microcontroller products totaled $2.2million for the three months ended September 30, 2005, as our design winswith customers move to production and therefore need our products.

 

Net sales of our other devices, whichexcludes Foundry sales, for the three months ended September 30, 2005decreased 28% to $4.8 million, which is down from $6.7 million in the sameperiod of 2004.  For the nine monthsended September 30, 2005, net sales of our other devices were $15.4million or 20% below net sales of $19.2 million during the same period of2004.  The decrease in other devices netsales during the three-month period and nine-month period of 2005 compared tothe same period of 2004 primarily reflects lower unit shipments of most majorproduct types.  These product categories donot have next generation product roadmaps and are not a focus of our researchand development activities.

 

Net sales of Foundry Services, for the three-month and nine-monthperiods ended September 30, 2004 were $0.4 million and $3.4 million,respectively, compared to no Foundry sales in the current year.  We are not anticipating any further foundrybusiness since we closed our MOD II wafer fabrication facility in July 2004.

 

**Gross Profit and Margin**.  Our cost of sales primarily representspurchased manufacturing services relating to wafer fabrication and packageassembly operations, as well as captive product testing, production planning,and manufacturing support costs.  Cost ofsales fluctuates, depending on materials and services prices from our vendors,manufacturing productivity and efficiency, product mix, equipment utilizationand depreciation. Gross profit as a percent of net sales (“gross margin”) was40% for the three months ended September 30, 2005, down from 46% in thesame period of 2004.  For the nine-monthperiod ended September 30, 2005, our gross margin was 40% compared to 49%in the same period of 2004.  The declinein overall gross margin for both the three and nine month periods ended September 30,2005 compared to the same periods of 2004 reflects the effect of lower sales andproduction volume which resulted in lower absorption of manufacturing costs inour test and manufacturing support operations. In addition, our gross margin in 2005 has been adversely affected by anincreasing proportion of flash-based microcontroller products which currentlygenerate lower gross margin than our more mature product offerings. Inaddition, during the nine months ended September 30, 2004, we incurredone-time charges totaling $0.6

 

19

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million relating to closure expenses for our MOD II wafer facilityincremental royalty revenue of $0.7 million resulting from a royalty audit. Themajority of products that we manufactured in our five-inch wafer fab during thenine-months ended September 30, 2004 have been transferred to X-FAB’ssix-inch facility in Lubbock, Texas.  Wewill continue to purchase our 0.35 micron wafers from outside foundriesprimarily in Taiwan, including wafers for our infra-red remote controls and newembedded flash based Z8 Encore! and eZ80 Acclaim! products.

 

**Research and Development Expenses.**  Research and development expenses were $5.6million in the three months ended September 30, 2005, reflecting a 8%increase from the $5.2 million of research and development expenses reported inthe three months ended September 30, 2004. On a year-to-date basis, research and development expenses increased 3%to $16.1 million compared to $15.6 million for 2004.  Our research and development spending in 2005reflects continued investments in new products, including our latest family ofFlash-based Microcontrollers, the Z8Encore!XPTM. During the third quarter of 2005 we incurred incremental engineeringcosts related to certain new products in our Encore! Product family as well asnew products focused on our target markets. We are also investing in product development to add additionalperipheral features to our Z8Encore! and eZ80Acclaim! product lines as well asnew devices and software features for our Crimzon line of consumer solution productsconcentrated in the Infra red remote control market segment.

 

**Selling, General and Administrative Expenses.**  Selling, general and administrative expensesdeclined 22% to $5.6 million for the three months ended September 30, 2005as compared to $7.2 million in the three months ended September 30, 2004.Selling, general and administrative expenses declined by $1.6 million, or 7%,to $20.2 million for the nine-month period ended September 30, 2005, ascompared to the same period in 2004. The decrease in our selling, general andadministrative spending for both the three-month and nine-month periods of2005, compared to 2004 primarily reflects lower incentive compensation andcommissions commensurate with our lower sales levels and lower payroll due to reducedheadcount in our sales, marketing and administrative support functions.  We expect that costs associated with theMicrochip lawsuit will partially offset these reductions in the short term.

 

**Special Charges**.  Special charges for each period indicated wereas follows (in millions):

 
| ** **                                                      | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                      | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Asset impairments:**                                          |       |                                       |       |                                      |       |   |   |   |   |
| MOD II assets                                                   |       | $                                          | —     |                                      | $          | — |   | $ | — |   | $ | 5.4 |   |
|                                                            |       |                                       |       |                                      |       |   |   |   |   |
| **Restructuring of operations:**                                |       |                                       |       |                                      |       |   |   |   |   |
| Employee severance and termination benefits  and transfer costs |       | 0.5                                        |       | —                                    |       | 1.6 |   | 1.9 |   |
| MOD II period maintenance and closure costs                     |       | 0.1                                        |       | 2.3                                       |       | 0.7 |   | 2.4 |   |
| MOD III period maintenance costs                                |       | 0.1                                        |       | 0.6                                       |       | 0.3 |   | 1.3 |   |
| MOD III period maintenance cost reimbursement                   |       | —                                     |       | (4.8                                      | )          | — |   | (4.8 | ) |
| **Professional fees for debt restructuring**                    |       | —                                     |       | —                                    |       | — |   | 0.1 |   |
|                                                            |       | $                                          | 0.7        |                                      | $          | (1.9 | ) | $ | 2.6 |   | $ | 6.3 |   |

 

During the second quarter of 2005, the Company initiated a plan ofaction to reduce its overall support costs to levels more commensurate withrevenues.  These actions will result inthe termination of approximately 40 employees. Certain of these activities havebeen or will be transferred from the Company’s San Jose, California andMeridian, Idaho facilities to its facility in Manila, Philippines.  The total severance and benefits cost of thisaction is expected to be approximately $1.5 million, of which $1.4 million hasbeen recorded as special charges during the nine months ended September 30,2005, and the remaining amount will be recorded over the required serviceperiods of the employees to be terminated. In addition, the Company continuesto incur period expenses to sustain the remaining assets of MOD II and MOD IIIin a saleable state.

 

During the third quarter of 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.

 

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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 December 31, 2004                           |       | $                                         | 0.3        |                               | $          | 0.7       |       | $ | 1.0 |   |
| Provisions for employee severance and  termination benefits |       | 1.5                                       |       | —                             |       | 1.5       |       |
| Cash paid                                                   |       | (1.4                                      | )          | (0.5                               | )          | (1.9      | )          |
| Balance at September 30, 2005                          |       | $                                         | 0.4        |                               | $          | 0.2       |       | $ | 0.6 |   |

 

***Three and Nine Months Ended September 30,2005***. Restructuring of operations during thethree-month period and nine-month periods ended September 30, 2005,included severance and termination benefits of approximately $0.5 million and$1.5 million, respectively, related to a reduction-in-force and supportactivity consolidation during the second quarter of 2005, and $0.1 million and$0.7 million, respectively, to maintain MOD II, and $0.1 million and $0.3million respectively to maintain MOD III.

 

***Three and Nine Months Ended September 30,2004***. Restructuring of operations during thenine-month period ended September 30, 2004, included severance andtermination benefits of approximately $1.9 million primarily related to theCompany’s reduction-in-force due to the closure of its MOD II five-inch waferfabrication facility in Nampa, Idaho on July 11, 2004,  and $5.4 million of asset impairments,primarily related to the write-down of MOD II assets to fair value during theperiod. During the three-month and nine-month period ended September 30,2004, other special charges included $2.3 million and $2.4 million,respectively, related to the closure and maintenance of MOD II, $0.6 millionand $1.3 million, respectively to maintain MOD III, and the reimbursement of$4.8 million of accumulated maintenance expenses of MOD III. Post-closuremaintenance costs of the MOD III eight-inch and MOD II five-inch waferfabrication 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 themigration of the MOD II production to outside foundries, has finalized ourstrategy of becoming fully fabless and our legacy products are primarilysourced from X-FAB and our newer products are sourced from foundries in Taiwan.

 

***Stock-Based Compensation.* **Our****stock-basedcompensation represents primarily amortization of deferred compensationassociated with stock options and restricted stock awarded to employees andcontractors at prices below fair value. During the three-month periods ended September 30,2005 and 2004, we recognized $0.1 million and $0.4 million and of stock-basedcompensation, respectively.  And duringthe nine-month periods ended September 30, 2005 and 2004, we recognized$0.9 million and $1.5 million of stock-based compensation, respectively.  These charges were recorded to reflect theintrinsic value of awards of restricted stock and stock options to certainexecutives, employees and consultants. These non-cash charges are primarilyincluded in our selling, general and administrative expenses.  During the second quarter of 2004, wecanceled a restricted stock award to our CEO and replaced it with stock optionsthat resulted in a non-cash compensation charge of approximately $0.2million.  Our right to repurchase sharesof restricted stock for $0.01 per share generally lapsed 25% on the award dateand 25% on each of the first three anniversaries following the award date.  Compensation expense for employee stockawards was measured on the award date and was recognized ratably over the threeyears vesting period as these restrictions lapsed.  All restricted shares became fully vested in May 2005.

 

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**Goodwill and Intangible Assets**.  Effective January 1, 2002, we adoptedthe provisions of FASB Statement of Financial Accounting Standards No. 142,“Goodwill and Other Intangible Assets” (“SFAS 142”).  Under SFAS 142, goodwill and intangibleassets with indefinite lives are not amortized, but are reviewed annually ormore frequently if impairment indicators arise. Separable intangible assets that are deemed to have defined lives willcontinue to be amortized over their useful lives (but with no maximumlife).  In connection with the Company’sfresh-start reporting, separable intangible assets based on independentvaluations were created with deemed defined lives.  These intangible assets are being amortizedutilizing the pattern-of-use method over their estimated useful lives of sixyears for current technology and ten years for brand name.

 

The separableintangible assets identified in connection with fresh- start accounting andincluded in the consolidated balance 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                  |       | 16.1                    |       | 4.4             |       | 20.5      |       |
| Book value  at September 30, 2005     |       | $                       | 0.9        |            | $          | 4.8       |       | $ | 5.7 |   |

 

The anticipated remainingamortization schedule for these assets is as follows (in millions):

 
| **Year**                   | ** ** | **Current  Technology** | ** ** | **Brand  Name** | ** ** | **Total  Amortization** | ** ** |
|----------------------------|------------|-------------------------|------------|-----------------|------------|-------------------------|------------|
| October-December 2005 |       | $                       | 0.3        |            | $          | 0.3                     |       | $ | 0.6 |   |
| 2006                       |       | 0.4                     |       | 1.0             |       | 1.4                     |       |
| 2007                       |       | 0.1                     |       | 0.8             |       | 0.9                     |       |
| 2008                       |       | 0.1                     |       | 0.8             |       | 0.9                     |       |
| 2009                       |       | —                  |       | 0.7             |       | 0.7                     |       |
| Thereafter                 |       | —                  |       | 1.2             |       | 1.2                     |       |
| Total                      |       | $                       | 0.9        |            | $          | 4.8                     |       | $ | 5.7 |   |

 

**Interest Income/Expense.**  Interest income relates to interest earned onour cash and cash equivalents.  Cashequivalents are primarily invested in money market funds and high-gradecommercial paper with maturities of 90 days or less. Interest income for thenine-months ended September 30, 2005 was $0.6 million as compared to $0.2million for the nine-months ended September 30, 2004.  The higher interest income reflects interestearned on cash raised by the Company in its March 19, 2004 offering ofcommon stock. There was no interest expense in 2005 as outstanding debt wasextinguished in 2004.

 

**Income Taxes.**   During the nine-month period ended September 30,2005, our income tax provision was $2.1 million, which primarily reflectsamortization of a deferred charge and provisions for taxes in profitableforeign jurisdiction.  We provide forincome tax expense in foreign jurisdictions where the foreign subsidiariesoperations generate profits that are taxable. Our income tax benefit for the nine-month period ended September 30,2004 reflects the estimated annual effective tax rate of 2% at that time basedon projections of operations.

 

The net tax benefits recorded in the period ended September 30,2004, includes the reduction of deferred tax liabilities associated with thebook-tax carrying value difference of MOD II assets which were reduced when werecorded the impairment associated with the announcement of the closure of theoperations in Nampa, Idaho on April 16, 2004.

 

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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.

 

**Liquidityand Capital Resources**

 

AtSeptember 30, 2005, we had cash and cash equivalents of $28.0 million,compared to $37.7 million at December 31, 2004.  Cash used by operating activities was $7.8million for the nine months ended September 30, 2005, compared to $6.4million of cash provided by operating activities in the nine months ended September 30,2004.

 

#### **During the nine-month periodended September 30, 2005, cash used by operating activities of $7.8million primarily reflects our $17.5 million net loss, offset partially by: (i) non-cashcharges for depreciation and amortization, including**amortization of fresh start intangible assets of $1.6million; (ii) cash provided for operations from reductions in accountsreceivable, inventories and prepaid expenses and other current and non-currentassets of $1.1 million, $3.0 million and $2.4 million, respectively; and (iii) theeffect of net changes in all other operating assets and liabilities netted to a$0.2 million increase in operating cash flow.

 

During the nine-month period ended September 30,2004, cash provided by operating activities of $6.4 million primarily reflectscash flows from decreases in accounts receivable and prepaid expense and othercurrent and non-current assets of $4.6 million and $2.3 million, respectively,goodwill adjustment of $7.4 million, as well as cash flows provided from anincrease in current liabilities of $1.4 million offset by our net loss of $9.2million.  Cash provided by operations wasincreased by non-cash charges totaling $2.6 million, including: a decrease ofdeferred income tax assets and liabilities of $10.0 million; an increase of$3.2 million for amortization of fresh-start intangible assets; $2.4 million ofdepreciation and amortization; a charge for impairment of long-lived assets of$5.4 million; and loss on asset disposal of $0.1 million; and stock-basedcompensation expense of $1.5 million.

 

Cashused by investing activities was $2.1 million and $4.2 million in thenine-month periods ended September 30, 2005 and 2004, respectively. Cashused for investing activities in both of these periods primarily reflectscapital expenditures for building improvements, software and equipment.  For the nine months ended September 30,2005, capital expenditures related primarily to purchase and implementation ofinternal-use software and new semiconductor test equipment.  For the nine-month period ended September 30,2004, capital expenditures were primarily related to CAD tools, facilities andequipment relating to our research and development activities, including ournew design centers in Shanghai and Idaho. During the 2005 period there were also $0.1 million of cash receiptsfrom sales of various MOD II assets.

 

Cashprovided by financing activities was $0.2 million for the nine-months ended September 30,2005 and consisted of proceeds for issuances of stock to employees under ouremployee stock purchase plan offset by $0.1 million for the repurchase ofrestricted common stock from a former employee.

 

Cashprovided by financing activities for the nine-month period ended September 30,2004 of $15.3 million primarily reflects the net proceeds of $24.4 million fromthe Company’s public offering of 2.3 million shares of common stock at a priceof $12.50 per share, net of offering expenses. The stock offering proceeds were offset by repayments of $5.0 million ofborrowings under our revolving line of credit, $4.5 million of stockrepurchased primarily under the stock repurchase program approved by our Boardof Directors on July 29, 2004. Additionally, net proceeds from issuance ofcommon stock under employee stock purchase plans were $0.4 million.

 

OnJuly 29, 2004, we announced that our board of directors has authorized astock repurchase program pursuant to which we may repurchase up to $5.0 millionin market value of our outstanding shares of common stock.  Purchases under the program may be made, fromtime-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. Purchases of common stock under this program, if any, may impact ourcash used by financing activities in future periods. As of September 30,2005, we repurchased a total of 572,100 shares costing $4.4 million.

 

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”

 

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calculationsfor purposes of determining certain employees’ incentive compensation and,subject to meeting specified adjusted EBITDA amounts, for accelerating thevesting of EBITDA-linked stock options. This measure of adjusted EBITDA wasapproved as part 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:

 

•                  Employeeretention bonuses, severance pay and termination benefits;

•                  Professionalfees for debt restructuring;

•                  Leasetermination costs;

•                  Terminationand exit charges, and

•                  MODIII 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  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                               | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Reconciliation of net loss to EBITDA:                                    |       |                                       |       |                                      |       |   |   |   |   |
| Net loss                                                                 |       | $                                          | (4.8       | )                                         | $          | (2.0 | ) | $ | (17.5 | ) | $ | (9.2 | ) |
| Depreciation and amortization                                            |       | 1.1                                        |       | 1.7                                       |       | 3.4 |   | 5.6 |   |
| Interest expense, net                                                    |       | (0.2                                       | )          | —                                    |       | (0.6 | ) | — |   |
| Income tax expense (benefit)                                             |       | 0.7                                        |       | 0.9                                       |       | 2.1 |   | (0.2 | ) |
| EBITDA                                                                   |       | $                                          | (3.2       | )                                         | $          | 0.6 |   | $ | (12.6 | ) | $ | (3.8 | ) |
|                                                                     |       |                                       |       |                                      |       |   |   |   |   |
| Reconciliation of EBITDA to net cash by  operating activities cash flow: |       |                                       |       |                                      |       |   |   |   |   |
| EBITDA                                                                   |       | $                                          | (3.2       | )                                         | $          | 0.6 |   | $ | (12.6 | ) | $ | (3.8 | ) |
|                                                                     |       |                                       |       |                                      |       |   |   |   |   |
| Interest expense, net                                                    |       | 0.2                                        |       | —                                    |       | 0.6 |   | — |   |
| Benefit (provision) for income taxes                                     |       | (0.7                                       | )          | (0.9                                      | )          | (2.1 | ) | 0.2 |   |
| Deferred income tax assets and liabilities                               |       | —                                     |       | (6.8                                      | )          | — |   | (10.0 | ) |
| Asset impairments                                                        |       | —                                     |       | —                                    |       | — |   | 5.4 |   |
| Loss on asset disposal                                                   |       | —                                     |       | —                                    |       | — |   | 0.1 |   |
| Stock-based compensation                                                 |       | 0.1                                        |       | 0.4                                       |       | 0.9 |   | 1.5 |   |
| Changes in operating assets and liabilities                              |       | (1.7                                       | )          | 17.1                                      |       | 5.4 |   | 13.0 |   |
| Net cash provided (used) by operating  activities                        |       | $                                          | (2.3       | )                                         | $          | 10.4 |   | $ | (7.8 | ) | $ | 6.4 |   |

 

Our cash needsfor 2005 primarily include funding operating losses, working capital, specialcharges and capital expenditures.  In April 2004,we announced the closure of our MOD II wafer fabrication facility whichresulted in the elimination of approximately 150 positions.  In May 2005, we commenced aconsolidation of our support activities. We anticipate the remaining cash costs of this action will beapproximately $0.4 million of stay-on entitlements, severance benefits andother cash costs to be paid primarily during the fourth quarters of 2005.  We

 

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currentlyanticipate that available cash will be adequate to satisfy our cashrequirements for at least the next twelve months.

 

We expectfiscal 2005 capital expenditures will total approximately $3.5 to $4.0 million,primarily for new semiconductor test equipment, building improvements andinternal use software.  Decisions relatedto cash requirements for investing activities are influenced by our expectedcash provided by or used in operations, our existing cash reserves and theinvestment needs of the business as we continue to expand our developmentactivities.

 

**Contractual Obligations.**  We lease certain of our facilities andequipment under non-cancelable operating leases, which expire in 2005 through2009. These facility lease agreements generally provide for base rental rateswhich increase at various times during the terms of the leases and also providefor renewal options at fair market rental value. We are also responsible forcommon area maintenance charges on certain office leases. These charges aregenerally less than 10% of base rents. Total operating lease expense, includingmonth-to-month rentals, was approximately $2.7 million, $1.7 million and $1.2million for the year ended December 31, 2003, the eight-month period endedDecember 31, 2002 and the four-month period ended April 30, 2002. Wedid not have any capital leases as of December 31, 2003 or 2002.

 

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 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 second quarter and peak in the thirdquarter driven by increased holiday demand from our customers in the homeentertainment and consumer products markets. Our revenues are generally lower in the first and fourth quarterscompared to the rest of the year.  Webelieve that this historical seasonal trend could be impacted in the currentyear by general economic conditions and reduction in sales of our other productportfolios. Additionally, general world-wide economic, political and regionalinstabilities may impact our results of operations in any given period.

 

***Recent Accounting Pronouncements. ***In November 2004,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-BasedPayment.” SFAS 123R requires employee stock options and rights to purchaseshares under stock participation plans to be accounted for under the fair valuemethod, and eliminates the ability to account for these instruments under theintrinsic value method prescribed by APB Opinion No. 25, and allowed underthe original provisions of SFAS No. 123, SFAS No. 123R requires theuse of an option pricing model for estimating fair value, which is amortized toexpense over the service periods.  Therequirements of SFAS No. 123R will become effective for fiscal periodsbeginning in 2006. SFAS No. 123R allows for either prospective recognitionof compensation expense or retrospective recognition, which may be back to theoriginal issuance of SFAS No. 123R or only to interim periods in the yearof adoption.  The Company is currentlyevaluating the alternatives under SFAS No.123R.

 

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

 

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American Jobs Creation Act of 2004 (“AJCA”).”The AJCA introduces aspecial 9% tax deduction on qualified production activities.  FSP 109-1 clarifies that this tax deductionshould be accounted for as a special tax deduction in accordance with Statement109.  The Company has not yet determinedthe impact, if any, of adopting FSP 109-1, but it does not expect the adoptionto have a material impact on its consolidated financial position, results ofoperations or 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%dividends received deduction on the repatriation of certain foreign earnings toa U.S. taxpayer (repatriation provision), provided certain criteria aremet.  FPS109-2 provides accounting anddisclosure 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.

 

**RISK FACTORS**

 

**Risks Related to Our Business and Industry**

 

*The following risk factors should beconsidered carefully in addition to the other information in the Form 10-Q.  The risks described below are the ones wedeem to be material to our business, but are not the only ones we face.  Additional risks we are not presently awareof or that we currently believe are immaterial may also impair our businessoperations. If any of these risks actually occurs, our business could be harmedmaterially.*

 

***We have experienced declines innet sales, and, if we fail to implement our new product strategy, we maycontinue to experience declines in sales and gross margins.***

 

In each of the past three years our net saleshave declined significantly and our future financial results are anticipated tobe subject to substantial fluctuations. Our total net sales were $95.6 millionfor the year ended December 31, 2004, $103.6 million in 2003.  In addition, our net sales in the thirdquarter of 2005 were $20.5 million, compared to net sales of $22.8 million inthe third quarter of 2004. We anticipate that sales of our legacy products wilcontinue to decline over time. Our future financial performance and success arelargely dependent on our ability to implement our new product strategy, whichconsists partly of refocusing our business on the next generation of micrologicproducts built around our core 8-bit micrologic architecture, beginning withthe Z8 Encore! and eZ80 Acclaim! flash products.  In November 2002 we launched our new 8-bitZ8 Encore! micrologic product, in February 2003 we launched our new eZ80Acclaim! micrologic product and in March 2004 our enhanced Z8 Encore! XPflash 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 10% 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 legacy productsfor the foreseeable future. Consequently, the introduction of new productscould have a negative impact on our gross margin even if sales from such newproducts offset declining revenues of our legacy products.

 

***If we are unable to obtainadequate production capacity or quality, our business will be harmed****.*

 

We rely on independent third-party foundrymanufacturers including X-FAB, TSMC, and UMC to fabricate wafers for all of ourproduct needs.  Industry-wide shortagesin foundry capacity could harm our financial results.  If we are unable to obtain the requisitefoundry capacity to manufacture our products, or if we have to pay higher than

 

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anticipated prices to foundries in periods oftight capacity, we may not be able to meet our customers’ demand for ourproducts.  Any delay in initiatingproduction at third-party foundries, any inability to have new productsmanufactured at such foundries or any failure to meet our customers’ demandscould damage our relationships with our customers and may decrease our sales.

 

Other significant risks associated withrelying on these third-party foundries include:

 

•                  reduced controlover the cost of our products, delivery schedules, capacity constraints andproduct quality;

 

•                  limitedwarranties on wafers or products supplied to us;

 

•                  increasedexposure to potential misappropriation of our technology;

 

•                  yield or qualityissues with the supplier which could result in us being unable to supplyproduct to customers or providing product that doe not meet their quality orperformance standards;

 

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

 

•                  the time andcost associated with switching or sourcing alternate foundries.

 

***If we are unable to prevail ina patent litigation lawsuit we may incur substantial monetary liability and maybe required to change our business practices.***

 

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 unspecified productsof 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 claimsand challenging the validity of the patents. A hearing has been scheduled for November 17th,2005.

 

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.

 

The Company is participating in otherlitigation and responding to claims arising in the ordinary course ofbusiness.  The Company intends to defenditself vigorously in these other matters. The Company’s management believes that it is unlikely that the outcomeof these other matters will have a material adverse effect on the Company’sfinancial statements, although there can be no assurance in this regard

 

***We depend on third-partyassemblers throughout Asia, including Indonesia, Thailand and the Philippines,and the failure of these third parties to continue to provide services to us onsufficiently favorable terms could harm our business****.*

 

We use outside contract assemblers inIndonesia, Thailand and the Philippines for packaging our products.  These countries have been subject topolitical instability and terrorist activities. The packaging of semiconductorsis a complex process requiring, among other things, a high degree of technicalskill and advanced equipment.  If we areunable to obtain additional assembly capacity on sufficiently favorable terms,our ability to maintain or grow our net sales could be impaired.  Shortages in contract assembly capacity couldcause shortages in our products and could also result in the loss of customersas a result of delays.  Because we relyon these third parties, we also have less control over our costs, deliveryschedules and quality of our products and our technology is at greater risk ofmisappropriation.

 

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***Our success depends on ourability to introduce new products on a timely basis.***

 

Our operating results depend on our abilityto introduce and sell new products on a timely basis that can competeeffectively based on price and performance and that address customerrequirements. Rapidly changing technologies and industry standards, along withfrequent new product introductions, characterize the industries that arecurrently the primary end-users of semiconductors. As these industries evolveand our customers and potential customers introduce new products, our successwill depend on our ability to adapt to such changes in a timely andcost-effective manner by designing, developing, manufacturing, marketing andproviding customer support for new products and technologies. In the past, wehave brought products to market on an untimely basis or canceled theintroduction of previously planned products, such as our Cartezian line of 32-bitmicroprocessors. Our ability to introduce and sell new products successfullydepends on several factors, including:

 

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

 

•                  propernew product selection;

 

•                  timelycompletion and introduction of new product designs;

 

•                  supportfrom our foundry service providers;

 

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

 

•                  marketacceptance of our products and our customers’ products.

 

The emphasis of our new product developmentis on the next generation of products built on our 8-bit micrologicarchitecture. If market demand for these products does not develop as weanticipate, our product development strategy could fail. Because our productsare complex, we may not meet the design and introduction schedules for any newproducts or any additions or modifications to our existing products, and theseproducts may not achieve market acceptance. In addition, we may not be able tosell these products at prices that are favorable to us.

 

***Our industry is highlycompetitive, and we may not be able to compete effectively.***

 

The semiconductor industry is intenselycompetitive and is characterized by price erosion, rapid technological changeand heightened competition in many markets. The industry consists of majordomestic and international semiconductor companies, many of which havesubstantially greater financial and other resources than we do with which topursue engineering, manufacturing, marketing and distribution of theirproducts. Emerging companies are also increasing their participation in thesemiconductor industry. Our current and future products compete with, or maycompete with, products offered by Atmel, Cypress Semiconductor, Intel,Microchip, Freescale, National Semiconductor, Renasas, ST Microelectronicsand Texas Instruments, among others. Some of our principal products such as theZ80 microprocessor are licensed by our competitors, or are in the publicdomain, and can be manufactured and sold to our customers by our competitors,possibly with added features or at lower prices than we charge. Our ability tocompete successfully in our markets depends on factors both within and outsideof our control, including:

 

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

 

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

 

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

 

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

 

•                  Ourefficiency of production;

 

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

 

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

 

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

 

***Our quarterly operating resultsare likely to fluctuate and may fail to meet expectations, which may cause theprice of our securities to decline.***

 

Our quarterly operating results havefluctuated in the past and will likely continue to fluctuate in the future. Ifour quarterly operating results fail to meet expectations, the price of oursecurities could fluctuate or decline significantly. In addition, highproportions of our costs are fixed, due in part to our significant sales,research and development and manufacturing costs. Therefore, small declines inrevenue could disproportionately affect our operating results in a quarter. Avariety of factors could cause our quarterly operating results to fluctuate,including:

 

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

 

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

 

•                  competitivedevelopments, including pricing pressures;

 

•                  technologicalchange and product obsolescence;

 

•                  changesin product mix or fluctuations in manufacturing yields;

 

•                  variabilityof our customers’ product life cycles;

 

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

 

•                  seasonality;

 

•                  inventorywrite-downs or asset impairments;

 

•                  restructuringcharges;

 

•                  increasesin the cost or scarcity of raw materials; and

 

•                  gainor loss of significant customers.

 

***We depend on orders that arereceived and shipped in the same quarter, and therefore our results ofoperations may be subject to significant variability from quarter to quarter.***

 

Our net sales in any given quarter dependupon a combination of orders received in that quarter for shipment in thatquarter and shipments from backlog. Our backlog at the beginning of eachquarter does not include all sales needed to achieve expected revenues for thatquarter. Consequently, we are dependent on obtaining orders to be shipped inthe same quarter that the order is received for a significant portion of netsales in that quarter. Moreover, customers may reschedule shipments, andproduction difficulties could delay shipments. Accordingly, we have limited visibilityinto future product shipments, and our results of operations may be subject tosignificant variability from quarter to quarter.

 

***We operate in the highlycyclical semiconductor industry, and have experienced a downturn in thebusiness cycle, which has adversely affected our revenues and cash generation.***

 

The semiconductor industry is highly cyclicaland has experienced significant economic downturns, often in connection with,or in anticipation of, maturing product cycles (for semiconductors and for theend-user products in which they are used) and declines in general economicconditions. These downturns have been characterized by diminished productdemand, erosion of average selling prices, production over-capacity and highinventory levels. For example, beginning in the fourth quarter of 2000 weexperienced a three-year downturn in our business cycle

 

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and are currently experiencing anotherdownturn. We believe that, in light of these events, some of our customerscurtailed and may in the future delay or further curtail spending ontechnology, which could negatively affect our quarterly results or financialcondition in the future.  Similareconomic downturn in the semiconductor industry could increase pressure on usto reduce our prices, which could impair our revenues, gross margins andoperating cash flow. From time to time, the semiconductor industry also hasexperienced periods of increased demand and production capacity constraints. Wehave in the past experienced substantial period-to-period declines in operatingresults, and will likely in the future experience substantial period-to-periodfluctuations in operating results that are attributable to semiconductorindustry conditions or events occurring in the general economy.

 

***Average selling prices in thesemiconductor industry typically decline over time, which directly affects ourrevenue and margins.***

 

Historically, average selling prices in thesemiconductor industry have decreased over the life of any particular product.To the extent that our products achieve market acceptance, competitorstypically seek to offer competitive products or embark on discount pricingstrategies. We have in the past and may in the future be required to reduce sellingprices in response to competition. From time to time technology andmanufacturing changes have the impact of lower average selling prices, such asthe conversion of hardware to software modems and packaged to die only sales.  If we are unable to offset any reductions inthe selling prices of our products by introducing new products at higher pricesor by reducing our costs, our revenues, gross margins and operating resultscould be impaired.  In addition, if the priceat which we can sell products in our inventory declines below the cost of suchproducts we may be required to write down the value of such inventory.

 

***A significant amount of ourrevenues comes from relatively few of our customers and distributors, and anydecrease of revenues from these customers and distributors, or the loss oftheir business, could significantly harm our financial results.***

 

***We depend on relatively fewdistributors for a substantial portion of our sales.***

 

Historically we have been, and we expect tocontinue to be, dependent on a relatively small number of distributors for asignificant portion of our revenues. We depend on third-party distributors tomarket and sell our products, and these third-party distributors accounted forapproximately 57% of our net sales for the third quarter 2005, 54% of our netsales for the nine-month period ended September 30, 2005, 50% of our netsales for 2004 and approximately 47% of our net sales for 2003. In addition,our five largest distributors accounted for approximately 45% of our net salesfor the third quarter of 2005, 43% of our net sales for the nine-month periodended September 30, 2005 and 41% of net sales for 2004. One distributioncustomer accounted for approximately 22% of our net sales for 2005, and 21% in2004 and was our number one customer for both 2005 and 2004. Our distributorsdecide whether to include our products among those that they sell, and they maycarry and sell product lines that are competitive with ours. Because ourdistributors are not required to make a specified minimum level of purchasesfrom us, we cannot be sure that they will prioritize selling our products. Wealso rely on our distributors to accurately report to us on a timely basistheir sales of our products and provide certain support services to ourcustomers.  Our inability to obtainaccurate and timely reports and to successfully manage these relationshipscould adversely affect our business and financial reports. Our distributors maynot continue to effectively market, sell or support our products.

 

***We depend on relatively fewmajor customers for a substantial portion of our sales.***

 

Our ten largest customers, excluding ourdistributors, accounted for approximately 31% and 35% of our net sales for thethree month and nine month periods ending September 30, 2005,respectively, 37% of our net sales for 2004, and approximately 38% of our netsales for 2003.  For the three monthperiod ended September 30, 2005, we had one distribution customer thataccounted for approximately 25% of our net sales and OEM customer thataccounted for approximately 7% of our net sales.  For the nine month period ended September 30,2005 we had one distribution customer that accounted for 22% of our net salesand one OEM customer that accounted for 10% of our net sales.  Concentration of net sales to particularcustomers may change from period to period, but we expect that sales to alimited number of customers will continue to account for a significantpercentage of our revenues in any particular period for the foreseeable future.We have very few long-term contracts with our customers, and, like us, ourcustomers typically compete in cyclical industries. We routinely purchaseinventory based on customers’ estimates of demand for their products, which isdifficult to predict.  Thus, ourcustomers may decide not to purchase our products at all, to purchase fewerproducts than they did in the past, or to alter their purchasing patterns

 

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on short notice, particularly because substantiallyall of our sales are made on a purchase order or sales order acknowledgmentbasis, which permits our customers to cancel, change or delay product purchasecommitments upon 30 days notice for standard products and 60 days notice forcustom products without paying a cancellation or rescheduling charge. Customersmay still cancel or reschedule within these time periods, however theyroutinely incur a cancellation or rescheduling charge. This cancellation riskis increased because our customers can purchase some similar products from ourcompetitors. 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 operationssubject us to risks inherent in doing business in foreign countries that couldimpair our results of operations.***

 

Approximately 58% of our net sales for thenine-month period ended September 30, 2005, approximately 48% of our netsales for 2004, and approximately 42% of our net sales for 2003, calculatedconsistent with revenue recognition of distribution revenue on a deferred(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 inovercoming the risks that relate to or arise from operating in internationalmarkets. Risks inherent in doing business on an international level include:

 

•                  economicand political instability;

 

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

 

•                  transportationdelays;

 

•                  powersupply shortages and shutdowns;

 

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

 

•                  existenceof language barriers and cultural distinctions;

 

•                  actsof God, including floods, typhoons and earthquakes;

 

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

 

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

 

In addition, our activities outside theUnited States are subject to risks associated with fluctuating currency valuesand exchange rates, hard currency shortages and controls on currency exchange.While our sales are primarily denominated in U.S. dollars, worldwidesemiconductor pricing is influenced by currency rate fluctuations, and suchfluctuations could harm our operating results materially.

 

The risks inherent in our internationaloperations have been increased by the threat of terrorist attacks.  These attacks, coupled with an internationalmilitary response, have created an uncertain economic environment, and wecannot predict the impact of these political threats or any related militaryaction, on our customers or our business.

 

***We have had a history oflosses, and we may not be profitable in the future.***

 

We have had a history of losses for each ofthe years in the five-year period ended December 31, 2004, excluding theone-time gain on extinguishment of debt and fresh-start adjustments in 2002. Wewere not profitable in the nine-month period ended September 30, 2005. Wemay not be profitable in the future.

 

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***We depend on key personnel, andthe loss of our current personnel or our failure to hire and retain additionalpersonnel could harm our business.***

 

We depend on our ability to attract and retainhighly skilled technical and managerial personnel. We believe that our futuresuccess in developing marketable products and achieving a competitive positionwill depend in large part on our ability to identify, recruit, hire, train,retain and motivate highly skilled technical, executive, managerial, marketingand customer service personnel. Competition for these personnel is intense,especially in Northern California, where our headquarters are located, and wemay not be able to successfully recruit, assimilate or retain sufficientlyqualified personnel. Our failure to recruit and retain necessary technical,executive, managerial, marketing and customer service personnel could harm ourbusiness and our ability to obtain new customers and develop new products. Inaddition, our history of losses and our bankruptcy filing could impair ourability to recruit and retain employees. We do not have employment contracts with any of our executive officersother than Mr. Grace and Mr. Sheridan. If we are unable to retain ourexecutive officers, including Mr. Thorburn as our Chief Executive Officer,our business may be harmed.

 

***We may fail to protect ourproprietary rights, and the cost of protecting those rights, whether we aresuccessful or not, may harm our ability to compete.***

 

The extent and value of our intellectualproperty is necessarily uncertain, and our efforts to protect our intellectualproperty rights may not be successful. Despite our precautions, a third partymay copy or otherwise obtain our devices or technology without authorization,requiring patent litigation to enforce our rights. Patent litigation is, by itsnature, expensive and unpredictable. If litigated, one or more of our patentsmay be found invalid or unenforceable or to have claims of such narrow scope asto be of little economic value. Third parties may design around our patents.Third parties may independently develop technology similar to our tradesecrets. In addition, the laws of some foreign countries where we have patentand trademark rights may not protect our intellectual property rights to thesame extent as the laws of the United States.

 

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

 

Litigation may be necessary to enforce ourintellectual property rights, to protect our trade secrets or to determine thevalidity and scope of our proprietary rights or the proprietary rights ofothers. Any such litigation could require us to incur substantial costs anddivert significant valuable resources, including the efforts of our technicaland management personnel, which may harm our business materially.

 

***The semiconductor industry ischaracterized by frequent litigation regarding patent and other intellectualproperty rights, both defensive and offensive.***

 

In addition to the Microchip lawsuitdescribed elsewhere, from time to time we have received, and may in the futurereceive, communications from other third parties asserting that a productoffered by us, or an aspect of our business, infringes a patent held by theother third party and/or requires a license thereto. With respect to those otherthird party communications that are currently pending, we believe, after havingconsulted with counsel, that either (i) we have meritorious defenses, (ii) basedon license terms previously offered to us or typically available in theindustry, we can obtain any necessary licenses on commercially reasonableterms, or (iii) we can modify our products to avoid such rights, but ifthis is not the case, we may be sued and assessed damages for pastinfringement. Indeed, licenses may not be available on commercially reasonableterms, or at all. In addition, we have certain indemnification obligations tocustomers with respect to the infringement of third party intellectual propertyrights by our devices.

 

We have received in the past a letter from anelectronic equipment manufacturer that makes products that are competitive tocertain of our key products, asserting that the sale of certain of our keyproducts may be infringing certain patents owned by them. After havingconsulted with counsel, we believe that we have meritorious defenses to theassertions set forth in the letter. However, should it become necessary toengage in litigation to defend against such assertions, such litigation couldbe expensive and time consuming. There can be no assurance that the ultimateresolution of this matter would not have a material adverse affect on ourbusiness.

 

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

 

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

 

Because the design and production process forsemiconductors is highly complex, we may produce products whose design deviatesfrom published specifications. In addition, one or more of our products may befound to contain production defects after we have already shipped suchproducts. These production defects could be caused by either raw materials orerrors in the production process. If errors or production defects arediscovered after we have already shipped one or more of our products in volume,we could be adversely affected in one or more of the following ways:

 

•                  replacementsor recalls could impose substantial costs on us;

 

•                  rumors,false or otherwise, may be circulated by the press and other media, which couldcause a decrease in sales of our products; and

 

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

 

***Changes in technologies orconsumption patterns could reduce the demand for our products.***

 

As a result of technological changes, fromtime to time our customers change the design of their products so as not to includeour products, which may have a negative impact on our net sales. For example,in 1999 and 2000, a number of our customers changed the designs of computermouse pointing devices that they manufactured, and as a result, these devicesno longer contain our products. Because we do not have long-term supplycontracts with most of our customers, changes in the designs of their productscan have sudden and significant impacts on our sales. For example, net sales ofour computer mouse pointing devices and other computer peripheral productsdecreased substantially from approximately $15.4 million in 2000 toapproximately $4.9 million in 2001, approximately $2.4 million in 2002, andapproximately $0.7 million for 2003 and approximately $0.1 million for 2004. Thesereduced sales due to design changes have harmed us in the past, and additionaldesign changes could result in lower revenues in the future.

 

***We have implemented significantcost cutting measures, and we may be required to implement additional cost cuttingmeasures depending upon our future revenues and operating results.***

 

We have implemented significant cost cuttingmeasures in the past, including during 2005. These cost cutting efforts haveincluded:

 

•                  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;

 

•                  refocusingour strategic priorities;

 

•                  reallocatingpersonnel and responsibilities to better utilize human resources;

 

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•                  reducingour workforce; and

 

•                  institutingtemporary office and facility shutdowns.

 

Cost cutting measures may not increase ourefficiency or lead to profitability.  Inthe past we have reduced our spending on research and development.  Reducing research and development spendingcould harm our ability to introduce new products in the future. If our revenueor operating results significantly decline in the future, we may be required toinstitute further cost reduction measures.

 

From time to time, we evaluate our strategicalternatives with respect to our facilities and we may take actions, such as thesales of the remaining assets of MOD II and our MOD III subsidiary, which mayresult in the occurrence of accounting charges. Some or all of these chargesmay be non-cash. Such charges would have a negative impact on our GAAPprofitability and may have a negative impact on our cash balance.

 

***We are subject to variousenvironmental laws and regulations that could have a material adverse effecton us.***

 

Under certain of these laws and regulations,current or previous owners or operators of property may be liable for clean-upcosts and other damages without regard to whether they knew of, or caused, thecontamination. The presence of, or failure to remediate, contamination couldadversely affect the value of, and the ability to transfer or encumber, our property.In addition, we may be required to incur significant expense in connection withgovernmental investigations of environmental or employee health and safetymatters.

 

***We may engage in acquisitionsthat could adversely affect our operating results, dilute our stockholders’equity, or cause us to incur additional debt or assume contingent liabilities.***

 

To increase our business and maintain ourcompetitive position, we have made acquisitions in the past and may do so inthe future. Acquisitions involve a number of risks that could harm our businessand result in the acquired business not performing 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;

 

•                  diversionof management time and attention from our core business to the acquired business;

 

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

 

•                  difficultiesin retaining relationships with suppliers and customers of the acquiredbusiness; and

 

•                  subsequentimpairment of the acquired assets, including intangible assets.

 

In addition, acquisitions could requireinvestment of significant financial resources and may require us to obtainadditional equity financing, which may dilute our stockholders’ equity, or toincur additional indebtedness.

 

***Acts of war or terrorism couldharm our business.***

 

The long-term effects of potential terroristattacks on the world economy and our business are unknown, but could bematerial to our business. Terrorist acts or acts of war, whether in the UnitedStates or abroad, also could cause damage or disruption to our business, oursuppliers, our freight carriers, or our customers, or could create political oreconomic instability, any of which could have a material adverse effect on ourbusiness.

 

***Failure to achieve and maintain effectiveinternal control over financial reporting in accordance with rules of theSecurities and Exchange Commission promulgated under Secion 404 of theSarbanes-Oxley Act or failure to maintain adequate disclosure controls and procedurescould harm our business and operating results and/or result in a loss ofinvestor confidence in our financial reports, which could in turn have amaterial adverse effect on our business and stock price.***

 

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Under rules of the Securities andExchange Commission promulgated under Section 404 of the Sarbanes-OxleyAct of 2002, beginning with our Annual Report on Form 10-K for the fiscalyear ended December 31, 2004, we were required to furnish a report by ourmanagement on our internal control over financial reporting.  In the course of our assessment of theeffectiveness of our internal control financial reporting as of December 31,2004, which assessment was conducted during the fourth quarter of 2004 and thefirst quarter of 2005 in connection with the preparation of 2004 auditedfinancial statements and our annual report on Form 10-K for 2004, weidentified two material weaknesses in our internal control over financialreporting which are more fully described under Item 9A, Controls and Proceduresin our Form 10-K for the year ended December 31, 2004.

 

In addition, in the course of our ongoing2005 evaluation of the effectiveness of the design and operation of ourdisclosure controls and procedures, we identified a failure to record andthereby disclose in our 2004 Form 10-K certain grants of options topurchase: (1) 160,000 shares of our common stock at an exercise price of$12.44 and; (2) 45,884 shares of our common stock at an exercise price of$5.20.  These grants were issued to ourChief Executive Officer in the second quarter of 2004 as more fully describedunder Item 4, Controls and Procedures, of our Form 10-Q for the periodended June 30, 2005.  A footnote tothe beneficial ownership table explaining the beneficial ownership of certainstock 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 financialreports, which in turn could have a material adverse effect on our stock price,and, if such weaknesses are not properly remediated, could adversely affect ourability to report our financial results on a timely and accurate basis.  Moreover, we continue to operate with arelatively small accounting staffing level. The loss of accounting personnel, particularly our chief financialofficer, would adversely impact the effectiveness of our control environmentand our internal controls, including our internal controls over financialreporting.  Additionally, we aremigrating 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 remediatedthese weaknesses and deficiencies and our disclosure control failure, we cannotassure you that this remediation has been successful or that additionaldeficiencies or weaknesses in our controls and procedures will not beidentified.  In addition, we cannotassure you that our independent registered public accounting firm will agree withour assessment that our material weaknesses have been remediated.

 

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

 

The Sarbanes-Oxley Act of 2002 that became law in July 2002required changes 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 andfinancial compliance 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 directorand officer liability insurance coverage, and we may be required to acceptreduced coverage or incur substantially higher costs to obtain coverage.  These new rules and regulations couldalso make it more difficult for us to attract and retain qualified members ofour board of directors, particularly to serve on our audit committee, andqualified executive officers.

 

***Changes in accountingprinciples generally accepted in the United States may adversely affect ourreported financial results or otherwise harm our business.***

 

We prepare our financial statements inconformity with accounting principles generally accepted in the United States.These accounting principles are subject to interpretation by the FinancialAccounting Standards Board, the American Institute of Certified PublicAccountants, the Securities and Exchange Commission and various bodies formedto interpret and create appropriate accounting policies. A change in thesepolicies or interpretations could have a significant effect on our reportedfinancial results, and could affect the reporting of transactions completedbefore the announcement of a change. For example, while current accounting rules allowus to exclude some expense of stock options from our financial statements,effective fiscal year 2006, the Company will be required to

 

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include the expenses of these options and the15% discount employees receive on purchase under the employee stock purchaseplan in the income statement in accordance with FAS 123R.   Technology companies generally, and ourcompany, specifically, rely heavily on stock options as a major component ofour employee compensation packages. Because we will soon be required to expense options, we may be lesslikely to achieve profitability or we may have to decrease or eliminate optionsgrants. Decreasing or eliminating option grants on our employee stock optionprogram may negatively impact our ability to attract and retain qualifiedemployees.  The impact may adverselyeffect our reported financial results.

 

***Changes in our businessconditions could result in impairment of our goodwill.***

 

In accordance with SFAS No.142 *Accounting for Goodwill and Other Intangible Assets* theCompany must perform at least an annual testing of the Company’s stated valueof its net assets including goodwill and other intangible assets in relation tothe implied fair market value of the Company. If the Company’s market capitalization or fair market value declines, wemay be required to record financial adjustments to the stated values of ourgoodwill and other intangible assets resulting in a material adverse effect onour financial condition and results of operations.

 

***Our North American distributorcould emphasize competing products, and we may lose some of our customers as aresult.***

 

In October 2002, we engaged FutureElectronics as our exclusive full-service distributor in North America.  Additionally, Future Electronics providesdistributor support to us in Europe and Asia on a non-exclusive basis.  For the nine months ended September 30,2005 and 2004, Future purchased approximately $13 million and $15 million,respectively, contributing approximately 22% and 20% to our net sales,respectively.  Future Electronicsdistributes products of our competition that may directly compete with ourproduct offerings. If Future Electronics chooses to promote those products overour products, our operating results could be harmed significantly. In addition,if Future Electronics were to terminate our distribution agreement, we couldexperience a period of significant interruption of our business while weobtained other distribution channels.

 

***Provisions in ourorganizational documents and Delaware law could discourage acquisitionproposals or delay a change in control that would be beneficial to ourstockholders.***

 

Our amended and restated certificate ofincorporation and bylaws contain anti-takeover provisions that could make itmore difficult for a third party to acquire control of us even if that changein control would be beneficial to our stockholders. These provisions include:

 

•                  providingfor a classified board of directors with staggered terms;

 

•                  limitingthe persons who may call special meetings of stockholders; and

 

•                  prohibitingstockholders from taking action by written consent.

 

In addition, provisions of Delaware law maydiscourage, delay or prevent someone from acquiring or merging with us.

 

***Our directors, named executiveofficers and our two largest stockholders, who beneficially own approximately33% of our common stock in the aggregate, may have interests that conflict withthe interests of our other stockholders.***

 

Our directors and named executive officers,together with five large stockholders, UBS Willow Management, L.L.C., fundsmanaged by Capital Research and Management Company beneficially ownedapproximately 33% of our outstanding common stock, in the aggregate, as of September 30,2005.  As a result of their ownership andpositions, our directors and named executive officers, together with UBS WillowManagement and Capital Research and Management Company, collectively are ableto significantly influence all matters requiring stockholder approval,including the election of directors and approval of significant corporatetransactions. Such concentration of ownership may also have the effect ofdelaying or preventing a change in control. If the ownership of our common stockcontinues to be highly concentrated, it may prevent you and other stockholdersfrom influencing

 

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significant corporate decisions. Theinvestment objectives of these stockholders may differ from those of our otherstockholders, including our future public stockholders.

 

**Item 3. Quantitative and Qualitative Disclosure About Market Risk**

 

**Interest Rate Risk**

 

Our exposure to market risk for changes in interest rates relatesprimarily to our short-term investment portfolio.  We do not use derivative financialinvestments in our investment portfolio. Our primary investment objectives are to preserve capital and maintainliquidity.  These objectives are met byinvesting in high-quality credit issuances and limiting the amount of creditexposure to any one company.  Our policyis to mitigate default risk by investing in only the highest quality securitiesand monitoring the credit ratings of such investments.  As of September 30, 2005, our cash andcash equivalents of $28.0 million were invested in bank time deposits and moneymarket funds.  We have no significantcash flow exposure due to rate changes for our cash equivalents as theseinstruments have very short maturities. The annualized average fixed interest rate for the three months ended September 30,2005 was approximately 2.35%.

 

**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.

 

**Item 4. Controls and Procedures**

 

**Evaluationof Controls and Procedures**

 

As of October 1, 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,  Mr. Thorburn and Mr. Graceconcluded that the Company’s disclosure controls and procedures operatedeffectively as of October 1, 2005 to ensure that information was properlycompiled, communicated and analyzed by management of the Company on a timely basisso that quality and timeliness of the Company’s public disclosures comply withits SEC disclosure obligations**.**

 

**Changes in Internal Controls**

 

There have not been any changes in the Company’s internal control overfinancial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) underthe Exchange Act) during the most recent fiscal quarter that have materiallyaffected, or are reasonably likely to materially affect, the Company’s internalcontrol over financial reporting.

 

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**PART II**

 

**OTHER INFORMATION**

 

**Item 1.  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 unspecified productsof 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 claimsand challenging the validity of the patents. A hearing has been scheduled for November 17th,2005.

 

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.

 

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

 

We are participating in other litigation andresponding to other claims arising in the ordinary course of business.  We intend to defend ourselves vigorously inthese matters.  Our management believesthat it is unlikely that the outcome of these other matters will have amaterial adverse effect on our financial statements, although there can be noassurance in this regard.

 

**Item 2. Changes in Securities, Use of Proceeds and Issuer Proceeds of EquitySecurities**

 

On July 29,2004, ZiLOG announced that its board of directors has authorized a stockrepurchase program pursuant to which ZiLOG may repurchase up to $5,000,000 inmarket value of its outstanding shares of common stock. ZiLOG’s common stocktrades on the NASDAQ National Market and purchases under the program are made,from time-to-time, in the open market, through block trades or otherwise.Depending upon market conditions and other factors, these purchases may becommenced or suspended at any time or from time-to-time without prior notice.  As of September 30, 2005, Zilog hadrepurchased a total of 572,100 shares costing $4.4 million.

 

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

 

None.

 

**Item6.  Exhibits**

 

a)     Exhibitsare filed or incorporated 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.                                                   |

 

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| 3.2 (b) |   | Amended and Restated Bylaws of  ZiLOG, Inc.                                                                                                                                                                                   |
|---------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|    |   |                                                                                                                                                                                                                               |
| 4.1 (c) |   | Form of Restricted Stock Purchase  Agreement.                                                                                                                                                                                 |
|    |   |                                                                                                                                                                                                                               |
| 4.2 (c) |   | Form of Non-Qualified EBITDA-Linked  Option Grant Agreement.                                                                                                                                                                  |
|    |   |                                                                                                                                                                                                                               |
| 4.3 (c) |   | Form of Non-Qualified  Non-EBITDA-Linked Option Grant Agreement.                                                                                                                                                              |
|    |   |                                                                                                                                                                                                                               |
| 4.4 (d) |   | Form of 2004 Non-Qualified Option  Grant Agreement, Date of Grant.                                                                                                                                                            |
|    |   |                                                                                                                                                                                                                               |
| 4.5 (d) |   | Form of 2004 Non-Qualified Option  Grant Agreement, Date of Hire.                                                                                                                                                             |
|    |   |                                                                                                                                                                                                                               |
| 4.6 (d) |   | 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  November 10, 2005.              |
|    |   |                                                                                                                                                                                                                               |
| 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  November 10, 2005.             |
|    |   |                                                                                                                                                                                                                               |
| 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 November 10, 2005. |

 

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

 

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

 

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

 

(d)                                 Incorporatedherein by reference to the item of the same name filed as an exhibit to theCompany’s Quarterly Report on Form 10-Q filed with the Commission on 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:  November 10, 2005

 

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